Bitcoin

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.

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.

The Internal Revenue Service continues to make frequent use of a relatively unknown information-gathering tool in its nearly decade-old crusade against offshore tax evasion: the “John Doe” summons. A John Doe summons may be used 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 the U.S. laws.

Because the identities of the targeted taxpayers are unknown, the summons is denoted with a “John Doe” moniker. Expressly authorized by Internal Revenue Code, a John Doe summons must first be approved by a federal judge before it can be served.

To date, federal judges have authorized the IRS to issue sweeping John Doe summonses for information and records around the globe, in countries including Switzerland, India, the Bahamas, Barbados, Belize, the Cayman Islands, Guernsey, Hong Kong, Malta, the United Kingdom and others.

In its most recent John Doe summons, the IRS obtained authority to summons documents and records relating to the use by U.S. taxpayers of debit cards linked to secret offshore bank accounts, a common technique used to repatriate funds held in foreign accounts.

IRS Authority to Seek John Doe Summonses

The Internal Revenue Code authorizes the IRS to issue a summons to gather information and/or testimony about a specific taxpayer whose identity is known, and the IRS frequently uses traditional summonses in the normal course of conducting audits and investigations.

A John Doe summons, by contrast, allows the IRS to gather information about a group of unidentified taxpayers believed to be violating the tax laws, such as investors in a tax shelter or account holders at a financial institution.

In United States v. Bisceglia, 520 U.S. 141 (1975), the United States Supreme Court expressly recognized the authority of the IRS to issue a John Doe summons in order to uncover the identities of individuals who may have failed to disclose all of their income.

Congress subsequently enacted section 7609(f) of the Internal Revenue Code, which authorizes service of a John Doe summons if the IRS convinces a federal judge that (1) the summons relates to the investigation of an ascertainable group or class of persons; (2) there exists a reasonable basis for believing that such group or class or persons may have failed to comply with U.S. tax laws; and (3) the information sought by the summons is not readily available from any other source.

To ensure that the John Doe summonses are not used as pure “fishing expeditions,” internal IRS policy mandates that such summonses may only be used in investigations that are at an advanced stage, rather than at the outset of an investigation. In addition, only certain high-ranking IRS officials are authorized to approve issuance of a John Doe summons; special agents, revenue agents and revenue officers are not authorized to issue such summonses.

A federal court’s determination of whether the IRS has satisfied the requirements for a John Doe summons is required to be conducted ex parte and must be based solely on the basis of a petition and supporting affidavits. Once a court determines that the IRS has met its burden, the agency is then authorized to serve the John Doe summons on the party to whom it is directed.

IRS Use of John Doe Summonses In Its Offshore Crackdown

Since 2009, the IRS (working hand-in-hand with the U.S. Department of Justice) has worked aggressively to combat tax evasion by U.S. taxpayers making use of secret offshore bank accounts, and John Doe summonses have played a prominent role in that enforcement effort.

In 2009, the IRS served a John Doe summons seeking the identities of U.S. taxpayers maintaining bank accounts at UBS in Switzerland. Two years later, the IRS received court approval to serve a John Doe summons seeking the identities of U.S. taxpayers maintaining undisclosed bank accounts at HSBC in India.

In January 2013, a federal judge authorized the IRS to serve a John Doe summons seeking the names of account holders at Swiss bank Wegelin & Co. In September 2015, a federal court in Miami authorized the issuance of a John Doe summons seeking information about U.S. taxpayers who held offshore accounts at Belize Bank International Limited or Belize Bank Limited.

The Latest John Doe Summons Target: Users of Offshore Debit Cards

Most recently, on Jan. 25, 2017, a federal judge in Montana authorized the IRS to serve a John Doe summons seeking information about U.S. taxpayers who had been issued a debit card that could be used to access the funds in offshore accounts in such a manner as to evade their tax obligations.[1]

The summons specifically seeks records regarding U.S. taxpayers who possessed a “Sovereign Gold Card” during the years 2005 to 2016 which could be used to access funds held in accounts established by Sovereign Management & Legal LTD, a Panamanian company (Sovereign).

Sovereign is an offshore services provider alleged to have offered clients, among other things, the formation and administration of anonymous corporations and foundations. The IRS believes that Sovereign’s related services included the maintenance and operation of offshore structures, mail forwarding, availability of virtual offices, re-invoicing and the provision of professional managers who appoint themselves directors of the client’s entity while the client maintains ultimate control over the assets.

The IRS has long been concerned with the use of debit cards by U.S. taxpayers as a way to repatriate funds held in offshore accounts. In 2000, the IRS began investigating the use of offshore credit cards and served numerous John Doe summonses on major credit card companies.

