We have previously written about the IRS efforts to curtail the use of bitcoin for tax evasion (please see our posts here and here). In late November, a federal court ordered Coinbase, the largest public digital currency exchange, to comply with an IRS summons and to produce records of clients’ names and transactions. Once the IRS receives these records, it will begin auditing taxpayers who did not declare and pay tax on their bitcoin (and other virtual currency) gains. The IRS has declared that bitcoin and other virtual currencies are considered property and are subject to capital gains tax, and the IRS believes that many owners of virtual currencies are not properly reporting gains and paying tax.
The IRS summons against Coinbase is reminiscent of its “John Doe” summons against Swiss bank UBS which sought identifying information on Americans who owned “secret” Swiss bank accounts that were hidden from the IRS. A “John Doe” summons seeks information from a financial institution (which would include a virtual currency exchange) regarding a broad class of U.S. taxpayers who are not individually named but whom the IRS has reason to believe may have utilized the financial institution to improperly evade tax. Courts regularly approve such summonses, whereby the IRS obtains information such as the identities of account owners (or, in the case of virtual currencies, wallet owners). The John Doe summons against UBS was approved by a federal court, which was the first step in the dismantling of Swiss banking secrecy and IRS enforcement against Americans who hid money in Swiss accounts away from the IRS. The IRS pursued similar summonses against other offshore banks, including in Belize, India, Bahamas, Barbados and the Cayman Islands.
We expect Coinbase to comply with the federal court order and turn over the documents requested in the IRS summons. This would negate the very anonymity championed by the proponents of bitcoin. In addition to the John Doe summons against Coinbase, reports have emerged that the IRS is utilizing Chainanalysis, a blockchain forensics firm based in New York, to study bitcoin transactions for tax evasion. Coinbase also offers “The Shift Card”, which is a debit card that allows a user to spend bitcoin wherever Visa is accepted. This too can result in tax non-compliance, because if you exchange your bitcoin for goods or services, that too is a taxable event, as the IRS considers you to have earned income on the value of the good or service, less your cost basis in the bitcoin (i.e., your bitcoin purchase price).
When the IRS proceeded against Americans who hid money in Swiss accounts, the IRS at the same time also encouraged the account owners to come forward and declare their foreign accounts and foreign income, in exchange for lower penalties and no criminal prosecution. This is known as a “voluntary disclosure” by the taxpayer, and it only works if the IRS doesn’t already have the name of the taxpayer. The IRS may already have the name of the taxpayer from a John Doe Summons, a Swiss bank, an audit, an investigation, the Foreign Account Tax Compliance Act (FATCA) or other ways. The Offshore Voluntary Disclosure Program (OVDP) resulted in thousands of American taxpayers declaring their foreign assets, paying tax due and avoiding much harsher penalties (and jail time) than if the IRS discovered the foreign assets first.
There is speculation that, like the voluntary disclosure program for foreign assets (which remains ongoing but may be terminated by the IRS at any time), the IRS may offer a voluntary disclosure opportunity for people to come into tax compliance with their virtual currency transactions. The danger, however, is that the IRS obtains information from Coinbase (or other sources) before the taxpayer comes forward to correct his or her tax noncompliance. In that case, the IRS will deny the taxpayer’s voluntary disclosure, begin an audit or examination, and assess the full range of penalties rather than the reduced penalties that may apply in a voluntary disclosure. Timing, as they say, is everything. Please contact us regarding tax compliance issues for bitcoin or any other assets – – offshore, onshore, or virtual.