Serving as a second layer on top of Bitcoin, enabling cheap and fast private payments, the Lightning Network has ushered in new businesses, projects and users to the space. But while Bitcoin’s Lightning Network seems to be proving itself a valuable solution (with exponential year-over-year growth in the total number of channels), new challenges have emerged with the implementation of this new technology.
Just when it seemed like accountants, auditors and tax professionals were beginning to understand the base layers of the Bitcoin network, the implementation of the Lightning Network unleashed an entirely new set of unresolved accounting, audit and tax challenges.
Audit Implications of the Lightning Network
Auditors used to look at the blockchain (typically using an explorer) to prove the existence of a Bitcoin transaction. However, that changed with the arrival of the Lightning Network. Since all transactions besides the opening and closing transactions occur “off chain,” auditors will need to understand and employ new strategies to confirm balances represented by a client within a payment channel.
Operationally, this process works great for second layer Bitcoin transactions. However, an auditor may have challenges confirming a client’s balances within a payment channel — a challenge technology will likely solve. Since these transactions are “off chain,” the traditional procedure of verifying transactions with a block explorer is unavailable. Furthermore, an auditor may have challenges confirming the true “current state” of the channel. In particular, a client could represent an “old state” of the channel as being the most current to the auditor thus overstating assets.
Lightning Network Tax Implications
While many important tax issues still remain due to the lack of guidance by the IRS, the Lightning Network introduces a variety of unique challenges. In particular, when does a transaction actually occur? Does the updating of a transaction between parties within a payment channel constitute a taxable event? Or would the “taxable event” wait until the channel closes and the transfer of funds is represented on chain? These are difficult questions, especially when you consider that a payment channel can be opened with any amount of bitcoin, and for a prolonged amount of time (theoretically forever).
From a speculative perspective, if the IRS follows the American Institute of Certified Public Accountants’ recommendation of implementing a de minimis amount for transactions, it would mean users wouldn’t have to worry about the tax implications for small purchases. Hypothetically, this would enable the Lightning Network to become tax free, with users repeatedly transferring funds right under the de minimis amount to avoid the tax liability. This could be advantageous for Bitcoin but could also be taken advantage of, prompting a secondary response from the IRS.
Lightning Network Accounting Implications
In essence, when users enter into a payment channel with another party, the funds enter a two-of-two multi-signature wallet. Each channel participant owns one half of the keys used to govern the channel. On an operational level, the Lightning Network ensures transactions within the channel are adhered to using hash time locked contracts, breach remedy contracts and revocable sequence maturity contracts.
However, how should these be accounted for in a company’s books? Should the funds in a payment channel be treated like escrowed funds in a “restricted cash” account? Should the bitcoin in a payment channel be complemented with a liability because the funds could seem as “encumbered” by the two-of-two multi-sig? These questions remain unanswered and are bound to exacerbate in the coming years.
Bitcoin Accounting Meets Technology
As the complexities with cryptocurrency transactions amplify in the coming years, accounting professional and companies alike will have to place a heavier reliance on automated technologies. Companies today, such as Blox, provide end-to-end solutions will serve as the first generation of automated software for cryptocurrency accounting and tax preparation. The automation, organization and sophistication of technology will play a significant role in ensuring that accounting, tax and business professionals have access to accurate calculations, reporting and tools to solve emerging challenges. For example, the technology can be used to exclude payments under the potential de minimis amount for tax purposes and track this exclusion automatically.
A Blox report on cryptocurrency accounting found that automated technology, a lack of complete user historical data and official guidance for financial institutions are the most prominent challenges immediately affecting today’s accounting and tax professionals. When introducing the Lightning Network’s unique approach, the challenge becomes even more difficult for companies seeking to solve these issues by leveraging technology. Needless to say, the future of cryptocurrency accounting is unique and full of great potential.
Ultimately, Bitcoin’s Lightning Network and the cryptocurrency community across the globe will need to come together if solutions are to be implemented and made viable. The interaction of so many complex moving parts is sure to create more questions and more challenges for businesses, professionals and investors, but that will be accompanied by many more opportunities.
This is a guest post by Michael Sasson, marketing and communications manager at Blox, and Jeremy Nau, CPA, CBP and senior manager in the blockchain practice at Armanino. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.