When do you add two plus two and get three as the result? Now.
There are a few reasons why basic math does not work when it comes to offshore financial assets and cryptocurrency. The Tax Adviser recently reported that the IRS plans to discontinue the 2014 Offshore Voluntary Disclosure Program (OVDP) in September. In a January 2018 article on the John Doe summons issued to Coinbase, the Tax Insider reported that the IRS is close to obtaining virtual currency records.
Here is where the math comes into play. Add the closure of the OVDP plus IRS enforcement of reporting requirements on virtual currency and the result is a large number of people who are likely not complying with the law. The IRS, in support of its John Doe summons, reported that fewer than 900 people per year reported gains and losses arising from virtual currency transactions on tax returns from 2013 through 2015, indicating a very low compliance rate from the estimated 13 million to 28 million wallets that have traded virtual currency. The Tax Insider article also reported that Coinbase had lost its dispute over the IRS John Doe summons it was served. Coinbase therefore was required to disclose identifying information of more than 13,000 wallet holders to the IRS.
So there is definitely underreporting of virtual currency transactions. The IRS appears to be getting its hands around who is underreporting. Why is that fact a big deal when the OVDP's closure is added? If the virtual currency exchange where the virtual currency wallet resides is organized in the United States, the taxpayer merely has an underreporting issue on Schedule D, Capital Gains and Losses.
However, if the virtual currency exchange on which the taxpayer's wallet resides is not organized in the United States, he or she potentially has a FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), filing obligation and a Form 8938, Statement of Foreign Financial Assets, reporting obligation, if the value exceeds the respective reporting thresholds. That outcome is derived from the Ninth Circuit Court of Appeals case, Hom, 657 Fed. Appx. 652 (9th Cir. 2016).
Hom involved an individual who participated in a number of online poker gaming webpages. Those online games were found not to be money transmitter businesses/foreign financial institutions and were therefore not foreign financial accounts subject to FBAR reporting. However, John Hom maintained an account with a money transmitter through which the transactions cleared. The court found that the money transmitter, which was not organized in the United States, was a foreign financial institution, which meant Hom was required to file FinCEN Form 114 since he exceeded the filing threshold of $10,000 worth of funds.
(For more on the Hom case, see "Online Poker Accounts Not Subject to FBAR Reporting." For more on tax information reporting requirements for cross-border transactions in general, see "Transnational Tax Information Reporting: A Guide for the Perplexed.")
The general noncompliance with reporting gains and losses on virtual currency transactions is established. How many of those noncompliant virtual currency users have wallets in non-U.S. exchanges is less clear. Suffice it to say, there are likely to be many noncompliant FBAR filers as well.
Now is probably a good time to mention the penalty structure for failure to file FBARs. The first point to note is these penalties and the requirement for FBARs are found in Title 31, the money and banking portion of the U.S. Code and related regulations, not Title 26, the Internal Revenue Code. The failure-to-file penalties basically fall into two categories — nonwillful/negligent and willful failure.
The nonwillful penalty can be up to $12,459 for each negligent violation with no criminal provision for the nonwillful taxpayer/filer. Taxpayers in the willful camp — who knew about the requirement, yet still failed to file — can be liable for a civil penalty up to the greater of $124,588 or 50% of the account balance at the time of the violation, for each violation. Absent fraud, the statute of limitation is open for six years for a foreign failure to file. If that civil penalty isn't bad enough on its own, the criminal penalty under 31 U.S.C. Section 5322 can be up to $250,000 and five years in prison. If certain other laws are broken as well, the criminal penalty is doubled (see IRS FBAR Reference Guide).
The IRS maintains two general approaches for voluntary disclosure of delinquent FBAR requirements: generally one for the nonwillful and one for the willful. The nonwillful nonfiler can make use of the streamlined procedures for voluntary disclosure using two separate procedures: one for U.S. taxpayers residing in the United States — Streamlined Domestic Offshore Procedures — and another for U.S. taxpayers residing outside of the United States — Streamlined Foreign Offshore Procedures.
Streamlined procedures: The streamlined procedures for nonwillful offenders require filing amended returns for three years to report any unreported income plus interest, including any forms that should have been filed with the original returns. That taxpayer must also file six years of delinquent FBARs. The penalty under the program for U.S. resident taxpayers is a flat 5% of the highest balance in the offshore account, while there is no penalty for nonwillful nonresidents.
