By Steven J. Mopsick and Allison J. Ornelaz, Mopsick
Tax Law, LLP
Almost everyone has heard about Bitcoin by now, a
digital currency which appears to offer the user a degree of privacy if not
secrecy. One of its biggest attractions is
it can be purchased and used anonymously which is a huge benefit for those
wishing to keep certain financial affairs as below the radar as possible. Although
every Bitcoin transaction is recorded in a public log, the user’s names are not
revealed, only their “digital wallet” IDs. These “digital wallets” are
basically a virtual bank account in which the user can access his funds.
Bitcoin appeared on the scene in 2009 attributable
to an individual(s) named Satoshi Nakamoto[1] as
a cryptocurrency[2].
Bitcoin is not tied to any government, currency, or bank, leaving the network under
the control of its users worldwide. As such, the value of Bitcoin fluctuates in
a real time market dependent on the number of users who are currently buying or
selling. Similar to fluctuations in stock values, the structure of the market
for Bitcoin is based on supply and demand which causes its value to be sometimes
quite volatile.
Over the last 8 years, the value of one Bitcoin
compared to the U. S. dollar has risen from practically no value to its all-time
high of $4,522.13 as of August 25, 2017[3].
Seeing the value fluctuate over the years has caused many users to use Bitcoins
as purely an investment opportunity, while others have turned Bitcoin trading
into a livelihood.
The IRS knows about Bitcoin activity and Uncle Sam is
pretty much convinced that with all of its popularity, there is bound to be
some uncollected taxes somewhere. As anonymity is the name of the game, one
could speculate a vast majority of Bitcoin users do not report their gains or
losses from the underlying transactions on their tax returns. Or perhaps more
importantly, it is likely that some of the transactions underlying the use of
Bitcoin are themselves illegal, giving rise to the possibility that other law
enforcement agencies may want to find out what is going on as well.
In Notice 2014-21,
the IRS defined virtual currency (i.e.,
Bitcoin and other cryptocurrencies) as “property” for federal tax purposes.
That means the exchange of Bitcoin for cash or Bitcoin for goods or services is
taxable as any other property would be under the Internal Revenue Code. It could
be considered a capital asset in the hands of some taxpayers or for others, it
could be property used in a trade or business, the proceeds of which are taxed
at ordinary income rates.
On November 30, 2016, the federal court for the
Northern District of California authorized[4]
the IRS to serve a “John Doe” summons[5] on
Coinbase, Inc. See U.S. v. John Doe,
No. 3:2016-cv-06658 (N.D. Cal filed Nov. 17, 2016) and U.S. v. Coinbase, Inc., No. 3:2017-cv-01431-JSC (N.D. Cal. filed
March 16, 2017). Coinbase defines itself
as “a secure online platform for buying, selling, transferring, and storing
digital currency;” i.e., Coinbase then,
is a “virtual wallet” for Bitcoin users.
The IRS summons requested information on all U.S. taxpayers who used a virtual
currency during the 2013-2015 tax years[6]. IRS
Commissioner John Koskinen stated “the John Doe summons is a step designed to
help the IRS ensure people doing business in the emerging economy are following
the tax laws and meeting their responsibilities[7].”
In response to the summons, a Coinbase customer
filed a motion[8]
to block the court order which would allow the IRS to access Coinbase’s Bitcoin
transaction records. Arguing that the summons was illegally over-broad,
Coinbase refused to comply with the summons and sought to quash it or
alternatively seek a protective order and an evidentiary hearing permitting
limited discovery[9].
On July 6, 2017, the IRS filed a notice of narrowed
summons requests for enforcement[10]
which limited the scope to only Coinbase users with at least $20,000 in any one
transaction type (buy, sell, send, or receive) in any one year during the 2013-2015 tax period and also limited
the scope with regard to each user. This litigation is ongoing.
Despite its reputation as the most visible symbol of
Big Government, if the use of Bitcoin is involved in a taxable or reportable
transaction, the IRS just wants to be paid. But why are they focusing so
heavily on Bitcoin users right now? Two reasons: it is an effort to reduce the
Tax Gap (the difference between the amount of tax the IRS collects vs. the
amount really owed) and it is a chance to peek into the Underground Economy.
Bitcoin, innocuous in itself, offers a splendid vehicle to bury a transaction
with digital finesse (if not the dark market itself) and avoid all regular
reporting, registration, and disclosures.
The IRS believes there is currently ongoing mass tax
evasion by a majority of Bitcoin users. In an affidavit[11] attached
to its pleadings, the IRS said it searched its
records for Form 8949, Sales and Other Dispositions of Capital Assets, for data
for tax years 2013 through 2015 which showed that in 2013, only 807
individuals reported a transaction on Form 8949 using a property description
likely related to Bitcoin; in 2014, that number went up to a modest 893 reported
transactions; and in 2015, 802 individuals did so.
Although currently unknown, there is
speculation that there are over 10 million Bitcoin users worldwide[12].
The IRS has contracted with a company
called Chainalysis[13]
to track down the identities of U.S. taxpayers with virtual wallets holding
Bitcoin. In a letter from the co-founder of Chanalysis to the IRS (screenshot
in an article by Fortune[14]),
Chainalysis says (emphasis added):
Transactions
in Bitcoin are made with pseudonyms, which need to be tied to real world
identities in order to gain insights about the parties involved in a
transaction and their purpose. Our
tool has information on 25 per cent of all Bitcoin addresses, which account for
approximately 50 per cent of all the Bitcoin activity. We additionally
have over 4 million tags on Bitcoin addresses that we have scraped from web
forums and leaked data sources including dark market forums and Mt. Gox deposit
and withdrawal information.
Is
there a message here for Bitcoin users?
It took the government a while to wake up to
technological advances which facilitate illegal activity and tax compliance
enforcement. Seven years after the enactment of FATCA and a decade and a half
of foreign bank account reporting (FBAR),
the IRS is now fully committed to staying up to date on ways people use the digital
world to evade the internal revenue
laws. It may be that everyone is
entitled as a matter of privacy to be anonymous, but the government is
convinced that no one has the right to be invisible.
One of the things the government is good at is
integrating databases. These include cross checking FBAR filings with income
tax filings, matching up 1099’s with forms 1040, soaking up reports on
Americans directly from FATCA-friendly countries and banks, and using a vast
cache of ever increasing digital data to search for patterns, transactions, and
related entities.
No advice is offered here if the reader is involved
in a criminal activity.
For those readers who use Bitcoin and see it as yet
another way to do business in the modern world, the best advice is to keep good
records. The IRS may want to chat with you at some time in the future.
