Ka-Ching! IRS Seeks to Cash in On Bitcoin

In November, 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.  According to an attorney familiar with the case, the IRS is seeking the records of all US customers who bought virtual currency from Coinbase in the period 2013 to 2015.  The John Doe summons can be accessed here.

What is a John Doe Summons?

The John Doe Summons has proved to be a very powerful IRS weapon in the battle against tax evaders whose identities are not known at the time.  A John Doe summons is unlike the traditional summons used routinely by the IRS in its tax investigations. Since a traditional summons must identify the taxpayer whose conduct is in question, it is of  limited value when the taxpayers are not known. In recent years, the IRS has used the John Doe summons in connection with uncovering those with undisclosed offshore accounts.  The John Doe summons is used when the IRS does not have the names of particular identifiable US persons, but nonetheless seeks to flush out Americans believed to be hiding accounts, transactions or other assets.  A “John Doe Summons” generally directs the recipient (here, Coinbase) to produce records identifying “all US persons” who conducted specified transactions or who maintained accounts. 

The John Doe Summons Issued to Coinbase

In the Coinbase summons, IRS is asking Coinbase to identify all US persons who transacted in convertible virtual currency at any time with the company, during the stated time frame. The summons directs Coinbase to provide information “for each Coinbase user for which your records show any U.S. address, U.S. telephone number, U.S. e-mail domain, or U.S. bank account.…” The information requested is extraordinarily broad and includes such items as 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 summons.  It remains to be seen if Coinbase will attempt to limit the scope of the information requested by the IRS by either petitioning the court or engaging in discussions with the IRS.

Implications for US Taxpayers

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.

The IRS Notice means that the general tax principles that apply to property transactions will apply to transactions using virtual currency.  Among other things, this means according to the IRS, that:

  • Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes.
  • Payments using virtual currency made to independent contractors and other service providers are taxable and self-employment tax rules generally apply.  Normally, payers must issue Form 1099.
  • The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
  • A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property. 

Tax Evasion and Virtual Currency

With virtual currency there is a strong likelihood of tax under-reporting since it is easy for the participants and the transaction to remain undetected and anonymous.  Instead of maintaining a secret offshore bank account, perhaps a virtual wallet will do.  If you have an account at Coinbase, for example, there are no FBARs, no Form 8938 to file….. sounds enticing!

Virtual currency exchanges are not required to report the trading activities of their users to the IRS; thus, the government cannot easily know what a taxpayer may have earned or lost in trading virtual currencies since third-party reporting is currently lacking (let’s see how long that lasts). Taxpayers who are self-employed can easily “forget” to declare all of their income when paid in cash. Virtual currency expands this opportunity  as it allows payment from all around the globe and eliminates the need to handle large amounts of cash. The individual can easily accept bitcoins for his or her services from anyone in the world, and just as easily, neglect to declare all of it. 

It is clear that through issuance of the John Doe summons, the IRS  wants customer names and other data so that it can compare what is gathered to taxpayer filings, followed by the opening of civil tax audits or criminal investigations.  Certainly the IRS will be very interested in any cases when virtual currency transactions involve foreign financial institutions, or foreign entities such as offshore corporations or trusts.  

Taxpayers who are not in tax compliance due to virtual currency transactions with Coinbase will need to act relatively quickly to ascertain their situation.  If they wish 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 is not on the side of the errant taxpayer. 

Let’s see if the Coinbase matter will bring some currency to US Treasury coffers. Taxpayers owing tax and penalties should note, however, that payments in Bitcoin are not acceptable! 

Those wishing further information about this case can access the IRS petition to serve the John Doe Summons, here; the Memorandum in support of the petition, here and the IRS Agent’s Declaration in Support of the Petition, here. The IRS Agent’s Declaration contains volumes of information about the workings of virtual currency and the challenges it poses for the taxman. Well worth the read.

Is Regulation On the Way?

In my view, regulation will clearly be forthcoming in this area. The Treasury Inspector General for Tax Administration (TIGTA) released a report dated 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. The IRS also agreed that additional guidance would be helpful and plans to share the recommendation with the IRS’s Office of Chief Counsel for coordination with the Department of the Treasury’s Office of Tax Policy.

Taxpayer Seeks to Quash the John Doe Summons

A Coinbase user, Jeffery K. Berns, who is also an attorney, just asked the court on December 13 to set aside the summons.  You can read his motion to intervene and to quash the summons here.  In seeking to quash the summons, Berns is what is called an “intervenor”, which means generally that court approval is required for his action. Berns hopes the court will completely set aside the summons, or, alternatively, that the court will narrow its breadth. He bases his request on various points including that the summons may subject Coinbase customers to possible hacking of their accounts, and will have a “chilling effect” on blockchain technology.  A hearing is scheduled in January.  

Watch this space!

Follow me on Twitter: @VLJeker



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