Wednesday, August 30, 2017


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.

[1] Speculation exists whether Satoshi Nakamoto is a real person or a group of individuals.
[2] A digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank.
[7] Id.