Cryptocurrency and taxes

About 10 to 15 years ago, the IRS began serving “John Doe” warrants to foreign banks to compel those banks to release the names of account holders on certain bank accounts. This was followed by a tough crackdown by the Service on taxpayers who failed to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), which certain foreign bank account holders are required to file (and face stiff penalties for not filing, including jail time).

On Nov. 30, 2016, a federal judge in the Northern District of California granted an IRS application to serve a John Doe summons on Coinbase Inc., which operates a virtual currency wallet and exchange business (In re the Tax Liabilities of John Does, No. 3:16-cv-06658-JSC (N.D. Cal. 11/30/16) (order granting ex parte petition)). This was done under the authority of Sec. 7609(f):

(f) Additional requirement in the case of a John Doe summons: Any summons . . . which does not identify the person with respect to whose liability the summons is issued, may be served only after a court proceeding in which the Secretary establishes that—

(1) the summons relates to the investigation of a particular person or ascertainable group or class of persons,

(2) there is a reasonable basis for believing that such person or group or class of persons may fail or may have failed to comply with any provision of any internal revenue law, and

(3) the information sought to be obtained from the examination of the records or testimony (and the identity of the person or persons with respect to whose liability the summons is issued) is not readily available from other sources.

Coinbase, a digital asset exchange company headquartered in San Francisco, operates exchanges of bitcoin, Ethereum, and other digital assets with currencies in 32 countries and bitcoin transactions and storage in 190 countries worldwide. The summonses asked Coinbase to identify all United States customers who transferred convertible virtual currency from 2013 to 2015. At that point, Coinbase dealt only with bitcoin.

Coinbase is not the only medium for trading cryptocurrencies. Largely, cryptocurrency has gone unregulated, so these warrants are issued to level the playing field for the government. The author believes that Coinbase is just the first of many IRS targets.

Cryptocurrency transactions

Why would the IRS care about cryptocurrency? For two reasons:

• Trading cryptocurrency is a taxable event; and  
• Converting cash into a virtual currency could be a way to launder money. 

I was the tax consultant for the largest fund of cryptocurrency a few years ago before it disbanded. The way this fund made money was by converting U.S. dollars or euros into bitcoin. Then the bitcoin was converted to another cryptocurrency, and then another, and so it went. All of these transactions were tracked and made public using blockchain, which is a digital ledger in which transactions made in bitcoin or other cryptocurrencies are recorded chronologically and publicly. Each conversion is a taxable transaction. 

It is easiest to think of cryptocurrency as a commodity, such as gold and platinum. Let’s say an investor buys an ounce of gold and then converts the gold to platinum. That would be a taxable event. Gold has a dollar value and platinum has a dollar value, with the difference being taxable. Just like any currency or commodity, the cost of one unit of any cryptocurrency changes by the second.

For example, let’s say a person bought $200,000 worth of bitcoin. His or her basis in the bitcoin would be $200,000. That number of bitcoin can either be converted into other cryptocurrencies or be used to pay for goods and services. In 2013, only a few large retailers would take bitcoin for payment. That number has since exploded to several thousand.

Miners, traders, or investors access their virtual currencies through a wallet, which is the bitcoin equivalent of a bank account. The wallet enables virtual currency owners to receive the virtual currency, provides storage for them, and enables the owner to send them to other wallets. There are two main types of wallet. The first is a software wallet, which virtual currency owners install on their computer or electronic device. This type of wallet gives the owner total control, yet it can be challenging to download and maintain. The second type, the web wallet (or hosted wallet), is hosted by a third party, and while it is easier to use, a certain trust must be placed in the provider to ensure the coins are protected.

Once a wallet is set up, the virtual currency owner then has an address that looks something like this: 1BvBMSEYstWetqTFn5Au4m4GFg7xJaNVN2.

After the wallet’s owner chooses a password, by the way, there is no way to change it, which makes it imperative that the owner write down the password and secure it in a safe location. A client of the author lost $250,000 because the safe where he kept his wallet address and password was sent to an incinerator. A wallet’s owner has no way to access the wallet without the string of letters and numbers and the password.

IRS takes notice

In response to concern over virtual currencies and their perceived potential for evading taxes, the IRS issued Notice 2014-21 in March 2014. This notice gave guidance on everything from paying employees with cryptocurrency to how the various trades between different currencies are treated.

But in a 31-page report from the Treasury Inspector General for Tax Administration, released Sept. 21, 2016, the IRS basically admitted that though a Virtual Currency Issue Team had been created, guidelines for compliance had not been developed. The recommendations from this report included developing a coordinated virtual currency strategy, providing updated guidance for requirements and tax treatments, and revising third-party reporting requirements and documents.

Another problem that the IRS has had with virtual currencies is that the transactions by miners, traders, or other investors are not currently reported on any tax forms. For instance, investors who trade foreign currency on the Forex (a foreign exchange site) are sent tax forms for all of the trades made on the platform. However, cryptocurrency exchanges do not currently issue Forms 1099 for transactions within the platforms.

As touched on earlier, cryptocurrency could conceivably be used for money-laundering activities. Unlike money issued by governments, cryptocurrency has no Federal Reserve, no gold backing, no banks, and no physical notes. Thus, it has the potential for being used in illegal activities. A criminal could simply convert “dirty money” gained through an illegal activity to something like bitcoin and use it to trade for goods and services.

Coinbase summonses

In response to the possibility that cryptocurrency users could be using their accounts for illicit activities or to evade tax, the IRS issued a John Doe summons to Coinbase asking for information about all of its customers from Jan. 1, 2013, to Dec. 31, 2015. According to the IRS, in a filing in support of the summons request, an IRS agent attested to the fact that he had uncovered two taxpayers who admitted that they disguised the amounts they spent purchasing bitcoins as deductible technology expenses (Erb, “IRS Wants Court Authority to Identify Bitcoin Users & Transactions at Coinbase,” Forbes (Nov. 21, 2106)). The estimated number of Coinbase’s customers during the period the summons covers could be “massive,” according to Forbes.

As cryptocurrency has evolved, the IRS has had to play catch-up with the miners and others trading on this platform. The John Doe warrants are just the beginning of this enforcement process for the IRS.

Craig W. Smalley, MST, is an enrolled agent and the founder and CEO of CWSEAPA PLLC, which provides accounting and financial services.