U.S. taxpayers who have traded in virtual currencies such as bitcoin, but have not reported and paid tax on the income or gains from those transactions, may face the heat as the IRS continues to press for greater tax compliance in the virtual currency arena.
Some taxpayers may evade their tax obligations by concealing or otherwise failing to report their proper amount of taxable income and thus underpay their taxes, according to the IRS, and the Service has identified several tax-compliance risks associated with virtual currencies, including a lack of third-party reporting.
Tax practitioners should understand how virtual currency transactions work because their clients may already be trading in virtual currency or will be in the near future.
Documents requested by the IRS
The government has been investigating the use of virtual currency that can be converted into traditional currency for the past several years. After the IRS issued Notice 2014-21, which took the position that transactions in virtual currency were property transactions that could result in gain or loss, it then served a John Doe summons on Coinbase Inc
Most recently, on Nov. 30, 2017, after a lengthy summons enforcement proceeding, a federal district court issued an order granting in part and denying in part the IRS’s petition to enforce the summons. The court’s order (Coinbase, Inc., No.17-cv-01431-JSC (N.D. Cal. 11/28/17) (order re: petition to enforce summons) requires Coinbase to produce the following documents for accounts with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013 to 2015 period:
- The taxpayer identification number;
- Name;
- Birthdate;
- Address;
- Records of account activity; and
- All periodic statements.
Once the documents are produced, the IRS will begin sifting through a vast amount of information to identify U.S. taxpayers who the IRS believes are not complying with their tax obligations. Those taxpayers may be subject to civil examinations and potentially owe tax, interest, and civil penalties. Other taxpayers with more serious issues could become subject to criminal investigation — if, for example, they have large amounts of unreported income over several years.
All of this is yet to be determined as the Coinbase case plays out. Taxpayers who think they may have exposure would be wise to take steps to comply, such as participating in the IRS domestic or offshore voluntary disclosure programs, as opposed to waiting for the IRS to catch them.
What to expect
The next step is for the IRS to begin sifting through the Coinbase data and identifying U.S. taxpayers who the IRS believes are not complying with their tax obligations by comparing the information received from Coinbase with information reported by taxpayers on their returns. Some U.S. taxpayers may be selected for audit.
The IRS will be looking for unreported income (e.g., gain from the sale or exchange of virtual currency based upon a review of a taxpayer’s periodic account statements), and taxpayers may face, at a minimum, the civil accuracy-related penalty (a 20% penalty under Sec. 6662) and possibly the civil fraud penalty (a 75% penalty under Sec. 6663). In cases with larger amounts of unreported income over a number of years, the IRS could refer the case to IRS criminal investigation (see Fink, 1 Tax Controversies: Audits, Investigations, Trials §5.01 (2017)).
Looking forward
The best course of action now for U.S. taxpayers who have used virtual currencies is to take steps to comply and minimize their exposure through, for example, the IRS voluntary disclosure process. Cases are harder to resolve, and the civil penalties can be greater, after the IRS contacts a taxpayer. Expect the IRS to be most interested in U.S. taxpayers who have traded in virtual currency. If a taxpayer is contacted, however, the following points are worth considering for tax professionals representing a client during a tax audit:
- Although the government has issued its position in Notice 2014-21 that virtual currency transactions are taxable as property, it is uncertain whether certain virtual currency transactions are actually subject to U.S. taxation. Tax professionals should carefully review the virtual currency exchange transactions, get a handle on the facts early on, and develop a defensible strategy as to the amount of unreported income.
- Notice 2014-21 recognizes that penalty relief may be available to taxpayers who are able to establish that the underpayment of tax is due to reasonable cause.
- Where the law is vague or unsettled on whether a transaction has generated taxable income, courts have found that the defendant lacked willfulness, which is a defense to tax evasion or the civil fraud penalty (Office of Chief Counsel, Criminal Tax Division, IRS Tax Crimes Handbook, p. 10 (2009), citing Harris, 942 F.2d 1125, 1131 (7th Cir. 1991) (involving payments by wealthy widower to mistresses where civil tax cases had held such payments were gifts); Garber, 607 F.2d 92, 100 (5th Cir. 1979) (novel issue of tax treatment of money received from sale of rare blood)). There is no question that taxation of virtual currency transaction is a relatively new and complex area of tax law.
- A good-faith misunderstanding of the law or a good-faith belief that one is not violating the law is a defense to willfulness (e.g., tax evasion or civil fraud penalty); a taxpayer simply may not have known that he or she had to report and pay tax on certain virtual currency transactions that the taxpayer had not converted into traditional currency (Cheek, 498 U.S. 192 (1991); Stadtmauer, 620 F.3d 238 (3d Cir. 2010)).
Compliance is key
Virtual currency tax cases are a new and evolving area of the law, and further developments are expected as cases begin to be worked by IRS agents and eventually wind their way through the agency and the courts. U.S. taxpayers who have traded in virtual currency would be wise to seek the advice of competent tax counsel, who can evaluate the case, explain the options, and develop a defensible strategy.