On November 28, 2017, a federal judge in California ordered Coinbase, Inc. (“Coinbase”), a major virtual currency exchange, to provide the Internal Revenue Service (“the Service”) with account information for thousands of individuals trading virtual currency through its exchange. (A copy of the entire Order in United States v. Coinbase, Inc., et al., No. 17-cv-01431-JSC (N.D. Cal., Nov. 28, 2017) can be found here. The related press release from the Department of Justice can be found here.) The issuance of this summons is part of an ongoing, multi-faceted effort by the Service to identify tax non-compliance involving virtual currency and to take enforcement efforts against violators. Virtual currency investors should be on notice of their tax obligations and address any non-compliance before they become the Service’s next target.
While the Service’s initial summons requested a much greater amount of information from Coinbase as part of “an investigation to determine the identity and correct federal income tax liability of United States persons who conducted transactions in a convertible virtual currency…for the years ended December 31, 2013, 2014, and 2015,” the order entered on November 28, 2017 requires Coinbase to comply with a much more narrowly tailored summons. In particular, the order covers approximately 8.9 million transactions and 14,355 account holders. Specifically, Coinbase will be required to produce the following information with respect to any account involved in a transaction (buy, sell, send, or receive) of over $20,000 during the 2013 to 2015 period:
- Taxpayer ID number;
- Birth date;
- Records of account activity including transaction logs or other records identifying the date, amount, and type of transaction (purchase/sale/exchange), the post transaction balance, and the names of counterparties to the transaction; and
- All periodic statements of account or invoices (or the equivalent).
In contrast, the first, much broader summons requested nine categories of documents, including: complete user profiles, know-your-customer due diligence, documents regarding third-party access, transaction logs, records of payments processed, correspondence between Coinbase and Coinbase users, account or invoice statements, records of payments, and exception records produced by Coinbase’s AML system. The stated goal of requesting the information was to narrow the tax gap caused by transactions in virtual currency: only approximately 800 or 900 persons electronically filed a tax return reporting transactions from property that is “likely related to bitcoin,” according to estimates of the Service. This figure paled in comparison to the roughly 10 million customers and $50 billion in virtual currency traded on the Coinbase platform through December 2017.
Tax Obligations of Virtual Currency Investors
Prior to 2014, there was little tax guidance regarding the tax treatment of Bitcoin and other virtual currencies, such as Litecoin, Ethereum, Ripple, and others. Even without guidance, it was commonly accepted that any gains from virtual currency were taxable income as they constituted an “accession to wealth” under existing case law. What was unclear was whether a taxable event was triggered merely by holding the virtual currency or if a sale or exchange was required.
Realizing this was a potential developing area of non-compliance, the Service released IRS Notice 2014-21. That notice generally clarified that virtual currencies are considered property for tax purposes (i.e., not like cash or currency). Accordingly, those transacting in virtual currencies are required to report gains or losses from sales or exchanges on their tax returns. For most taxpayers, assuming the cryptocurrency is held within an account (not exchanged or sold), no gain or loss is recognized on any accrued appreciation or depreciation in value; however, when the virtual currency is sold, the gains must be reported on a Form 8949 and Schedule D, and will generally be subject to normal rules governing capital gains and losses. For those investors who purchased Bitcoin in 2013 – when the value per unit was less than $100 – any sale occurring in the past year – when the value has spiked from about $1,000 per unit to more than $10,000 per unit – could result in a significant taxable event. For those merchants accepting virtual currency as a payment for goods or services, it is required that the value of those payments be included when computing gross income. The publication of IRS Notice 2014-21 also provides ammunition for the Service in contesting any “reasonable cause” arguments against imposition of accuracy-related penalties.
