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“Cryptocurrency” has become a part of our vocabulary and plays an increasingly important role in our economy year after year. In 2020, the asset class is still considered relatively new and the term is often misunderstood. In this article, we hope to offer clarity by presenting some basic crypto facts, and answering a few common questions: What is cryptocurrency? How does one obtain it? Additionally, we will discuss how to discover if cryptocurrency is being concealed during divorce litigation.

Basic terminology and facts:

1. What is Cryptocurrency? Cryptocurrency is a digital currency exchanged between peers without requiring a third party, such as a bank or financial institution. It enables consumers to digitally connect through a transparent digital process that reveals the value of transactions, but not the identities of those conducting them. Networks consisting of a chain of computers approve cryptocurrency exchanges, preventing the duplication of transactions and potentially reducing the possibility of fraud.

2. Three Main Categories of Cryptocurrency. Bitcoin, Altcoins, and Tokens. Bitcoin (BTC) was the first cryptocurrency, created and launched in 2009. Bitcoin is a global peer-to-peer electronic payment system that allows parties to transact directly with each other without the need for an intermediary such as a bank. Bitcoin’s release paved the way for thousands of other cryptocurrencies to be created, otherwise known as ‘alternative coins’ or ‘altcoins’ that use a variation of the bitcoin blockchain or a different underlying blockchain technology (for example Ethereum). Unlike Bitcoin and Altcoin, tokens cannot operate independently and are dependent on the network of another cryptocurrency, which means they are built on top of an existing cryptocurrency’s blockchain (for example an ERC20 token on the Ethereum blockchain). 

3. What is a Blockchain? Blockchain is the technology that records and stores data across multiple computer systems linked by a peer-to-peer network and was introduced alongside Bitcoin, as a method of recording transactional data – namely, in blocks that are linked together to form a chain. As the number of transactions grows, so does the blockchain. Blocks record and confirm the time and sequence of transactions, which are then logged into the blockchain, a discrete network governed by rules agreed upon by network participants. Think of blockchain as an operating system, such as Microsoft Windows or MacOS, and bitcoin as one of the many applications that can be run on that operating system.

4. Cryptocurrency Wallets. Some types of cryptocurrencies can be stored in a shared wallet, but many forms of cryptocurrency have their own wallets. For example, if you purchase Bitcoin, then you will have a Bitcoin wallet.

5. Hot and Cold Wallets. Hot wallets have been or are connected to the internet; so they are more accessible but less secure. Hot wallets are either (1) downloaded and installed on a PC or laptop and accessible only from the computer on which they are downloaded, (2) accessible online from any device via the cloud, or (3) mobile, running on a phone app that can be used anywhere, including retail stores.

Cold wallets (commonly referred to as cold storage) are kept offline. They are less accessible, but more secure. A user’s private and public access keys are either (1) stored on a hardware device (such as a USB) or (2) recorded on a physical printout.

6. Cryptocurrency ATMs. Just like a bank ATM, one can buy cryptocurrency at a stationary exchange with cash or a credit card. Some ATMs will verify the identity of its users by requesting a phone number, then send that number a text message with a code to enter into the machine. The ATM will then ask for a cryptocurrency wallet address. If no wallet address has been established, the ATM will create one. Once the ATM has processed the cash or credit card payment, cryptocurrency will be sent to a cryptocurrency wallet.

7. Cryptocurrency Keys. Each wallet has a public and private key. In simple terms, one can think of a public and private key just like an email account or bank login; the public key is like a username or email address, while the private key is like a password. Sending coins from one wallet to another requires a private key. If a private key is lost or destroyed, the wallet may be permanently inaccessible – meaning those funds will be lost. If a private key is stolen, funds can be taken from their rightful owner, who will have no recourse as cryptocurrency transactions are irreversible.

How do I know if my client or his/her spouse has cryptocurrency?

Cryptocurrency can be hard to find unless the buyer of the cryptocurrency purchases coins with a bank or credit card account, or via a financial exchange.

1. Bank and Credit Card Statements: The first place to look would be monthly/periodic bank and credit card statements. One may also consider reviewing Venmo and PayPal account activity and transactions. Finding transfers to or from a cryptocurrency exchange is evidence that someone has been transacting in cryptocurrency, and will open the door for additional discovery for exchange account records. Further, one can look for any purchases of hardware devices such as Ledger, Trezor or KeepKey.¹

2. Tax Returns: Reviewing tax returns may also reveal whether or not a client is transacting in cryptocurrency. According to IRS Notice 2014-21, 2014-16 I.R.B. 938 (March 25, 2014), cryptocurrency is considered property (and not currency) by the IRS. Therefore, for tax purposes, cryptocurrency transactions of individuals are generally reported as capital gains or losses assuming that the cryptocurrency qualifies as a capital asset in the hands of the taxpayer. For example, stocks, bonds, and other investment property are generally capital assets. A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer. Inventory and other property held mainly for sale to customers in a trade or business are examples of property that are not capital assets. Assuming that the cryptocurrency will be characterized as a capital asset in the hands of the taxpayer, which will generally be the case subject to the foregoing sentence, an individual would then have to report cryptocurrency transactions in their personal income tax return, Form 1040, Schedule D, as capital asset sales. While merely purchasing and holding cryptocurrency is not a taxable transaction, each time an individual sells cryptocurrency or makes an acquisition using cryptocurrency, that transaction is characterized as the sale of property for federal tax purposes and should be reported in an income tax return. If an individual is paid (as an employee or subcontractor) in cryptocurrency, that individual should also be provided a Form W-2 or Form 1099 that values the payments in dollars as of the date the payments were made.

