602-277-2010

Best Law Firms
Frazer Ryan Goldberg & Arnold LLP

Blog Post

IRS pursues cryptocurrency holders

Brandon Keim and Sarah Lauterbach • Jul 22, 2020
Brandon Keim

With record-breaking momentum and utilization of cryptocurrency, the IRS is taking an aggressive look at individuals involved in cryptocurrency investments, purchases, sales, and mining operations.


In a world where identity theft and cyber security are top concerns, cryptocurrencies are taking the lead in financial innovation. While the pseudonymous nature of cryptocurrency allows its users to enjoy privacy, the IRS believes that privacy creates a high risk that its users are engaged in financial crimes and illegal activity.


INTRODUCTION TO CRYPTOCURRENCY


Cryptocurrency is a digital currency that uses technology to regulate the generation of units and verify the transfer of funds. Satoshi Nakamoto, the inventor of Bitcoin - one such cryptocurrency - published an October 2008 whitepaper describing a tamper-proof, decentralized peer-to-peer version of electronic cash that would allow online payments to be sent from one party to another without a financial institution.

Although Nakamoto, whose name is thought to be a pseudonym for an individual or group, has been silent since 2011, his prototyped cryptocurrency system continues to explode, with many new forms of cryptocurrency available. Its blockchain structure, in which a publicly available ledger tracks all transactions, has potential applications beyond currency.

For example, self-enforcing agreements embedded in computer code and managed by a blockchain, known as “smart contracts,” may be used to replace certain contracts, since they allow parties to digitally facilitate and enforce the performance of contracts. Because of its decentralized nature, there is no need to pay intermediaries, and, if drafted properly, smart contracts could prove to be faster and more secure than traditional systems.

IRS GUIDANCE

Although the application of blockchain technology appears limitless, the IRS’s guidance is not. The IRS first provided cryptocurrency guidance in April 2014, when it published Notice 2014-21, IRS Virtual Currency Guidance, concluding that cryptocurrency should be treated as property rather than as currency under section 988.

Subsequently, in October 2019, the IRS issued Rev. Rul. 2019-24, addressing the tax consequences of “hard forks,” or changes to the protocol of the block. The IRS determined that certain hard forks result in income to holders of coin. The IRS also provided answers to 45 frequently asked questions (see “IRS FAQs (Oct. 9, 2019)”).

The IRS has not answered a myriad of questions, including:
  • whether like-kind exchange treatment applies to crypto-to-crypto trades (pre-2017 tax reform act);
  • the tax consequences of mining activities and whether it rises to the level of a trade or business;
  • the proper reporting of lost or stolen cryptocurrency; and
  • reporting requirements of non-US persons transacting in cryptocurrency.
However, lack of guidance is not stopping IRS enforcement efforts.

IRS ENFORCEMENT EFFORTS

The IRS ensures that taxpayers report wages, investment income, sales of homes, credit card sales, and cancellation of debt through information-reporting requirements that require payors to report the payments to the IRS. (There are steep penalties when a payor fails to properly report payments to the IRS.) The IRS then compares that data against taxpayers’ returns to identify unreported income.

No reporting requirement specific to cryptocurrency exists. Because the blockchain has no owner, even if such a requirement existed, there is no mechanism for the IRS to require that the blockchain report information to the IRS. Much like the challenges it experienced with foreign bank accounts before widespread reporting by foreign banks, the IRS is digging for information.

Coinbase is an electronic wallet that stores cryptocurrency, like Bitcoin. Although the IRS cannot force blockchains to report information, it can obtain information from electronic wallets that store cryptocurrency. And that is exactly what the IRS is doing.

In 2016, the IRS served Coinbase, one of the largest cryptocurrency exchanges, with a “John Doe” summons for tax years 2013 to 2015. A John Doe summons is a powerful investigative tool that allows the IRS to summons information without knowing the identify of the taxpayer whose information it seeks. A district court must approve the summons, and the Northern District of California did that in the Coinbase case. In 2018, Coinbase provided the IRS with information regarding 13,000 of its users.

During 2019 the IRS started notifying account holders that it had information regarding their cryptocurrency activity. Letter 6174-A notes, “We have information that you have or had one or more accounts containing virtual currency but may not have properly reported your transaction involving virtual currency, which include cryptocurrency and non-crypto virtual currencies.” The IRS is expected to aggressively pursue individuals using cryptocurrency and not reporting gains on trades, or income received.

While the outlook for virtual currencies and financial innovation is that they will continue to grow in popularity, the tax consequences and regulations will also continue to encroach on individuals and companies utilizing these currencies.

If you are invested in cryptocurrency, using it as a daily currency, or have a mining operation, you should (a) be on the lookout for correspondence from the IRS regarding your involvement, and (b) ensure that you have reported all cryptocurrency transactions on income tax returns.

Before responding to any IRS correspondence (even “soft letters” like the above-referenced Letter 6174-A) or amending returns, taxpayers should consult with a tax controversy professional regarding the tax implications of their use of cryptocurrencies to minimize tax and penalties and, in certain situations, criminal exposure.

Brandon Keim is a tax litigation attorney and a former senior IRS trial attorney. Co-author Sarah Lauterbach represents taxpayers before the IRS as an Enrolled Agent. Brandon and Sarah are actively representing clients in crypto audits.

Share by: