As an investor in cryptocurrency, I have extensive knowledge of the various types of cryptocurrency, and what each one is designed to do, and as an accounting professional, I keep up on the tax implications of Bitcoin and Cryptocurrency. However, even with the gain in popularity with-in the last year, the idea of ‘Bitcoin’ is foreign to most, including the IRS! They have committed resources to learn, regulate, and gain an understanding of what  ‘Cryptocurrency’ should be classified as, capital asset with capital gains, like stocks, or assets and taxed at individual rates. All they know is with potential for large gains, comes their chance to get big tax dollars! Read our latest Bitcoin tax news.  But, let’s take a step back for a moment to answer the question: What is Bitcoin?  To answer this, let’s explore this illustrative example posted at

What is Bitcoin?

Released as an open-source software in 2009, Bitcoin is often credited as the world’s first cryptocurrency and is best defined as a digital currency that only exists electronically.

Bitcoin is decentralized, meaning it doesn’t have a central issuing authority or political institution that controls the amount of bitcoin in circulation. But the Bitcoin platform is far from anarchy.

The whole process is pretty simple and organized: Bitcoin holders are able to transfer bitcoins via a peer-to-peer network. These transfers are tracked on the “blockchain,” commonly referred to as a giant ledger. This ledger records every bitcoin transaction ever made. Each “block” in the blockchain is built up of a data structure based on encrypted Merkle Trees. This is particularly useful for detecting fraud or corrupted files. If a single file in a chain is corrupt or fraudulent, the blockchain prevents it from damaging the rest of the ledger.

Instead of relying on a government to print new currency, Bitcoin’s blockchain programming handles when bitcoins are made and how many are produced. It also keeps track of where bitcoins are and ensures the transactions are accurate.

There are currently about 17 million bitcoins in circulation. There isn’t a central regulatory agency or government controlling the supply of bitcoins, meaning the supply is controlled by design. The total supply to ever be created is capped at 21 million bitcoins.

This cap raises an argument that Bitcoin could have problems scaling. However, since Bitcoin is essentially infinitesimally divisible (meaning users can transfer as little as 0.00000001 bitcoins), this doesn’t really create a scaling issue. The magic number of 21 million is arbitrary.

It’s believed that Bitcoin was designed to become a deflationary currency to combat the government’s use of inflation as a hidden taxation to redistribute earned wealth. Many people praise Bitcoin for empowering the people by overthrowing the currency printing powers of transient politicians.

How Does Bitcoin Work?

One of Bitcoin’s most appealing features is its ruthless verification process, which greatly minimizes the risk of fraud. Since Bitcoin is decentralized, volunteers—referred to as “miners”—constantly verify and update the blockchain. Once a specific amount of transactions are verified, another block is added to the blockchain and business continues per usual.

What is “Mining”?

Instead of a single central server verifying every transaction, essentially every other person on the network verifies each transaction.

Cue the “miners.”

Let me simplify the process so we all understand: Miners are presented with a complicated math problem and the first one to solve the math problem adds the verified block of transactions to the ledger. The calculations are based on a Proof of Work (POW), or the proof that a minimum amount of energy was spent to get a correct answer.

There aren’t actual human beings hunched over computers with scraps of notebook paper and calculators doing pre-calculus homework; hardware is used to perform Bitcoin mining.

Bitcoin’s built-in reward system compensates successful miners with a chunk of bitcoins. The reward changes over time per Bitcoin’s programming, and the block reward halves about every four years. The current reward for each new block of verified transactions is about 12.5 bitcoins.

The mining processes have become increasingly sophisticated. The most popular method uses ASICS–Application-Specific Integrated Circuits. ASICS are hardware systems similar to CPU computers that are built for the sole reason of mining bitcoins.

Bitcoin mining operations take a lot of effort and power, and the sheer amount of competition makes it difficult for newcomers to enter the race and profit. A new miner would not only need to have adequate computing power and the knowledge to use it to outcompete the competition, but would also need the extensive amount of capital necessary to fund the operations.

A Simple Bitcoin Transaction Example

While Bitcoin’s underlying technology may seem hard to grasp, using Bitcoin does not have to be difficult.  Here’s an example of how simple a real world Bitcoin transaction can be.

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