bitcoin

Over the past few years, the IRS has focused on whether taxpayers are properly reporting income from transactions involving virtual currencies including Bitcoin. See our previous articles: “IRS Advances Against Bitcoin Tax Evasion”, “Bitcoin Surges in Value Again: Tax Consequences”, and “Now Is The Time To Confirm Your Bitcoin Is Tax Compliant.” Recently, the IRS issued IR-2019-132, which announced the IRS’s next step: sending letters to taxpayers who may have failed to properly report income from virtual currency transactions. These letters further demonstrate that the IRS will enforce the tax laws applicable to virtual currencies. Compliance with these laws is necessary to avoid penalties.

There are three types of letters sent to taxpayers, differing based on the degree of potential violation: Letter 6173, Letter 6174, and Letter 6174-A. While the IRS stated that these letters are “educational letters” to inform taxpayers of their responsibilities to report virtual currency transactions, penalties might still apply. The letters range from a “soft notice” to a warning letter for those whom the IRS suspects of more serious violations.

These letters demonstrate the IRS’s focus on digital currencies, and whether taxpayers are properly reporting gains on income tax returns. As IRS Commissioner Chuck Rettig explained, “the IRS is expanding our efforts involving virtual currency, including increased use of data analytics. We are focused on enforcing the law and helping taxpayers fully understand and meet their obligations.” This goal was first highlighted in 2014, when the IRS released Notice 2014-21, which stated that virtual currencies like Bitcoin are “property” and are taxable to individuals and businesses that use virtual currencies as (1) a means for sale or exchange, (2) payment for goods and/or services, or (3) holding as investments.

For federal tax purposes, because virtual currency is treated as property, every time one disposes of virtual currency, whether to trade, sell, as payment for a good or service, etc., it is to be taxed as a capital gain or loss. To properly report any gain or loss from virtual currencies, taxpayers should file IRS Form 8949 and Form 1040 Schedule D, which apply to short-term and long-term capital assets.

In addition to income tax reporting, one area of ambiguity is whether virtual currencies held in foreign wallets are reportable on FinCEN Form 114, Report of Foreign Bank and Financial Accounts (known as the “FBAR” form). Taxpayers are required to fill out the FBAR when they have a financial interest in a foreign financial account with an aggregate value of at least $10,000 during the calendar year. Recently, AICPA Virtual Currency Task Force contacted FinCEN for further clarification on the issue of whether offshore digital wallets are reportable on the FBAR. FinCEN, surprisingly, responded that virtual currencies held in foreign accounts do not qualify for FBAR reporting. Despite FinCEN’s comment, it does appear that a foreign cryptocurrency account or wallet would meet the definition of “foreign financial account” and would require an FBAR filing. The same applies regarding IRS Form 8938, Statement of Specified Foreign Financial Assets, which a taxpayer must file when he or she has certain foreign financial assets with an aggregate value of more than $50,000 (higher for joint accounts).

As a further example of the IRS taking action against Bitcoin and other digital currencies, in November 2016, a federal court authorized the IRS to issue a John Doe summons to Coinbase, Inc., a web-based digital currency exchange. Through this summons, the IRS sought records for Coinbase users with a U.S. address, phone number, e-mail address, etc. who traded virtual currencies. Although Coinbase initially opposed the IRS’s attempts to obtain its client information, Coinbase ultimately revealed its clients’ transactions to the IRS, which allowed the IRS to send out warning letters and audit taxpayers.

“Taxpayers should take these letters very seriously by reviewing their tax filings and when appropriate, amend past returns and pay back taxes, interest and penalties,” stated IRS Commissioner Rettig. According to the IRS, approximately 10,000 or more taxpayers will receive the new letters. Though the IRS did not explicitly state from where it obtained these taxpayers’ names, it may be assumed that the John Doe summons against Coinbase provided the IRS with information on specific taxpayers who traded virtual currencies and may not have reported income.

Please contact us if you have received a letter from the IRS regarding tax compliance issues for virtual currencies, as well as if you have other tax-related issues for any other assets – – offshore, onshore or virtual.

Brian Zharov, a student intern, assisted in the drafting of this article.