The streamlined procedures, which require a certification that the offender was nonwillful, do not prevent the IRS from initiating a criminal prosecution. Therefore, someone who is willful and applies using the streamlined procedures designed for nonwillful offenders can find himself or herself in great peril.
OVDP: The second program is the OVDP, which is closing in September 2018. In the OVDP, a person who willfully failed to file FBARs and/or report the related foreign income has the opportunity to avoid criminal prosecution by filing eight years of delinquent FBARs and eight years of amended returns reporting all of the previously unreported income, plus potentially pay the 20% accuracy related penalty under Sec. 6662(a) and failure-to-file and failure-to-pay penalties under Sec. 6651.
In addition, the offender will be subject to an "offshore penalty" of 27.5% of the highest offshore balance during that time period, unless the accounts were housed in a "bad" bank, a list of which is reported on the IRS webpage. If the account was at a "bad" bank, the penalty is increased to a one-time 50% of the highest balance. ("Bad" banks are foreign financial institutions for which there has been a public disclosure that either (1) they are under investigation by the IRS or the Justice Department in connection with accounts that are beneficially owned by a U.S. person; (2) they are cooperating with the IRS or the Justice Department in connection with accounts that are beneficially owned by a U.S. person; or (3) they have been identified in a court-approved issuance of a summons seeking information about U.S. taxpayers who may hold financial accounts at the foreign financial institution.)
Evidence of willfulness
The internet is a wonderful tool that makes a lot of information (accurate or not) available to anyone with an internet connection. It is the author's opinion that it is just a matter of time before evidence that a person has visited a webpage explaining the requirements to file FBARs, read an online article, or consulted with a professional about FBAR filing responsibilities may be considered proof of willfulness if he or she fails to remediate at once. What happens to the virtual currency investors who knew about FBARs when they can no longer make use of the OVDP?
FinCEN issued FIN-2013-G001 on March 18, 2013. In that notice, FinCEN clearly indicates that users of virtual currency are not money service businesses subject to Bank Secrecy Act (BSA), P.L. 91-508, reporting requirements and regulations. That notice also clearly indicates that virtual currency administrators or exchangers are money transmitters and money service businesses subject to FinCEN regulations and reporting requirements. Therefore, virtual currency exchanges that fail to register with FinCEN run the risk of FinCEN prosecution for failing to register and to follow the requirements of the BSA and related regulations.
The net is closing
In summation, the net is closing on virtual currency users and exchanges. The IRS is getting information that can be used to identify virtual currency users and then check to see if their gains and losses are reported. FinCEN has told the author that is working on identifying the domicile of virtual currency exchanges to determine which are in the United States and which are not in the United States. The likely procedure will be to check for both gains and losses on the income tax returns and FBAR/BSA compliance when a taxpayer is scrutinized.
The bottom line is this: It is very difficult to not be aware of FBAR filing requirements with all of the press coverage of those requirements. That means qualifying for streamlined procedures for voluntary remediation will be increasingly difficult. Willful noncompliant taxpayers had better get their OVDPs filed as soon as possible to have a path forward without a criminal record.
Sooner is better than later: OVDP filings are time-consuming and a great deal of data may need to be gathered, depending upon the taxpayer's recordkeeping. Gains and losses from virtual currency transactions are difficult and time-consuming to calculate. Because there is no standard data format of wallet transactions between exchanges, no handy data extraction program yet exists that can identify amounts realized on disposition and adjusted basis across multiple exchanges. Since most virtual currencies settle in bitcoin, and then bitcoin is translated or sold for fiat currency, taxpayers could potentially have two gain/loss realizations for each transaction.
Some individuals have suggested that trading one virtual currency for another can be construed as a like-kind exchange under Sec. 1031. That treatment was highly uncertain before Jan. 1, 2018, because the IRS construes virtual currency as property and likens trading virtual currency to stock sales. After Dec. 31, 2017, Section 13303 of the Tax Cuts and Jobs Act of 2017, P.L. 115-97, amended Sec. 1031 to eliminate like-kind exchanges for anything other than real property exchange transactions.
Edward R. Jenkins, CPA, CGMA, M. Taxation, MBA,(firstname.lastname@example.org) is a full-time instructor of accounting at the Pennsylvania State University Smeal College of Business and a senior tax consultant at Boyer & Ritter, LLC, Certified Public Accountants and Consultants in State College, Pa. He is currently a member of the AICPA Council. To comment on this article or to suggest an idea for another article, contact senior editor Sally Schreiber at Sally.Schreiber@aicpa-cima.com.