IRS Notices 2014-21 and 2019-24
Given the publicity surrounding cryptocurrency tax compliance and the new question added to the 2019 individual tax return, taxpayers are on notice that they must report any income earned from the purchase and sale of cryptocurrency or the receipt of cryptocurrency as payment for employment or the sale of goods. In calculating any tax liabilities, you should know that the IRS does not treat cryptocurrency as real currency. Instead, the IRS treats cryptocurrency as akin to property. This has been the case since 2014.
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 (using the term virtual currency) is not designated as legal tender, it recognized that it could operate like real currency by acting as a “convertible virtual currency” that can be converted to currencies such as the U.S. dollar. Under traditional tax rules, 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 cryptocurrency, the taxpayer must convert the payment to dollars and pay any tax owed. The onus is on the taxpayer to keep good records and should consider using services that assist taxpayers with complying with their obligations.
Last October, after repeated requests for additional guidance from taxpayers, practitioners, the cryptocurrency industry, and members of Congress, the IRS finally issued additional guidance regarding the treatment of hard forks and airdrops of new cryptocurrency. See IRS Notice 2019-24. If the taxpayer receives new cryptocurrency and receives the benefit of that cryptocurrency, then the taxpayer should be treating that new cryptocurrency as income. To assist taxpayers in understanding their obligations, the IRS maintains FAQs regarding cryptocurrency on the Service’s website. There are currently 45 FAQs, including questions about reporting, record keeping, transfer of cryptocurrency between your own wallets, and acceptance of cryptocurrency by a charitable organization.
While the IRS is providing additional guidance, questions remain, especially given the lack of uniformity in how various cryptocurrency companies report transactions and the lack of information reported. Furthermore, open questions remain about reporting obligations related to cryptocurrency held offshore. At least arguably that question is partially alleviated by the new question taxpayers must answer in filing a Form 1040 individual tax return. Regardless of these unanswered questions, the IRS is prioritizing investigations into whether taxpayers used cryptocurrency to commit tax or other crimes and whether those taxpayers should face criminal and civil tax consequences.
United States v. Coinbase
Even though the IRS received information from Coinbase more than two years ago, tax investigations take time and the IRS will continue to prioritize these cryptocurrency enforcement efforts. In evaluating the length of a criminal tax investigation, it is important to remember that criminal tax cases are subject to a six-year statute of limitations. See 26 U.S.C. § 6531. However, this should leave enough time for the IRS to continue to investigate crimes committed in connection with the 2015, 2016, and 2017 tax years, as well as to continue ongoing criminal tax investigations related to the 2014 tax year.
By way of background, it is important to understand the Coinbase litigation and the pervasive tax-compliance issues by users of cryptocurrency. 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 Coinbase’s website, Coinbase claims to be “the world’s most trusted crypto exchange” and is used by more than “35+ million people.” Coinbase provides users with the ability to create a digital wallet to store digital currency, including Bitcoin and other cryptocurrencies. As detailed in the Coinbase decision, 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 reported Bitcoin transactions on their tax returns. Coinbase, 2017 WL 5890052, at *4. 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 gains on their tax returns.” Id. Thus, the court concluded that the government had a “legitimate interest in investigating these taxpayers.” The government’s interest has only increased since Bitcoin’s price appreciation in 2017.
After rejecting Coinbase’s arguments, 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 *2. Specifically, the court ordered Coinbase to provide the following documents:
- taxpayer ID number
- taxpayer name, birth date, and 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
- all periodic statements of account or invoices
According to Coinbase in the litigation, the IRS should have received information regarding more than 8.9 million transactions of these more than 13,000 customers.
In the years since, the IRS also has received additional information. For tax years 2017–2019, Coinbase filed 1099-Ks for qualifying customers as described on its website (200 virtual currency transactions whose total value exceeds $20,000 and that meet additional criteria). See Form 1099-K Tax Information for Coinbase Pro and Prime, Coinbase (2020) (as noted by Coinbase, the information reporting is different for five states and the District of Columbia). In addition to this information, recent cases demonstrate how the IRS and the U.S. Department of Justice (DOJ) have been able to obtain additional information through a summons or a grand jury subpoena in connection with individual civil and criminal investigations. See United States v. Gratkowski, 964 F.3d 307, 310 (5th Cir. 2020) (affirming denial of motion to suppress where the government mined evidence from publicly available Bitcoin blockchain information to obtain information from Coinbase and then used it in a criminal case); Zietzke v. United States, 2020 WL 264394 (Jan. 17, 2020) (IRS summons to Coinbase for taxpayer-specific information); Zietzke v. United States, 2019 WL 6310661 (W.D. Wash. Nov. 25, 2019) (IRS summons to Bitstamp, another cryptocurrency exchange).