The value of Bitcoin has surged 125% in 2017 alone. In addition to its value ascent, it has also gained in legitimacy. While it was once the currency of choice on the illicit Silk Road “dark web”, shut down by the U.S. Department of Justice in 2013, Bitcoin is now accepted for payments by Amazon.com and other mainstream businesses. Whether you’ve weathered the Bitcoin roller coaster or invested recently, you must ensure IRS compliance for Bitcoin.

The IRS has taken an interest in Bitcoin for various reasons. First, Bitcoin is largely unmonitored and stands apart from the traditional structure of U.S. banking with 1099 forms and regular reporting. There is a huge mass of Bitcoin value that is relatively unknown to the IRS, and gains in value are essentially hidden from the IRS, and the IRS doesn’t like that. In addition, Bitcoin has a large potential for tax non-compliance, both because its very nature is anonymous, and because Bitcoin holdings give rise to significant IRS reporting (the “FBAR” form, IRS Form 8938, IRS Form 8949, capital gains taxes, etc.) and many Bitcoin owners don’t heed (or even know) the reporting requirements.

In November 2016, the IRS obtained a federal court authorization to issue a “John Doe” summons to Coinbase, Inc., a web-based global digital currency wallet and platform. The IRS has in the past successfully used the “John Doe” summons to obtain information from financial institutions (e.g., UBS, HSBC and Cayman Islands banks) for 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. The John Doe summons upon Coinbase seeks records from 2013 through 2015 for any Coinbase user with a US address, telephone number, e-mail domain, etc., and all records related to disbursement of funds to any user. A recently filed Affidavit by an IRS agent in the Coinbase enforcement litigation revealed that in 2015, only 802 taxpayers revealed Bitcoin information to the IRS on Form 8949, which is the form applicable to capital gains and losses. Other virtual currency platforms, such as Localbitcoins, Kraken and ItBit may receive similar summonses for transactions with Bitcoins and other virtual currencies like Ethereum and Litecoin.

Bitcoin’s anonymity feeds its non-compliance, and there are many opportunities to run afoul of tax law and IRS requirements, intentionally or inadvertently. One issue is the failure to report income with respect to Bitcoin. In 2014, the IRS issued Notice 2014-21 describing how various income recognition and other US tax principles apply to virtual currency transactions. In that Notice, the IRS clarified that virtual currencies are “property” subject to income tax, capital gains tax, etc. This means that if Bitcoin is sold for a profit, that profit is income and is subject to capital gains tax. The income is reportable on IRS Form 8949 which is then attached to Schedule D of Form 1040. 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).

If you are audited by the IRS regarding Bitcoin, you may have to show multiple cost bases for multiple transactions. Proper record keeping with respect to Bitcoin is essential. The IRS could take the position that your cost basis in your Bitcoin is zero, and you would pay tax on the full value of the Bitcoin on the date of the transaction, unless you can provide records of your purchases of Bitcoin.

In addition to income tax issues on Bitcoin income, there are reporting issues irrespective of income. Because a Bitcoin wallet would be considered by the IRS to constitute an “account”, if you hold your Bitcoins in foreign wallets or on foreign Bitcoin exchanges, then foreign account reporting requirements are triggered, including the FBAR (FinCEN Form 114, Report of Foreign Bank and Financial Accounts) and IRS Form 8938 (Statement of Specified Foreign Financial Assets). If you invested in a foreign fund that invested in Bitcoin, the IRS may consider the fund to be a “PFIC” (Passive Foreign Investment Company), which has its own tax methodology, and IRS Form 8621 would be due. Penalties for non-reporting foreign accounts are significant, including potentially 50% of the value of the account.

Clearly, the IRS’ increased interest in Bitcoin necessitates proper compliance with respect to Bitcoin assets. The IRS offers opportunities to come into compliance before the IRS obtains information about unreported assets (virtual or actual) and income, including via a pre-emptive voluntary disclosure (offshore or domestic) of digital currency income and accounts. A voluntary disclosure also provides the opportunity to calculate, with a reasonable degree of certainty, the total cost of resolving open tax issues, along with peace of mind and finality.

Please contact us to discuss IRS compliance for Bitcoin assets, along with other tax issues.