The Takeaway: Addressing Prior Non-Compliance
IRS Notice 2014-21, the enforcement of the Coinbase summonses, and other events should make it clear that virtual currency investors are on the watch list of the Service and other government authorities. The Service already has a virtual currency investigation team in place that is determining the best way to identify and address this growing tax issue. As the Service continues to develop its knowledge base, it is undoubtedly only a matter of time before the Service flexes its civil and criminal tools in an effort to reign in the tax gap. For those accountholders covered by the Coinbase summons, particularly those with large unreported gains, it would be wise to address any non-compliance now. Investors need only look at developments in the offshore tax compliance area to see where the Service’s enforcement efforts will likely be headed. See, Offshore Tax-Avoidance and IRS Compliance Efforts, available at: https://www.irs.gov/newsroom/offshore-tax-avoidance-and-irs-compliance-efforts. The Service has many tools at its disposal to coerce or, indeed, to force taxpayers into compliance, including, but not limited to:
- Extended statutes of limitation for assessment (R.C. § 6501 (6 year limitations period on assessment for substantial omissions of income and unlimited limitations period on assessment for fraudulent tax returns));
- Substantial civil penalties (R.C. § 6662 (20% penalty for negligent or substantial understatements) and I.R.C. § 6663 (75% penalty for fraudulent understatements)); and
- Substantial criminal penalties (e.g., R.C. § 7201 (tax evasion) and I.R.C. § 7206 (fraud and false statements)).
Furthermore, those holding virtual currency in foreign financial accounts may be exposed to penalties for failure to report foreign financial assets under FBAR rules and FATCA. These penalties are based on the underlying value of the property (not the gains) and, for willful multi-year violations, may exceed the value of the accounts. Taxpayers with substantial unreported gains from virtual currency could be looking over their shoulder for a long time before they are in the clear.
Qualified Amended Returns
For those that have past non-compliance involving virtual currency and have not yet been subjected to a civil or criminal investigation, several compliance mechanisms are available. Individuals may be able to file a “qualified amended return” for any year in which there were previously unreported gains involving virtual currency. A “qualified amended return” can be used to mitigate or eliminate accuracy-related penalties that could be imposed on previously unreported gains. Pursuant to I.R.C. § 6662, a 20% accuracy-related penalty can apply to any underpayment of tax attributable to “negligence or disregard of rules or regulations” or to any “substantial understatement of income tax.” That means that if an individual sold virtual currency at a gain of $100,000, and there was a resulting income tax of $35,000, an accuracy-related penalty of $7,000 could be applied by the Service.
To the extent the additional tax is reported on a “qualified amended return,” the underpayment of tax is reduced as it is essentially deemed reported on the original tax return. Accordingly, any accuracy-related penalty may be eliminated through this process. In order to qualify for this treatment, the amended return must be filed (1) prior to any contact from the Service regarding the examination of the return for that year and (2) prior to the date the IRS serves a “John Doe” summons relating to the tax liability of a person, group, or class that includes the taxpayer with respect to an activity for which the taxpayer directly or indirectly claimed any tax benefit on the return, amongst others. Treas. Reg. § 1.6664-2(c)(3). For those included as part of the Coinbase summons, eligibility for the “qualified amended return” provisions may already be unavailable. In addition, to the extent that any underpayment is due to a fraudulent position taken on the original return, a “qualified amended return” cannot be used to reduce or eliminate accuracy-related penalties.
For those that may not qualify under the “qualified amended return” provisions, resolution under the Service’s Voluntary Disclosure Practice may be appropriate. This is likely the only affirmative compliance procedure that can be used by those who, though not yet under civil or criminal investigation, have fraudulently underreported their tax as a result of virtual currency transactions. The Service’s Voluntary Disclosure Practice, the terms of which are set forth in Internal Revenue Manual (“IRM”) 18.104.22.168 (12-02-2009), provides that an affirmative disclosure of past tax misdeeds by a taxpayer will result in the Service’s recommendation for non-prosecution. In particular, the IRM provides that:
It is currently the practice of the IRS that a voluntary disclosure will be considered along with all other factors in the investigation in determining whether criminal prosecution will be recommended. This voluntary disclosure practice creates no substantive or procedural rights for taxpayers as it is simply a matter of internal IRS practice, provided solely for guidance to IRS personnel. Taxpayers cannot rely on the fact that other similarly situated taxpayers may not have been recommended for criminal prosecution.