Based upon information gathered through that project, the IRS confirmed that the use of payment cards (including credit and debit cards) linked to offshore bank accounts is a common means of obtaining access to such funds. A United Nations report focused on money laundering similarly concluded that “[c]redit and debit cards are the way people who have laundered money draw ready cash without leaving a financial trail. As one advertisement for a bank put it, it is the best way to stay in touch with your offshore account.”[2]

In its petition seeking court approval for the John Doe summons, the government alleged that Sovereign advertised various “packages” that afforded individuals the ability hide assets offshore. These packages include corporations owned by other entities (including phony charitable foundations) which are held in the name of nominee officers provided by Sovereign.

Sovereign would then open bank accounts for these entities and provide debit cards in the name of the nominee to the U.S. taxpayer. By using such debit cards, taxpayers could access their offshore funds without revealing their identities.

Upon consideration of the government’s petition, the court determined that the IRS had a reasonable basis for believing that U.S. taxpayers may be using Sovereign Gold Cards to evade their U.S. tax obligations.

The IRS investigation of Sovereign has been ongoing for several years, and was initiated as a result of information derived from a federal narcotics investigation. As part of an investigation of online marketplaces for drug trafficking, the Drug Enforcement Administration learned that traffickers frequently moved money through Panamanian bank accounts controlled by Sovereign using debit cards.

Using information generated through that drug investigation, the IRS sought, and obtained, court approval for several John Doe summonses in late 2014 requiring various courier delivery services and U.S. financial institutions to produce information about U.S. taxpayers who might be evading or have evaded federal taxes by using Sovereign’s services.[3]

The IRS alleged that Sovereign used certain couriers to correspond with U.S. clients, and certain money transmission services to transmit funds to and from clients in the United States. In addition, the IRS alleged that wire services operated by various financial institutions, and U.S. correspondent bank accounts held for Sovereign’s banks in Panama and Hong Kong, were believed to have records of financial transactions between Sovereign and its clients in the United States.

The IRS also relied upon information generated through its ongoing Offshore Voluntary Disclosure Program to support its latest application for the John Doe summons seeking debit card information. In a revenue agent’s affidavit submitted to the court, the IRS disclosed that its “voluntary disclosure program databases” revealed at least one taxpayer who acknowledged using Sovereign’s services to establish numerous offshore structures and 21 undeclared accounts, 11 of which were opened in Panama.

During an IRS interview, that taxpayer stated that he discovered Sovereign through an Internet search and subsequently utilized Sovereign’s services to set up structures, establish offshore accounts and open a Sovereign Gold Card to access funds in those accounts.

Warning to Non-Compliant Taxpayers

The most recent John Doe summons stands as yet another stern warning to non-compliant taxpayers that the era of bank secrecy and secret offshore accounts in tax haven jurisdictions is over.

Indeed, in a Justice Department press release announcing court approval of the latest John Doe summons, Tax Division Acting Assistant Attorney General David A. Hubbert stated that “[t]his John Doe summons is yet another example of how we are using all available tools to identify, investigate and hold accountable those who cheat our nation’s tax system by hiding money offshore, as well as those individuals and entities facilitating U.S. taxpayers engaged in this conduct.”[4]

Hubbert further warned that “[t]he time to come forward and come into compliance is running short, and those who continue to violate U.S. tax and reporting laws will pay a heavy price.”

The IRS continues to offer voluntary disclosure initiatives, including the Offshore Voluntary Disclosure Program, that provide a pathway for taxpayers with undisclosed foreign assets to come back into compliance and avoid criminal prosecution, but those options are generally available only if the taxpayer comes forward before the IRS or Justice Department learn of their non-compliance.

Conclusion

As its latest John Doe summons demonstrates, the IRS now has more access to information about the offshore activities of U.S. taxpayers than at any previous time in the tax agency’s history. With a wealth of information gathering tools at its disposal, including John Doe summonses, the IRS has the ability to command production of a vast array of documents relating to offshore tax evasion schemes and to uncover the identities of those involved.

And the IRS can be expected to make full use of that information in undertaking enforcement activity against non-compliant taxpayers. Taxpayers with undisclosed offshore financial assets would be well-advised to take advantage of IRS voluntary disclosure options promptly, as time is of the essence as the IRS continues to aggressively crack down on offshore tax evaders.

[1] See In the Matter of the Tax Liabilities Of: John Does, Case No. CR 17-02-BU-BMM (D. Mont.).

[2] United Nations, Global Programme Against Money-Laundering, Office for Drug Control and Crime Prevention, “Financial Havens, Banking Secrecy and Money Laundering” (1998).

[3] See In the Matter of the Tax Liabilities Of: John Does, Case 1:14-mc-00417 (S.D.N.Y.).

[4] U.S. Department of Justice Press Release, “Court Authorizes Service of John Doe Summons Seeking the Identities of U.S. Taxpayers Who Have Used Debit Cards in Furtherance of Tax Evasion” (Jan. 25, 2017).

Reprinted with permission from Law360. (c) 2017 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.