Cryptocurrency Investigations and Prosecutions Going Forward
Even in the midst of a global pandemic and limited resources, the IRS continues to focus on doing more with fewer resources. While the IRS has been able to hire additional employees and plans to use some of them to investigate possible cryptocurrency crimes, the IRS is focusing on data analytics in utilizing its existing resources and strengths in deterring the use of cryptocurrency to commit tax and nontax crimes. As with data that the IRS received regarding unreported foreign accounts, the IRS will continue to use its data to open cryptocurrency-related investigations. Information from Coinbase, civil audits, whistleblowers, and other sources—including U.S. Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and DOJ cryptocurrency investigations—presumably will be examined in connection with the priorities of IRS-CI and the IRS’s Fraud Enforcement Office director.
For example, IRS-CI will use this data in connection with its other data analytics priorities. 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. Internal Revenue Serv., IRS: Criminal Investigation—Annual Report 2018, at 22 (2018). As listed in IRS-CI’s 2018 and 2019 annual reports, the NCIU’s areas of high priority include cryptocurrency, along with employment tax and other traditional and nontraditional tax areas. Id. While cryptocurrency is treated as a stand-alone area, it also can be used to evade employment taxes, hide money offshore, and launder money. Id. In addition to working domestic cases, the IRS has spent the last two years working with the J5 to combat international tax fraud and will continue to do so even after IRS-CI Chief Don Fort retires in September. The NCIU uses data analytics tools, as well as information contained in public blockchains, to pursue criminal investigations. Using publicly available information is discussed in the Gratkowski and Zietzke cases cited above. Additional data will be generated by the responses to the new question added to the 2019 Form 1040: “At any time during 2019, did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?” If the IRS has information that a taxpayer has cryptocurrency holdings and has not acknowledged these holdings on his or her tax return, that could trigger a red flag that leads to more investigation by the IRS and to potential criminal scrutiny.
Furthermore, as noted above, the reach of these investigations will be global. IRS-CI is one of five members of the J5. The J5 includes the Australian Taxation Office (ATO), the Canadian Revenue Agency (CRA), the Dutch Fiscal Information and Investigation Service (FIOD), the United Kingdom’s Her Majesty’s Revenue and Customs (HMRC), and the United States’ IRS-CI. The fruits of this cooperation resulted in the first plea agreement announced in July. As noted in a press release issued by the U.S. Attorney’s Office for the District of New Jersey, a Romanian man admitted to conspiring to engage in wire fraud and to offering and selling unregistered securities in connection with BitClub Network, a cryptocurrency mining scheme worth at least $722 million. This continued cooperation presumably will lead to more criminal cases. Notably, last year IRS-CI and the World Bank hosted more than 120 international and domestic law enforcement partners from approximately 20 countries for cyber training, which included emerging areas associated with cryptocurrency and blockchain. Taxpayers and practitioners should note that cryptocurrency cases will not stop at the borders of the United States.
Additional examples of criminal cases involving cryptocurrency include the following:
- September and October 2020: A criminal complaint was filed against several individuals, who have been indicted in connection with a $5 million cryptocurrency fraud scheme involving charges of commodities fraud, wire fraud, and money laundering. Customers purportedly paid defendants, a fugitive awaiting extradition proceedings and an attorney, to purchase cryptocurrency. Rather than purchase cryptocurrency, these defendants allegedly defrauded the customers and used the money for their own personal purposes. In another cryptocurrency fraud case in the U.S. District Court for the Southern District of New York, the principal of a bitcoin escrow company pled guilty to defrauding investors of more than $3 million, and settled other charges with the CFTC. Customers paid him to purchase cryptocurrency that he never had and that the customers never received.
- June and July 2020: Jack Abramoff was indicted and then pled guilty to various charges related to his involvement with an entity and its raising of funds through an initial coin offering that could be later converted to a cryptocurrency referred to as AML BitCoin. In Abramoff’s plea agreement, he also pled guilty to the first known criminal prosecution under the Lobbying Disclosure Act of 1995. DOJ has also indicted the founder of AML Bitcoin on money laundering and wire fraud charges, and the SEC has alleged that both Abramoff and AML Bitcoin’s founder violated federal securities laws. The founder disputes these charges and will continue to defend himself in these actions.
