Civil and Criminal Tax Fraud
Failing to properly disclose cryptocurrency transactions can trigger both civil and criminal tax fraud. If—or perhaps when—the IRS eventually traces cryptocurrency transactions back to the taxpayer, the Internal Revenue Code allows a 75% civil penalty for any underpayment of taxes attributable to fraud. While the IRS bears the burden of proving by clear and convincing evidence that the underpayment is due to fraud, the burden is met by showing that an underpayment of tax exists, and that the taxpayer intended to evade taxes known to be owed intentionally concealing, misleading, or otherwise preventing the collection of taxes.
Criminal tax fraud is also a possibility if the taxpayer fails to truthfully answer the cryptocurrency question on the tax return. However, the federal criminal tax fraud statutes include the heightened mens rea element of willfulness, which is not found in the civil tax fraud statutes. Courts have construed “willfulness” in the context of tax fraud to require the government to show that the law imposed a duty on the taxpayer, that the taxpayer knew of the duty, and that the taxpayer voluntarily and intentionally violated the duty. Given the incongruence between the common use of cryptocurrency in transactions and the tax treatment thereof by the IRS, many taxpayers may be saved by the willfulness element.
Some observers have noted the similarities in the IRS’s early approach to foreign account disclosures and the tactics currently employed with regard to cryptocurrency. Under the Offshore Voluntary Disclosure Program (“OVDP”), first instituted in 2009, taxpayers with undisclosed foreign financial accounts could avoid criminal prosecution and heightened civil penalties by fully disclosing accounts and paying a lesser amount. This “carrot”—contrasted with the “stick” of criminal prosecutions—netted the IRS $11.1 billion of voluntary payments.
Some have called for an IRS voluntary disclosure and amnesty program for cryptocurrency users, similar to the OVDP. At least one observer has described the IRS’s game plan thusly: use Joe Doe summonses directed to cryptocurrency exchanges to obtain user information, push Congress to pass legislation addressing third-party reporting of cryptocurrency transactions, and then offer amnesty for violators that voluntarily disclose. Thus far, the IRS has rebuffed calls for cryptocurrency tax amnesty but Sen. Portman’s proposed legislation may be a vehicle to advance the outlined strategy.
Foreign Cryptocurrency Accounts
Subsequent to the initial OVDP amnesty, Congress passed the Foreign Account Tax Compliance Act (“FATCA”) in 2010. Like OVDP, FATCA is tool to reduce tax avoidance via foreign financial accounts. Under the statute, foreign financial institutions are obligated to identify and report information about U.S. account holders to the IRS. Institutions that fail to comply with the requirements face a 30% withholding tax on certain types of U.S.-sourced income.
At least one observer has called on regulators to include cryptocurrency within the FATCA regime, noting the similarity between cryptocurrency virtual wallets and financial accounts. Indeed, regulators announced in 2020 that the current foreign reporting regulations would be updated to address cryptocurrency.
But FATCA relies on cooperation between the IRS, foreign governments, and foreign financial institutions in order to complete reporting of foreign accounts. It is unclear whether a FATCA-style reporting system is workable with cryptocurrency—virtual wallet providers beyond the scope of the IRS’s jurisdiction may not voluntarily report their users’ activity, especially when supposed anonymity is one of the selling points of cryptocurrency usage.
Tax Whistleblower Statute
Cryptocurrency users should also be aware of the federal tax whistleblower statute. In a commercial transaction, the vendor and buyer necessarily have identifying information about the other, so that the vendor can ensure that payment is received, and the buyer can ensure that goods or services are delivered according to the contractual specifications. This is true even in commercial transactions with cryptocurrency serving as the medium of exchange—the vendor must be able to match the cryptocurrency to the transaction as a bookkeeping function.
Thus, if a vendor accepting cryptocurrency learns that the buyer is using cryptocurrency to avoid taxes, the vendor may be able to take advantage of the whistleblower program. Under the statute, a whistleblower is eligible to receive up to 30% of the proceeds collected by the IRS in an enforcement action, with lesser amounts available depending on the extent of the whistleblower’s assistance.
The tax whistleblower statute is in contrast with the federal False Claims Act, which permits qui tam actions by individuals to encourage whistleblowing. In a qui tam action, a private person may file a suit under seal on behalf of the government against the defrauding party. The government may take over the case, in which case the relator is entitled to 15% to 25% of the amount recovered; alternatively, the government may decline the case, in which case the relator may continue the action and receive 25% to 30% of the recovery. A successful relator is also entitled to recover attorney fees and other expenses.
Because commercial counterparties will have greater access to information about cryptocurrency usage than the IRS., the qui tam scheme may be especially helpful in eliminating tax fraud. However, the federal False Claims Act specifically excludes tax cases,so qui tam actions are not available to private persons who may know of a tax avoidance scheme. Some have argued for an expansion of the False Claims Act to include federal tax fraud, in an effort to encourage private participation in eliminating tax fraud.
Speculating on Forthcoming Cryptocurrency Taxation and Regulation
Thus far, Sen. Portman has been coy about the specifics of his forthcoming bill. His comments raise two general areas of concern: defining cryptocurrency for tax purposes, and improving information reporting. With regard to the first concern, a more consistent overall federal regulatory approach treating cryptocurrency as a true medium of exchange would be welcome for commercial parties.
With regard to the second, foreign cryptocurrency account reporting certainly seems to be on the regulatory radar, as discussed above. Vendors accepting cryptocurrency as payment may also see additional information reporting requirements—such as Form 1099s specifically for cryptocurrency transactions. This could potentially open the door for private enforcement mechanisms such as qui tam actions, but there is no indication that policymakers are considering that tactic.
Portman’s comments also specifically highlighted a $1 Trillion “tax gap” between amounts owed by taxpayers and collected by the IRS, with taxes owed on cryptocurrency transactions constituting part of that gap. Treasury Secretary Janet Yellen has also criticized the use of cryptocurrencies in certain commercial transactions as “extremely inefficient.”
One may speculate as to whether enhanced information reporting requirements will be sufficient to close the gap, or whether stronger disincentives towards cryptocurrency use may be on the regulatory horizon. Users of cryptocurrency should consider what a cryptocurrency-specific taxation scheme could look like. A financial transfer tax, such as the “Tobin tax”or “Section 31 Fees” could serve as a model for a federal excise tax on cryptocurrency transactions.