The Internal Revenue Service has prevailed in its long-running dispute with Coinbase, the largest U.S.-based Bitcoin exchange, with a federal judge ordering Coinbase to comply with a “John Doe” summons seeking customer information. In an opinion issued on November 28, 2017, the court in San Francisco found that the government’s narrowed request for information on Coinbase’s customers served the legitimate purpose of investigating whether Bitcoin users properly reported gains or losses on their income tax returns. The Court also found that the customer records sought by the government were relevant because they can be used by the IRS to determine whether a particular Coinbase customer is tax compliant. Coinbase must now hand over to the IRS records for accounts that had at least one transaction of at least $20,000 value during the period 2013 to 2015. According to Coinbase, this will require it to divulge trading records regarding nearly 9 million transactions conducted by over 14,000 customers. With this data in hand, it will be relatively easy for the IRS to cross-check filed tax returns to determine if Coinbase customers properly reported Bitcoin transactions on their returns. Individuals who failed to do so can expect to hear from the IRS and should consider prompt corrective action, if necessary, to mitigate the consequences of any such inquiry.

A “John Doe” summons is an information-gathering tool that is being used with increasing frequency by the IRS to obtain information and records about a class of unidentified taxpayers if the IRS has a reasonable belief that such taxpayers are engaged in conduct violating U.S. tax laws. Because the identities of the targeted taxpayers are unknown, the summons is denoted with a “John Doe” moniker. Expressly authorized by the Internal Revenue Code, a John Doe summons must first be approved by a federal judge before it can be served. The IRS sought to serve a summons on Coinbase because of its concern that the anonymous nature of virtual currencies like Bitcoin may allow users to engage in tax evasion and other illegal conduct:

Virtual currency, as generally defined, 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 and largest is bitcoin. Because transactions in virtual currencies can be difficult to trace and have an inherently pseudo-anonymous aspect, taxpayers may be using them to hide taxable income from the IRS.

In late 2016, a federal judge authorized the IRS to serve a “John Doe summons” on Coinbase seeking information about U.S. taxpayers who conducted transactions in virtual currency during 2013, 2014, and 2015. In court documents, the Justice Department stated that Coinbase was the fourth largest exchanger globally of Bitcoin and the largest exchanger in the United States. The Justice Department further stated that Coinbase offered buy/sell trading functionality in 32 countries, maintaining over 4.9 million wallets with wallet services available in 190 countries, serving 3.2 million customers, with $2.5 billion exchanged in Bitcoin. According to the IRS, only 2,500 taxpayers reported transactions in Bitcoin on their U.S. income tax returns during the three years in question, as compared to nearly 500,000 U.S. customers reported by Coinbase during the same period. Coinbase has vigorously resisted the John Doe summons, and the matter has been in litigation for the past year, with the IRS eventually agreeing to narrow the scope of its summons.

In its ruling approving the Coinbase summons, the Court determined that the summons “serves the legitimate purpose of investigating the ‘reporting gap between the number of virtual currency users Coinbase claims to have had during the summons period’ and ‘U.S. bitcoin users reporting gains or losses to the IRS during the summoned years.’” The Court found that Coinbase is the largest U.S. exchange of bitcoin into dollars with at least 5.9 customers served and 6 billion in transactions while only 800 to 900 taxpayers a year have electronically filed returns with a property description related to Bitcoin from 2013 through 2015. This discrepancy, wrote the Court, creates an inference that more Coinbase users are trading bitcoin than reporting gains on their tax returns.

As narrowed, the IRS summons seeks information regarding 8.9 million Coinbase transactions and 14,355 Coinbase account holders. That only 800 to 900 taxpayers reported gains related to Bitcoin in each of the relevant years and that more than 14,000 Coinbase users have either bought, sold, sent or received at least $20,000 worth of Bitcoin in a given year suggests, the Court concluded, that many Coinbase users may not be reporting their Bitcoin gains. Under these circumstances, the Court ruled that IRS has a legitimate interest in investigating these taxpayers.

In a victory for Coinbase, the Court ruled that the scope of information sought by the IRS was overbroad, and trimmed the types of records that would be required to be turned over by Coinbase. Coinbase is only required to produce the following data for its customers: taxpayer identification number; name; date of birth; and address. The Court refused the government’s request for additional information, including account opening records; copies of passports and/or driver’s licenses; wallet addresses; and public keys for accounts/wallets/vaults; “know your customer” due diligence records; and customer correspondence.

As a result of the Court’s ruling, Coinbase must now turn over to the IRS the following documents for accounts with at least the equivalent of $20,000 in any one transaction (buy/sell/send/receive) in any one year during the 2013 through 2015 time period:

  • Taxpayer identification number;
  • Name;
  • Birth date;
  • Address;
  • Records of account activity including transaction logs or other records identifying the date, amount, and type of transaction (purchase/sale/exchange), the post transaction balance, and the names of counterparties to the transaction; and
  • Periodic statements of account or invoices (or their equivalent).

Once it receives the summoned data from Coinbase, the IRS will cross-check tax returns filed by the individuals in question to determine if they properly reported their Bitcoin trading gains and losses. Individuals who have not properly reported their Bitcoin holdings will likely be contacted by the IRS, and the nature of that contact will be dictated by the magnitude of each individual’s tax non-compliance. For Coinbase customers with a relatively small number of unreported transactions, the IRS may simply send a “soft” letter advising them to file amended tax returns. Coinbase users with a greater number of unreported transactions may be selected for audit and face penalties for not properly reporting Bitcoin transactions. The most egregious examples of non-compliance may well face criminal investigation by the IRS, if there is evidence those customers deliberately intended to evade their tax obligations by trading in Bitcoin. As we previously reported, drug trafficking organizations and other illicit actors are using digital currencies with increasing frequency to engage in money laundering.

Coinbase has not stated publicly whether it intends to appeal, but in a blog post the company said it was “in the process of reviewing the order” and would “continue to keep our customers updated.” In that same piece, Coinbase noted that the summons affected less than 1 percent of its customer base. Coinbase also said that “[i]n the event that we ultimately produce the documents under this Court order, we intend to notify impacted users in advance of any disclosure.” This advance notice will presumably afford concerned accountholders an opportunity to quickly rectify their tax filings, if they deem it advisable.