- March 2020: Criminal charges and a civil forfeiture complaint were filed against Chinese nationals charged with laundering over $100 million of funds stolen by North Korean actors from a hack of a cryptocurrency exchange.
- Feb. 2020: An Ohio man was charged with operating a Darknet-based cryptocurrency laundering service that attempted to conceal cryptocurrency transactions from law enforcement and allegedly helped launder more than $300 million.
Recent events also have shown that cryptocurrency could be subject to price manipulation. One case may arise from the use of TikTok to promote Dogecoin, another cryptocurrency. In that case, the TikTok user started a post that resulted in a challenge that involved the currency. Even if there is no criminal activity, this is an example of a situation where someone can use social media to potentially pump up the price of a cryptocurrency, like pump-and-dump scams involving penny stocks. Another case involving price manipulation is the recent hack of various Twitter accounts that involved a Bitcoin scam or the use of cryptocurrency as the payment of choice for perpetrators of ransomware attacks. Investors and the general public need to be wary of who is behind information campaigns related to cryptocurrency, as well as unidentified individuals who want to be paid in cryptocurrency.
Finally, the IRS is focusing its civil resources on investigating cryptocurrencies. Specifically, this year, according to an IRS press release, the IRS appointed a former IRS-CI veteran special agent as the newly established Fraud Enforcement Office director. The IRS Fraud Enforcement Office will be within the IRS Small Business/Self-Employed Division and, according to the press release, will focus on agency-wide compliance issues using “applied analytics” that would include cryptocurrency. Appointing IRS employees with criminal experience also will help further the IRS’s goal of providing quality criminal referrals to IRS-CI. In addition, the IRS Large Business and International Division continues to work on a compliance campaign related to cryptocurrencies. In an announcement, the IRS urged taxpayers with “unreported virtual currency transactions” to come forward. Finally, while the IRS modified its voluntary disclosure program form (Form 14457) in April to include virtual currency as one of the categories, it did not enact a voluntary disclosure program for tax noncompliance issues related to cryptocurrency. This campaign continues and presumably will continue to be coordinated with the IRS’s Fraud Enforcement Office director.
Minimizing Criminal and Civil Tax Exposure
Given the continued publicity surrounding cryptocurrency and the information that the IRS and DOJ have received from Coinbase, as well as information from other sources including the additional specific question on the 1040 tax return, taxpayers are forewarned if they attempt to use cryptocurrency to commit tax fraud or some other nontax crime. If taxpayers have unreported income associated with dealings in cryptocurrency, those taxpayers should consult with experienced criminal tax attorneys to explore available options, including whether to submit a Form 14457 for a request for voluntary disclosure preclearance. While the IRS has changed the program recently, it still may be suitable for taxpayers facing criminal tax issues associated with unreported income from cryptocurrency or other criminal tax issues. 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 other third parties for failing to report transactions involving cryptocurrencies. See Frequently Asked Questions on Virtual Currency Transactions, IRS.gov (2020).
Because IRS-CI is focusing on the use of cryptocurrencies to commit tax fraud, taxpayers and others who may conspire with others to commit tax fraud using cryptocurrency remain at risk of criminal prosecution. These types of cases should continue to be favored by the IRS under the leadership of James Lee, the new IRS-CI director who started on October 1, 2020, 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 at some of the lowest percentages in history, taxpayers and tax practitioners should not rely upon these percentages in conducting their tax and other financial affairs. Instead, taxpayers should be aware of any potential criminal and civil consequences that they may face and be proactive in determining what course of action to take. This includes whether the taxpayer has any reportable transactions and whether the taxpayer should amend any prior filings or discuss any voluntary disclosure options. Finally, if you or your client’s activities are the target of an IRS-CI investigation, then, in determining how best to proceed and in evaluating any available defenses, you should be mindful of the government’s successful track record in prosecuting cases and the prison sentences imposed on defendants. See Internal Revenue Serv., IRS: Criminal Investigation—Annual Report 2019 (2019) (a conviction rate of 91.2 percent in fiscal year 2019 and an incarceration rate of 79 percent).
