Bitcoin – Coming Back to Bite You?

In November last year, the Internal Revenue Service (IRS) issued a so-called John Doe Summons to “Coinbase”,  the largest digital currency exchange firm in the US and the largest exchanger in the United States of bitcoin into US dollars.  The IRS was seeking the records of all US customers who bought virtual currency from Coinbase in the period 2013 to 2015.  The John Doe summons sought a veritable galaxy of documents from Coinbase; it can be accessed here.

With a John Doe summons there is no specific allegation of wrongdoing.  Nevertheless, the compliance costs for Coinbase in meeting this particular IRS summons would be huge, let alone issues of privacy that are raised by the breadth of information requested in the summons. Coinbase would have to produce or re-create an extremely significant volume of highly detailed records including for example, records pertaining to every account wallet or vault owned or controlled by a user, the complete user profile, history of changes to user profile, user preferences, security settings, user payment methods, and any information related to the funding sources for the account; records pertaining to customer due diligence (e.g., KYC rules) and so on.  (The information requested goes on for pages and can be found commencing page 13 of the John Doe summons issued to Coinbase).

Coinbase has refused to comply with the summons claiming that the IRS demands are illegally broad.  This led the IRS to file a lawsuit in March in the United States District Court in San Francisco to enforce the summons.  An affidavit from IRS agent David Utzke was filed to persuade the court to enforce the IRS summons.  The affidavit provides some insight into how the IRS is carrying out its investigation. Straight from the horse’s mouth, here’s what the IRS agent had to say:

IRS Agent Affidavit – Sparse Tax Compliance for Virtual Currency Transactions

It was revealed in the affidavit that the IRS maintains various databases with information from filed tax returns. One database, the Modernized Tax Return Data Base (MTRDB), contains some of the information reported on tax returns that are e-filed. Capital gain or loss for property transactions are reported on Form 8949, which is attached to Schedule D of a taxpayer’s Form 1040. The Form 8949 includes a section for the description of the property sold, and this information is captured in the MTRDB and can be queried using search terms. As further discussed below, gains and losses from virtual currency are considered as arising from a property transaction.

IRS agent Utzke searched the MTRDB for Form 8949 data from e-filed tax returns, for the tax years 2013 through 2015.  In each of these years, e-filed tax returns accounted for at least 83% of the total number of filed tax returns.  Agent Utzke’s analysis found that in 2013, out of 122.5 million tax returns electronically filed, only 807 individuals filed a Form 8949 to account for a “property description likely related to bitcoin.”  In 2014 this number rose to 893 out of 125.8 million e-filed returns. In 2015, only 802 individuals filed a Form 8949 to account for a bitcoin property related description out of 128.8 million e-filed tax returns.  Based on these numbers it appears there is a very low level of tax compliance with regard to virtual currency transactions.

Tax Treatment of Virtual Currency

Blockchain application is a prime example of how technology has simply outpaced the law. There is only some bare-bone guidance from the IRS covering how the most high profile blockchain technology, that is, virtual currency, is to be treated for US tax purposes.

In 2014, the IRS announced in Notice 2014-21 that virtual currency is to be treated as “property” and not “currency” for US federal tax purposes.  Even though virtual currency operates like “real” currency — i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance — it does not have legal tender status in any jurisdiction.  Virtual currencies that can be converted into traditional currency are “property” for US income tax purposes. This means a taxpayer can have a gain or loss on the sale or exchange of a virtual currency, depending on the taxpayer’s cost to purchase the virtual currency (i.e., his so-called tax “basis” in the property).

That’s all the tax guidance we have at the moment.  More is needed on how to treat virtual currency transactions, especially since some US courts have held that “bitcoin” is money for other regulatory purposes, in complete divergence from the IRS tax position. See e.g., US v. Faiella 39 F. Supp.3d 544 (2014) and U.S. v Murgio et al, U.S. District Court, Southern District of New York, No. 15-cr-00769 (2016).

