February 06, 2019 Articles

United States v. Coinbase: One Year Later

Individuals who have used or are contemplating using cryptocurrency to shield income should be forewarned.

By Benjamin Tompkins

While cryptocurrency owners may be fretting the significant plunge in values from their December 2017 highs, this decline has not stopped Internal Revenue Service Criminal Investigation (IRS-CI) from continuing to investigate the use of cryptocurrency to commit tax fraud and other crimes.

More than a year ago, the Northern District of California ordered Coinbase to disclose information pertaining to more than 13,000 of its customers who have engaged in transactions involving Bitcoin (and possibly other cryptocurrency transactions). United States v. Coinbase, Inc., Case No. 17-cv-01431-JSC, 2017 WL 5890052 (N.D. Cal. Nov. 28, 2017) [hereinafter Opinion]. Coinbase did not appeal. Instead, after informing its customers, Coinbase turned over the information in March 2018. While much of the work is in private, the IRS indicated publicly that it has begun using this information in its investigations.

The IRS is also committed to combating the use of cryptocurrency to commit tax fraud. See IRS, Criminal Investigation Annual Report 2018 (2018) (further detailing its cryptocurrency efforts). As reported in October 2018, the IRS estimates that potentially unreported cryptocurrency tax liabilities represent approximately 2.5 percent—or more than $11 billion—of the over $450 billion tax gap. See IRS, Information Reporting Advisory Committee Public Report (Oct. 2018). Thus, individuals who have used or are contemplating using cryptocurrency to shield income, whether legal- or illegal-source income, should be forewarned and consult an attorney regarding how to proceed. 

IRS Notice 2014-21

The IRS issued its only real guidance concerning cryptocurrency almost five years ago. In March 2014, the IRS issued Notice 2014–21, which “describe[d] how existing general tax principles apply to transactions using virtual currency.” While the IRS acknowledged that cryptocurrency could operate like real currency, it is not designated as legal tender even though it acts as a “convertible virtual currency” that can be converted to other currencies, such as U.S. dollars. Because the IRS concluded that cryptocurrencies are more akin to property, it applied traditionally understood tax rules to their use. As a result, taxpayers are required to pay any tax resulting from the gain or loss on a sale or exchange of cryptocurrencies. Furthermore, if a taxpayer is paid in cryptocurrencies, the taxpayer must “include the fair market value of the virtual currency, measured in U.S. dollars. . . .” The taxpayer would then also owe taxes when cryptocurrencies are spent or otherwise converted into currency. The onus is on the taxpayer to keep good records; the taxpayer may consider using sites like bitcoin.tax and cointracking.info to assist with compliance. While this notice generated publicity, a vast majority of taxpayers did not comply.

 In this notice, the IRS also answered 16 FAQs that raised more questions than answers among attorneys, accountants, and taxpayers. For instance, questions remain regarding hard and soft forks in cryptocurrencies and the use of section 1031 exchanges for transfers from one cryptocurrency to another prior to the section’s amendment in connection with the most recent tax reform bill.

In September 2016, the Treasury Inspector General for Tax Administration (TIGTA) reported that the IRS had not developed a comprehensive cryptocurrency tax strategy that focuses both on encouraging taxpayer compliance and ensuring that employers and businesses are required to report information to the IRS. The report indicates that the IRS agreed with TIGTA’s recommendations; however, despite multiple requests, including those from the American Bar Association (ABA) and the American Institute of Certified Public Accountants, the IRS has not revised Notice 2014-21 and has not implemented any of TIGTA’s other recommendations, including those related to information reporting. See 2018 IRS, Information Reporting Advisory Committee Public Report (Oct. 2018); Letter from Orrin Hatch, Senate Fin. Comm., Kevin Brady, House Ways & Means Comm., and Vern Buchanan, House Ways & Means Oversight Subcomm., to John Koskinen, IRS Comm’r (May 17, 2017) (requesting an update on the implementation of these regulations).

Instead, the IRS issued IR-2018-71, reminding taxpayers that they are responsible for maintaining adequate records and paying any applicable taxes. Acknowledging that there are more than 1,500 known cryptocurrencies, the IRS noted that “[b]ecause transactions in virtual currencies can be difficult to trace and have an inherently pseudo-anonymous aspect, some taxpayers may be tempted to hide taxable income from the IRS.” Rather than issue additional guidance, the IRS is investigating whether taxpayers should face criminal and civil tax consequences.

United States v. Coinbase

In 2016, the government filed an ex parte application seeking an order permitting the IRS to serve a “John Doe” administrative summons on Coinbase.

