Digital/virtual currencies

irsThree influential members of Congress have questioned the Internal Revenue Service’s strategy for addressing the tax treatment of digital or virtual currencies, such as Bitcoin, and its efforts to uncover the identities of taxpayers who used such currencies through a “John Doe” summons to Coinbase, a virtual currency exchanger in San Francisco. In a letter dated May 17, 2017, Orrin G. Hatch, Chairman of the Senate Finance Committee; Kevin Brady, Chairman of the House Ways and Means Committee; and Vern Buchanan, Chairman of the Oversight Subcommittee of the House Ways and Means Committee, wrote to IRS Commissioner John Koskinen to express concern about the manner in which the IRS is undertaking to treat digital currencies for tax purposes.

In the letter, the three members noted that in March 2014, the IRS released guidance on the tax treatment of digital currencies for the first time. In IRS Notice 2014-21, which consisted of a series of “frequently asked questions” (and answers), the IRS announced that virtual currency would be treated, and taxed, as property. Among other things, this announcement meant that:

  • Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes.
  • Payments using virtual currency made to independent contractors and other service providers are taxable and self-employment tax rules generally apply. Normally, payers must issue Form 1099.
  • The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
  • A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.

In Notice 2014-21, the IRS acknowledged that “there may be other questions regarding the tax consequences of virtual currency not addressed in this notice that warrant consideration,” and invited public comment.  Soon thereafter, the IRS stated informally that virtual currency was not reportable for purposes of the Report of Foreign Bank and Financial Accounts (FBAR), but cautioned that this position could change in the future.

In June 2016, the American Institute of CPAs (AICPA) urged the IRS to issue additional guidance on virtual currency transactions, noting ten areas left unaddressed by Notice 2014-21 and for which guidance was needed:

  • Acceptable valuation and documentation;
  • Expenses of obtaining virtual currency;
  • Challenges with specific identification for computing gains and losses;
  • General guidance regarding property transaction rules;
  • Nature of virtual currency held by a merchant;
  • Charitable contributions;
  • Virtual currency as a “commodity;”
  • Need for a de minimis election;
  • Retirement accounts, and
  • Foreign reporting requirements for virtual currency.

In September 2016, the Treasury Inspector General for Tax Administration (TIGTA) issued a report criticizing the IRS for failing to develop a “coordinated virtual currency strategy” during the two years following issuance of Notice 2014-21:

Although the IRS issued Notice 2014-21, Virtual Currency Guidance, and established the Virtual Currency Issue Team, there has been little evidence of coordination between the responsible functions to identify and address, on a program level, potential taxpayer noncompliance issues for transactions involving virtual currencies. None of the IRS operating divisions have developed any type of compliance initiatives or guidelines for conducting examinations or investigations specific to tax noncompliance related to virtual currencies. In addition, it does not appear that any of the actions already taken by the IRS to address virtual currency tax noncompliance were coordinated to ensure that the IRS maintains a strategic approach to the tax implications of virtual currencies.

TIGTA further pointed out that although the IRS solicited public comments to Notice 2014-21, the agency has taken no actions to address comments received.

In response, the IRS agreed with TIGTA’s recommendations and stated that it “plans to develop a virtual currency strategy including an assessment of whether changes to information reporting documents are warranted.” According to TIGTA, the IRS also agreed that “additional guidance would be helpful and plans to share the recommendation with the IRS’s Office of Chief Counsel for coordination with the Department of the Treasury’s Office of Tax Policy.” To date, however, no such additional guidance from the IRS regarding virtual currency has been issued.

Approximately two months later, however, the IRS issued a “John Doe” summons to Coinbase, a U.S. company that serves as a digital currency wallet where merchants and consumers can conduct transactions using virtual currencies such as Bitcoin and others. A “John Doe” summons is a relatively unknown 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 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.

In an affidavit submitted to the Court in support of its application for a John Doe summons, the IRS claimed that in 2015, only 802 taxpayers reported a Bitcoin transaction on Form 8949.

The “John Doe” summons directed to Coinbase requires that company to produce records identifying U.S. taxpayers who have used its services during the years 2013 and 2015. In response, both Coinbase and one of its customers have sought to quash the summons. In March 2017, the IRS filed a petition in federal court to enforce the summons against Coinbase. Subsequently several Coinbase customers have sought to intervene in the summons enforcement proceeding anonymously. To date, the Court has not ruled on these applications, and Coinbase has not produced any records in response to the summons.

In the Congressional letter to the IRS, the authors express concern with the Coinbase summons, pointing out that the summons is estimated to affect 500,000 active Coinbase customers and would result in the production of millions of pages of transaction records. The letter further points out that “90 percent of these customers engaged in less than $10,000 in cumulative, gross transactions during the entire period requested.” Under these circumstances, the three members question whether the IRS genuinely has a reasonable belief that Coinbase customers are engaging in tax evasion:

However, we strongly question whether the IRS has actually established a reasonable basis to support the mass production of records for half of a million people, the vast majority of whom appear to not be conducting the volume of transactions needed to report them to the IRS. Based on the information before us, this summons seems overly broad, extremely burdensome, and highly intrusive to a large population of individuals. The IRS’s actions in this case also set a dangerous precedent for companies facilitating virtual currency transactions that could be subject to a similar summons.

The letter concludes by demanding that the IRS respond, by June 7, 2017, to a broad set of questions about the agency’s strategy for addressing the tax treatment of digital currencies:

1.  Please describe the IRS’s current digital currency strategy and provide any existing policies and procedures.

a.  What efforts has the IRS made to conduct industry outreach or coordination on its digital currency strategy?

b.  What, if any, industry concerns have been raised and what actions is the IRS taking to address these?

c.  How does the John Doe summons issued to Coinbase fit into the larger IRS digital currency strategy?

2.  As mentioned earlier, to issue a John Doe summons, the IRS must first establish that it has a reasonable basis to believe that the individuals may fail or may have failed to comply with internal revenue law. What is the justification for the IRS’s position that all Coinbase customer records are needed for this timeframe?

a.  When seeking this summons, what provision(s) of the IRC did the IRS believe Coinbase customers not to be in compliance with?

b.  Did the IRS consider issuing a more narrowly tailored summons? If so, what impediments existed to the IRS issuing a more narrowly tailored summons?

3.  TIGTA made three recommendations in its 2016 report referenced above. What is the current status of the IRS’s implementation of each of these recommendations and what actions have been taken to address each one?

4.  How has or will the IRS assess and take into account the compliance burdens on start-up financial technology companies as well as digital currency users (especially those engaging in light to moderate transactional use) when developing and refining its digital currency strategy?

5.  Will the IRS consider a de minimis exemption or other action to remove practical obstacles to such moderate, transactional use of digital currencies?

This letter from Congress is the latest example of criticism of the IRS’s digital currency strategy (or lack thereof). As noted above, the issuance of Notice 2014-21 was helpful in providing initial guidance in this area, but it left unanswered many more questions than it answered, as evidenced by follow-up comments from the AICPA and TIGTA. And the IRS is encountering resistance in its efforts to enforce its John Doe summons to Coinbase. The Congressional letter only adds to the growing chorus calling for the IRS to clarify this area once and for all.