Tax Reporting

Sophisticated players will understand the tax concepts of basis and gains or losses with regard to virtual currency exchanges.  Whether the average taxpayer can be expected to understand the tax implications of virtual currency and properly report it on a tax return is another question.  Personally, I don’t know very much about blockchain, bitcoin and other virtual currencies. I do know that virtual currencies can be used to maintain anonymity and that current tax rules do not require any type of 1099 or similar reporting by the digital currency exchange firm. These factors mean that virtual currencies can be very attractive for those with nefarious purposes in mind.  Tax evasion included.

But, not everyone using bitcoin is a tax evader! A good example is the use of virtual currency by credit card companies as loyalty points for customers.  End-users can exchange their loyalty points into other digital value which can be used at any location. The same system can be used for regional currencies; this means that the blockchain-based product can work globally and potentially everywhere digital currencies exist and are accepted.

As for the average taxpayer, I have yet to see a “tax organizer” mentioning digital currency transactions and remember, at the moment (although this will certainly change), the digital currency exchange firm has no duty to send a Form 1099 or W-2 type of report to the individual who has an account or “wallet” with the firm detailing his transactions in digital currency.  Reports such as a Form 1099, set out in detail the particular transaction that a taxpayer must report on his or her tax return (e.g., dividends paid, stocks sold and so on).  Copies of the Form are sent to the IRS. These forms greatly assist taxpayers in preparing their tax returns because they make the information readily accessible and easy to understand.

Certainly, change is on the tax horizon for virtual currencies.  The Treasury Inspector General for Tax Administration (TIGTA) released a report on September 21 2016: Rising Use of Virtual Currencies Requires IRS to Take Additional Actions to Ensure Taxpayer Compliance in which it made three recommendations. The IRS agreed with TIGTA’s recommendations and plans to develop a virtual currency strategy, including an assessment of whether changes to information reporting documents are warranted.

Call to Action

Coinbase said it has not produced any records in response to the IRS summons, and stated it would continue to fight against its scope.  Taxpayers who are not in tax compliance due to virtual currency transactions with Coinbase will still need to act relatively quickly to ascertain their situation.  The Coinbase matter is also a wake-up call to those with transactions at other virtual currency exchanges.

If any Coinbase user wishes to enter an IRS Voluntary Disclosure program, they need to do so before Coinbase releases names and other information pursuant to the John Doe summons.  The issuance of the John Doe summons alone, does not disqualify a taxpayer from making a voluntary disclosure, but time may not be on the side of the errant taxpayer.

The Future

For those with an interest in the promising future for blockchain, Poyner Spruill enlightened me on its potential uses, copied below. In a word, they are breathtaking! And with these strides in development, the tax law will simply have to keep up.

First, faster settlement. Transactions through the Automated Clearing House take two to three days; blockchain could cut this time to a second.

Second, lower transaction costs. As a frame of reference, companies like Western Union charged approximately $36 billion in fees to move money in 2015 – a blockchain-based funds transfer system would cost a fraction of that.

 Third, facilitating bilateral contracts. Blockchain technology can be programmed to permit automatic release of funds upon the satisfaction of certain conditions, functioning as an electronic escrow. Honduras and the Republic of Georgia have been piloting programs to incorporate blockchains into their land registries. Sweden has likewise taken tentative steps in that direction. Other countries will almost certainly follow.

Fourth, corporate governance. Corporate law has long dealt with the fact that publicly traded securities are typically not held in the name of the beneficial owner. The Delaware Blockchain Initiative has launched a pilot project that will soon enable Delaware corporations to issue shares using distributed ledger technology. This change will permit beneficial owners to assert greater control over the direction of the corporation while preserving the ability to efficiently transfer shares in the public markets.

Fifth, global financial change. Billions of people have smartphones, but only a fifth of them have bank accounts. Blockchain technology could potentially open the global financial system to the billions of unbanked who still require financial services. The remote Saharan farmer with a herd of cattle and a smartphone is about to have a vista of potential opportunities open before him.

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