According to its website, Coinbase “is a secure online platform for buying, selling, transferring, and storing digital currency.” Specifically, currently, Coinbase provides users with the ability to create a digital wallet to store digital currency, including Bitcoin, Ethereum, Litecoin, and six other cryptocurrencies. As further detailed on its website, at the time of the order, Coinbase had been used in the exchange of more than $50 billion, supports 32 countries, and has served more than 10 million customers. Those figures are now reported to be more than 20 million users and more than $150 billion traded.

The IRS served its summons because it believed that Coinbase’s customers were not complying with Notice 2014-21. Specifically, the government disclosed that only 800 to 900 taxpayers a year had been reporting Bitcoin transactions on their tax returns. Opinion at 6.

In enforcing the summons, the court noted that the “discrepancy” between the taxpayers that reported the transactions and the admitted number of transactions “creates an inference that more Coinbase users are trading Bitcoin than reporting tagins on their tax returns.” Id. Furthermore, the price of Bitcoin appreciated from January 2013 at under $15 through December 2017 when one Bitcoin was valued at more than $21,000. Thus, the court concluded that the government had a “legitimate interest in investigating these taxpayers.” Opinion at 6.

After a year of litigation and a narrowing of the scope of the summons, the court ordered Coinbase to turn over information regarding accounts “with at least the equivalent of $20,000 in any one transaction (buy, sell, send, or receive) in any one year during the 2013–2015 period.” Id. at 3. Despite the government’s interest in investigating taxpayers who were not reporting their Bitcoin or other cryptocurrency transactions, the court limited the customer information that Coinbase was ordered to produce to what it found to be relevant: (1) taxpayer ID number; (2) name, (3) birth date, (4) address, (5) records of account activity, and (6) all periodic statements of account or invoices.

In ordering Coinbase to produce these categories of documents, the court rejected the government’s broad request for “account opening records, copies of passports or driver’s licenses, all wallet addresses, all public keys for all accounts/wallets/vaults, records of Know-Your-Customer diligence, agreements or instructions granting a third-party access, control, or transaction approval authority, and correspondence between Coinbase and the account holder.” Opinion at 10. While the court left open the possibility that the government could get this information, there is no indication that Coinbase provided this information.

Regardless, according to Coinbase in the litigation, the IRS should have received information regarding more than 8.9 million transactions of the more than 13,000 customers. The IRS also received additional information from Coinbase regarding its customers. For tax year 2017, Coinbase filed 1099-Ks for qualifying customers as described on its website (200 virtual currency transactions whose total value exceeds $20,000 and meets additional criteria). This practice should continue for 2018 and beyond. Of course, if the IRS needs more information, the government can obtain this information through a new summons or a grand jury subpoena in a criminal investigation.

Cryptocurrency Investigations and Prosecutions

As with data that the IRS received regarding unreported foreign accounts, the IRS will continue to use its data to open up cryptocurrency-related investigations. Information from Coinbase, civil audits, whistle-blowers, and other sources—including other SEC, CFTC, and DOJ cryptocurrency investigations—will presumably be examined in connection with the priorities of IRS-CI and the IRS Large Business and International Division’s (IRS-LBI) cryptocurrency compliance campaign.

In May 2017, IRS-CI created the Nationally Coordinated Investigations Unit (NCIU) to use a “data driven approach” to address key noncompliance areas and emerging threats. IRS-CI Annual Report 2018, at 22. As listed in IRS-CI’s 2018 annual report, the NCIU’s areas of high priority include cryptocurrency, employment tax, international tax, and significant money laundering. Id. While cryptocurrency is treated as a stand-alone area, it can also be used to evade employment taxes, hide money offshore, and launder money. Id. The goal of the NCIU is to ensure that cases are referred by all 25 of IRS-CI’s field offices and that cases are being referred to DOJ. Id.

IRS-CI’s Cybercrimes Unit is also focusing on cybercrimes and other crimes involving cryptocurrencies. At the recent ABA conference, Chief Fort reiterated the point he has made previously that one of the results of IRS-CI’s efforts to combat identify theft was the development of a team of IRS-CI employees who are the forefront of the understanding of cryptocurrencies. See Id. at 3, 11.

The IRS is also focusing its civil resources on investigating cryptocurrencies. One example is the July 2, 2018, IRS-LBI announcement of its compliance campaign related to cryptocurrencies. In the announcement, the IRS urged taxpayers with “unreported virtual currency transactions” to come forward as soon as possible, noting that the IRS “is not contemplating a voluntary disclosure program specifically to address tax non-compliance involving virtual currency.”

