On November 30^th, a federal district court in California entered an order authorizing the IRS to serve a John Doe Summons on Coinbase Inc. seeking information about U.S. taxpayers who conducted transactions in virtual currency. In the court’s order, U.S. Magistrate Judge Jacqueline Scott Corley found that there is a reasonable basis for believing that virtual currency users may have failed to comply with federal tax laws.

There are no allegations by the Department of Justice that Coinbase has engaged in any wrongdoings in connection with its virtual currency exchange business. The IRS uses John Doe summonses to obtain information about possible violations of tax laws by individuals whose identities are unknown.  This John Doe summons directs Coinbase to produce records identifying U.S. taxpayers who have used its services, along with other documents relating to their virtual currency transactions.

Virtual currency is a digital representation of value that functions in the same manner as a country’s traditional currency.  There are nearly a thousand virtual currencies, but the most widely known is Bitcoin.  Because transactions in virtual currencies can be difficult to trace, taxpayers may be using them to hide taxable income from the IRS.

Bitcoin was launched in January 2009 by a person or persons under the pseudonym of Satoshi Nakamoto. Bitcoin is a digital currency that is maintained by a distributed network of computers and does not having the backing of a government. Bitcoin transactions are visible on the Bitcoin network but the identity of the participants are encrypted. Coinbase, a virtual currency exchanger headquartered in San Francisco, was founded in 2012 and offers “wallet” services to its customers (online accounts for holding and trading Bitcoin). Coinbase currently maintains about 5 million “wallets” for its customers.

In Notice 2014-21, the IRS declared that virtual currencies that can be converted into traditional currencies are property for tax purposes. Consequently, a taxpayer can have recognizable gains or losses on the sale or exchange of virtual currency.

In response to the court’s authorization of the John Doe summons, Principal Deputy Assistant Attorney General Caroline D. Ciraolo, head of the Justice Department’s Tax Division, stated that “as the use of virtual currencies has grown exponentially, some have raised questions about tax compliance.” She went on to say that “tools like the John Doe summons authorized today send the clear message to U.S. taxpayers that whatever form of currency they use – Bitcoin or traditional dollars and cents – we will work to ensure that they are fully reporting their income and paying their fair share of taxes.”

“Transactions in virtual currency are taxable just like those in any other property,” said IRS Commissioner John Koskinen.  “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.”

The IRS may use any account information gathered from the John Doe summons to audit a taxpayer or mount a criminal investigation. The U.S. taxes income from all sources and payments received in Bitcoin or other digital currencies may be considered income. Furthermore, for digital currencies held in offshore accounts, Forms 8938 or FBARs may be required. For employers, the IRS has made clear that Forms 1099 must be filed for payments to independent contractors in digital currencies and that wages paid to employees in digital currencies must be reported on Form W-2 and are subject to withholding and payroll taxes. Failure to pay payroll taxes can lead to civil penalties and potentially criminal charges on the individual officers of a business.

If you own Bitcoin or any other digital currency, you should consult with a tax advisor to ensure proper tax reporting.