Beginning in 2019, U.S. individual taxpayers are required to “check the box” on Schedule 1 to Form 1040 to disclose whether or not they received, sold, sent, exchanged, or otherwise acquired any financial interest in any cryptocurrency (referred to as “virtual currency” by the IRS). The IRS has found that taxpayers are claiming far less than they actually hold or trade. As a result, the IRS was granted access to all Coinbase (the most commonly used domestic exchange) transactions valued at more than $20,000 by a U.S. Federal judge in 2017, to identify transactions and issue letters to taxpayers (see United States v. Coinbase).² Right now, it is difficult for the IRS to conduct similar investigations of foreign cryptocurrency exchanges.

3. Subpoenas: It might be possible to subpoena account records from cryptocurrency exchanges. Be aware that many cryptocurrency exchanges are not U.S. based; therefore, obtaining documents from them might prove challenging. Further, it might be possible to depose individuals or business partners who might have paid cryptocurrency to any parties involved in a dispute.

4. Public Blockchain: If one is able to obtain any public addresses, the historical transactions related to those public addresses are publicly viewable on the blockchain. The blockchain can be searched online via many free websites. Keep in mind that each cryptocurrency has its own blockchain and some cryptocurrencies have been designed for privacy, therefore not all of the underlying information would be visible on the public blockchain.

5. Physical Inspection of the Marital Residence: If the client still has legal access to the marital residence, items there could indicate the ownership of cryptocurrency. Clients can be instructed to look for evidence of paper wallets such as private keys, public addresses, QR codes and seed phrases. Specifically, the client should look for any written strings of alpha-numeric characters or random strings of words. Seed phrases are typically a listing of seemingly random words (typically 12, 18, or 24 words long). Clients can also look for hardware devices which store a user’s public and private keys on them, such as Ledger, Trezor or KeepKey.³

6. The Spouse’s Electronic Devices: If a party is making an intentional, careful, well-researched effort to hide marital assets, he or she might be able to avoid leaving a paper trail. In that case, the last remaining recourse is to obtain and search the spouse’s electronic devices with the help of a computer forensic expert. This can often be done through the court discovery process. If this is not preferred or not possible, attorneys should consider the legal implications of the potential clandestine forensic imaging of the spouse’s electronic devices (see Byrne v. Byrne)⁴ - assuming the client still has legal and physical access to them. 

Computer forensic experts are able to search for evidence of cryptocurrency use—such as public addresses, private keys, software wallets, internet history and emails that might include cryptocurrency trade confirmations or other relevant information—on electronic devices.

How do I know what to ask for?

Because it is elusive and difficult to find, cryptocurrency will require special attention when clients or adversaries are not forthcoming regarding the disclosure of their assets. One may consider including language specific to cryptocurrency holding in discovery demands or interrogatories. A few examples may include requests for:

a. Forms 1099-K issued by exchanges.
b. List of all digital assets/digital currencies that you hold, receive, accept, utilize, purchase or sell as of [specify date(s)].
c. List all computer hardware (and its physical location(s)) and software devices which you use, or have previously used, to accept, transfer or store virtual or digital assets.

Consider hiring a forensic accountant:

If you suspect that your client or an adversary’s client is hiding cryptocurrency, you may wish to hire a forensic accountant to assist you in your case. Friedman, in conjunction with our affiliate company CyZen, has developed the sophisticated infrastructure necessary to trace blockchain transactions.⁵

The technological concepts illustrated in this article may be equally relevant in other types of legal disputes, both civil and criminal, involving transactions, money laundering allegations and business valuation calculations.

Friedman’s Forensic Accounting, Litigation and Valuation Services (FLVS) Practice and cybersecurity professionals stand at the forefront of the technology industry. We are ready to assist.

[1]  Types of hardware wallets which are special types of bitcoin wallets which store the user’s private keys in a secure hardware device.

[2]  United States v. Coinbase, Inc., 2017 U.S. Dist. LEXIS 196306 (Nov. 28, 2017).

[3] Before accessing the information contained in privately owned devices, litigants should first check with their lawyers about any potential legal ramifications including the legality of accessing information without the permission of the spouse to which it may legally belong. 

[4] Byrne v. Byrne, 315 Mich. 441 (Mich. 1946).

[5] IBID.