Because the IRS and the Department of Justice have now received information from Coinbase, as well as information from other sources, individuals are on notice that they may be the subject of a criminal investigation if they use cryptocurrency to commit tax fraud or some other, nontax crime. Furthermore, because the Tax Cuts and Jobs Act has now limited the use of section 1031 exchanges to real estate transactions beginning with the 2018 tax year, holders of cryptocurrency will no longer be allowed to defer taxable gains by exchanging one form of currency for another. As a result, taxpayers who hold cryptocurrencies with taxable gains or are looking to use cryptocurrencies to hide legal- or illegal-source income may shift their focus to other schemes to shield their gains.

Regardless of limitations created by the IRS’s shrinking resources, IRS-CI will continue to investigate and work with the DOJ to prosecute taxpayers and other individuals who commit or assist others in committing tax fraud. A sampling of recent events from publicly available sources suggests that the prospect of charging criminal cases or assessing civil penalties appears to be closer:

  • In March 2018, Coinbase informed 13,000 of its customers that it would be giving information on their accounts to the IRS.
  • On March 23, 2018, the IRS issued IR-2018-71, reminding taxpayers to report cryptocurrency transactions.
  • On July 2, 2018, the IRS-LBI announced its cryptocurrency compliance campaign.
  • In the fall and winter of 2018, Darren Guillot, director of Field Collection for the IRS Small Business / Self-Employed Division, publicly acknowledged that he has accessed the Coinbase information and shared the information with revenue officers. He also recently acknowledged that IRS revenue officers seized a cryptocurrency wallet and levied the value of cryptocurrencies held in the hands of third parties.
  • Recently, Bryant Jackson, IRS-CI assistant special agent in charge (Los Angeles), said that IRS-CI has been expecting fraud referrals from the Coinbase summons response and that this priority/expectation was reiterated by Chief Fort at the recent ABA Tax Fraud Conference and in IRS-CI’s 2018 annual report.
  • The October 2018 IRS public report requested additional guidance from the IRS regarding the tax consequences of cryptocurrency transactions.

In focusing on the use of cryptocurrency to commit tax fraud, practitioners should help taxpayers understand the criminal and civil penalties, including those potentially faced by third parties for failing to report transactions involving cryptocurrencies. As noted in the IRS’s answer to FAQ 16, accuracy penalties will apply for failures related to the reporting of gains under section 6662 and failure to file information returns under sections 6721 and 6722.

Minimizing Criminal and Civil Tax Exposure

 Because IRS-CI is focusing on the use of cryptocurrencies to commit tax fraud, taxpayers and those who may conspire with others to commit tax fraud using cryptocurrency remain at risk of criminal prosecution. Individuals should recognize that IRS-CI’s NCIU will use its resources to convince the DOJ to prosecute cryptocurrency cases in other parts of the country. The IRS will favor these types of cases because they will generate media attention (local, regional, or national) and deter others from violating the law.

Thus, even though the chances of being subject to an audit or criminal investigation are historically low, taxpayers and tax practitioners should not rely upon this knowledge in conducting their tax and other financial affairs. Instead, taxpayers should consult their tax advisers to determine whether they have any reportable transactions, consider whether to amend any prior filings that failed to disclose such transactions, and discuss all available disclosure options. Taxpayers should also consider consulting their tax advisers in calculating any applicable cryptocurrency-related tax liability. Such discussions should include, among other things, the taxpayer’s basis and any gains (or losses) that the taxpayer may have incurred as a result of any such transaction (regardless of whether or not the taxpayer received a Form 1099 showing any taxable gain). Furthermore, any business or other third-party organization that currently transacts business using Bitcoin or any other cryptocurrencies should consult with a tax adviser to determine (1) any information reporting or other withholding requirements related to these transactions, (2) whether that reporting requirement needs to include the disclosure that the underlying transaction involved cryptocurrency, and (3) whether the business or third party is adequately tracking information related to its own cryptocurrency holdings. Any possible review should also include situations where a business pays an independent contractor or employee in Bitcoin (or other cryptocurrency) rather than fiat currency, such as U.S. dollars.

Finally, in determing how best to proceed if you or your client’s activities are the target of an IRS-CI investigation, you should be mindful of the government’s successful track record in prosecuting cases and the prison sentences imposed on defendants. See 2IRS-CI Annual Report 2018 (a conviction rate of 91.7 percent in fiscal year 2018 and an incarceration rate of 82 percent).

Benjamin Tompkins is an attorney at Graves Garrett LLC in Kansas City, Missouri.


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