Spike in Cryptocurrency Market Value Fuels IRS Crackdown and Privacy Debate

In January 2021, the market value of the world’s cryptocurrencies passed $1 trillion – a record-breaking milestone for digital currencies that only six months prior had a total market value of around $260 billion. Although the masses have yet to adopt digital currencies as a widely used, primary medium of exchange, cryptocurrency is now the world’s fifth most circulated currency by value, suggesting it’s becoming more mainstream.

Many legal and regulatory questions and challenges have arisen across the globe in response to the currency’s growing role in the investment marketplace. With no centralized institution to record each crypto transaction on the blockchain, it is much more difficult for the IRS to track these exchanges.

The IRS Cracks Down on Bitcoin and Cryptocurrency Reporting

The IRS did not issue guidelines on bitcoin taxation until 2014. In fact, in 2013, only 807 Americans reported crypto income at all, according to the agency. However, in recent years, the IRS has invested significant resources to combat tax noncompliance with reporting income associated with crypto.

In July 2018, the IRS Large Business and International Division added virtual currency to its list of compliance campaigns. The IRS also announced the creation of a multinational organization called the Joint Chiefs of Global Tax Enforcement, also known as J5. J5 is dedicated to fighting “transnational tax crime and money laundering through increased enforcement collaboration” focused around the use of crypto.

Bitcoin Users Raise Privacy Concerns and Challenge IRS in Court with Potentially Far-Reaching Impacts

As part of its efforts to curb fraud in recent years, the IRS has also made an example out of a few particularly non-compliant taxpayers.

Among the most commonly cited examples of the IRS crackdown are the summonses issued to bitcoin user William Zietzke, who was audited after amending his 2016 tax return and crypto exchanges from Coinbase and Bitstamp. These summonses requested “all account history information” for any accounts affiliated with Zietzke, including “digital wallet information, blockchain addresses, transaction IDs and any other information related to the identity or location of the parties involved.” This included not only Zietzke’s public addresses, but also the identities and wallet addresses of anyone he had transacted with through those exchanges.

Zietzke filed motions to quash the summonses to Bitstamp and Coinbase and refused to comply with the summons to himself, insisting they are unnecessary, unwarranted and a violation of the Fourth Amendment. The United States District Court denied the petition, but did find the summonses overbroad, requiring the IRS to file a proposed amended summons that limited the demand for information to Zietzke’s 2016 transactions. This case continues to have far-reaching implications for crypto users, and these summonses quickly exploded into an ongoing battle with the IRS over bitcoin privacy, raising questions about what kinds of information taxpayers should be expected to share with the government during an audit.

Numerous cases have made headlines since Zietzke, including the arrest of Bruno Elmaani, Founder of Oyster Pearl, who evaded reporting his crypto income and raked in millions of dollars from selling the digital currency. Elmaani is facing up to 10 years of imprisonment.

Most recently, a crypto user named James Harper filed a lawsuit against the IRS in 2020 over alleged overreach in requesting vast amounts of records from Coinbase simply based on users’ volume of crypto use. This information was used to distribute 10,000 letters to crypto users, including Harper, warning they might not have paid taxes properly and detailing how the IRS is expanding efforts involving virtual currency through increased use of data analytics. The letters caused an uproar among confused recipients who believed they had complied with tax obligations and was viewed as a pointed attack by the IRS against crypto holders.

The impact of Harper’s case could be profound. A victory for Harper would expand privacy for crypto users, marking the court’s recognition that a “John Doe” summons to a financial institution for records related to past and current virtual currency holders violates due process. Tens of thousands of crypto users who also received letters in 2020 await a verdict, as well as third parties in the crypto space as they consider the impact it could have on privacy policies, terms of service, online contracts and subpoena-request processes.

What’s Next?

In November 2020, the Criminal Investigation (CI) division of the IRS released its annual report. The report indicated that in fiscal year 2020, more information was shared regarding crypto, tax crimes and related enforcement than in the previous 10 years combined. CI also saw the first guilty pleas for a case under the J5 umbrella.

The IRS has warned digital currency users that 2021 marks a shift from education to enforcement. Last May, the agency announced its interest in hiring outside contractors considered experts in crypto to assist in identifying investors whose tax returns either omit or contain incorrect data regarding crypto transactions. This suggests the agency plans to increase the volume and scrutiny of crypto audits.

Former head of the IRS CI division Dan Fort recently stated in an op-ed that he believes the agency has yet to fully turn its attention to enforcing these laws, with just a few cases of crypto tax-related prosecution. It’s likely that the IRS will use the data collected from Coinbase and Bitstamp to crack down on users who evade paying their taxes, especially as the tax gap widens and digital currency grows in market value. According to Fort, it’s possible the digital currency industry could have over $40 billion in tax liabilities.

To make sure crypto holders stay compliant and avoid fines or penalties, they should:

  • Report every transaction during the year in which the person received, sold, sent, exchanged or otherwise acquired a financial interest in a virtual currency, or summarize the information on their tax return and attach relevant account statements;
  • Evaluate the holding period for each sale transaction and consider whether the digital currency was acquired by purchase, hard fork, mining, air drop, etc.;
  • Determine whether digital currency held in accounts outside of the U.S. needs to be disclosed; and
  • Consider reinvesting in Opportunity Zones to defer or reduce the amount of U.S. taxes due on capital gains.

We’re Here to Help

It’s clear that crypto does not provide the anonymity many users assume it does. As the IRS ramps up its enforcement efforts, it’s in taxpayers’ best interests to review tax responsibilities and correct any incomplete or misleading returns from past years immediately. Bennett Thrasher’s Individual Tax practice helps clients navigate these complexities and make sure that they stay compliant. To learn more about our services, contact Michael Klug or Zack Leder by calling 770.396.2200.

 

The above information is general in nature and should not be relied upon for any specific tax implication or investment decision. Actual results may differ, and readers are cautioned not to place reliance on these general observations. Consult with your adviser or counsel before undertaking any specific action.