Though the terms of the Voluntary Disclosure Practice indicate that it does not create any substantive legal rights, in practical effect, a disclosure is likely to eliminate criminal exposure. While individuals frequently will be required to accurately amend up to six years of tax returns, a voluntary disclosure also will likely reduce the change of the Service seeking the fraud penalty, which can be up to 75% of the underpayment of tax. See I.R.C. § 6663. In order to qualify for the Voluntary Disclosure Practice, a taxpayer must (1) not have any illegal source income, (2) show a willingness to cooperate in determination of the correct tax liability, (3) make good faith arrangements to pay any liabilities in full, and (4) must not already be under civil or criminal investigation by the Service. See IRM 22.214.171.124(3-4). That means that, if the Bitcoin was obtained or used as part of illegal conduct, an individual may not qualify for the Voluntary Disclosure Practice. Even if a voluntary disclosure is made, this will not insulate an individual from liability for other non-tax offenses. The Voluntary Disclosure Practice can be time-consuming and costly – both in terms of legal fees and tax liabilities – but it may be a good resolution for those with substantial risk of criminal liability.
Other Means to Address Non-Compliance
Even if an individual does not qualify for the “qualified amended return” provisions and cannot employ the Voluntary Disclosure Practice, other compliance measures can be taken in an attempt to mitigate potential civil and criminal exposure relating to virtual currency gains. For example, addressing compliance on a going forward basis (i.e., correctly reporting current and future income on income tax returns) may adequately address issues for those with isolated or insubstantial non-compliance. And for those with more substantial non-compliance, filing amended tax returns may demonstrate that an individual intends (or intended) to comply with their tax obligations and, therefore, more substantial civil and criminal penalties should not be sought by the Service. That said, if an individual files amended tax returns of any kind, they should carefully consider the consequences with a tax professional, as doing such may be construed as an admission of fault (and could be used to develop a civil or criminal case against them). As with addressing most any type of tax non-compliance, the facts and circumstances of each case must be considered as there can be any number of collateral consequences and pitfalls for the unwary.
The Service is typically slow in adapting to changes in technology. It is also slow in identifying those who might use technology to avoid obligations to pay their fair share of taxes. However, once the Service identifies an issue posing a large enough tax drain, it will put its significant resources to use. Not only was this seen recently with offshore tax enforcement efforts (e.g., the Offshore Voluntary Disclosure Program and a significant number of criminal tax prosecutions), but also in the Service’s litigation of tax shelter cases, tax preparer fraud, Stolen Identity Refund Fraud, and similar schemes. The United Kingdom has already announced similar plans to regulate transfers of virtual currencies in an effort to mitigate tax evasion and money laundering.
Given that virtual currency has worked its way into the mainstream as a multi-billion dollar industry and can be used as a tool in tax evasion and money laundering, a largescale crackdown can be expected in the near future. Though the Service does not have the resources to catch all non-compliance, it will undoubtedly make a public example out of a number of violators as a general deterrence measure. For at least a few with numerous and/or substantial unreported gains from virtual currency, there are likely to be criminal prosecutions. For those who are audited, the Service is likely to fully apply available civil penalties. And it is likely that the Service will attempt to engage in more information-gathering – through more “John Doe” summonses and use of sophisticated information technology – to identify additional targets for civil and criminal investigation. The Service has proven time and again that its revenue agents are capable in forensic accounting and can track down unreported income through third-party tips, bank deposit analyses, and other indirect methods. Depending upon the expected scope of non-compliance in this area, the Service may seek support to pass additional rules and regulations requiring virtual currency exchanges and brokers to report information on supported transactions. The secretive nature of virtual currency can only hide those seeking to avoid taxes for so long.
All told, for those who entered the virtual currency market in 2017 (or who have not yet sold virtual currency), these recent developments should serve as a reminder that income taxes must be paid on any gains, as dictated in IRS Notice 2014-21. And for those with prior dealings (and gains), the various alternatives for addressing prior non-compliance should strongly be considered; otherwise, they may find themselves facing very real consequences as a result of their dealings in virtual currency.
For more information on virtual currency, please read other articles previously published by Rosenberg Martin Greenberg, LLP’s tax controversy group:
- Bitcoin Buffs Beware! IRS Ramps Up Efforts to Monitor Potential Criminal Activities Involving Virtual Currency
- Are there federal tax consequences associated with using Bitcoins in my business?
These descriptions are intended for informational purposes only and should not be taken as legal advice on any particular set of facts or circumstances. Rosenberg Martin Greenberg, LLP is experienced in all aspects of federal and state tax laws, including criminal tax matters, addressing prior compliance issues, white collar criminal litigation, and more. Please contact Brandon Mourges at 410.951.1149 or firstname.lastname@example.org for a free consultation.