Over the past few years, the IRS has been slowly issuing guidance and warnings regarding the reporting and taxation of the usage and exchanging of virtual currency. Recently, on July 26, 2019, the IRS advised those who have engaged in virtual currency usage that they have begun sending educational letters to taxpayers with virtual currency transactions who either may have failed to report income and pay the resulting tax from virtual currency transactions or did not report their transactions properly.

The educational letters are as follows:

Letter 6173;
Letter 6174;
Letter 6174-A.

IRS Commissioner Chuck Rettig advised, “Taxpayers should take these letters very seriously by reviewing their tax filings and, when appropriate, amend past returns and pay back taxes, interest and penalties. The IRS is expanding our efforts involving virtual currency, including increased use of data analytics. We are focused on enforcing the law and helping taxpayers fully understand and meet their obligations.”

The IRS started sending these educational letters to taxpayers mid-July and predicted that more than 10,000 taxpayers would receive these letters by the end of August. The names of these taxpayers were obtained through various ongoing IRS compliance efforts. 

How did we get to the point of these letters being sent and what were the warnings to those affected taxpayers? There have been a few signs, and anyone following this matter should not be surprised by these letters. Brief summary can be found below:

December 2016: John Doe Summons

As found under IRC§ 7602(a), the John Doe Summons is one of the various enforcement tools available to the IRS which authorizes the IRS to utilize its summons power for any bona fide civil tax audit or tax collection purpose. A summons may be issued to: (1) ascertain the correctness of a return; (2) make a return where none has been made; (3) determine the liability of any person for any internal revenue tax; (4) determine the liability of any transferee or fiduciary; or (5) collect any internal revenue tax liability.

In December 2016, the IRS served a “John Doe” summons on Coinbase, Inc. (“Coinbase”) one of the largest virtual currency exchanges, requesting information relating to Coinbase’s U.S. customers who conducted transactions in a convertible virtual currency, as defined in IRS Notice 2014-21, between January 1, 2013 and December 31, 2015. The IRS was requesting the identities of these customers.

In response, Coinbase filed a petition to quash the summons in the U.S. District Court for the Northern District of California.

The IRS, in attempt to streamline its request,  then filed a "Notice of Narrowed Summons Request for Enforcement" with the court, seeking more specific types of information regarding accounts "with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2012 – 2015 period," with limited exceptions. In response, Coinbase admitted that this request covered almost 9 million transactions and approximately 14,400 account holders. ((United States v. Coinbase, Inc., Case No.17-cv-01431-JSC, at *3 (N.D. Cal.Nov. 28, 2017)) For those accounts, the IRS sought, among other items, registration records, transaction logs, payment records, and correspondence. Coinbase again refused to comply with this narrowed summons.

“To obtain a court order enforcing a summons, the IRS must first establish ‘good faith’ by showing that the summons: (1) is issued for a legitimate purpose; (2) seeks information relevant to that purpose; (3) seeks information that is not already in the IRS's possession; and (4) satisfies all of the administrative steps set forth in the Internal Revenue Code. United States v. Powell, 379 U.S. 48, 57-58 (1964). “The government's burden is a slight one, and may be satisfied by a declaration from the investigating agent that the Powell requirements have been met.” Crystal, 172 F.3d at 1144 (quoting United States v. Dynavac, Inc., 6 F.3d 1407, 1414 (9th Cir. 1993)). The showing need only be minimal “because the statute must be read broadly in order to ensure that the enforcement powers of the IRS are not unduly restricted.” (Liberty Fin. Servs. v. United States, 778 F.2d 1390, 1392 (9th Cir. 1985))  

According to United States v. Coinbase, Inc., the IRS believed (and still believes) that tax noncompliance associated with cryptocurrency is widespread and that virtual currency gains have been widely underreported. In support of this belief, the IRS advised that their virtual currency investigative team, formed by the IRS in 2016, examine electronically filed  Form 8949, Sales and Other Dispositions of Capital Assets, and found only between 800 to 900 taxpayers reported bitcoin transactions in 2013 – 2015 while Coinbase claimed to have served 5.9 million customers and exchanged $6 billion in bitcoin through its buy/sell trading functionality as of the end of 2015.

These findings portray an underreporting by U.S. taxpayers with the sale or exchange of bitcoins. This finding did satisfy the government’s good faith requirement for the summons to be enforced; On Nov. 28, 2017, the court denied Coinbase’s motion to quash and ordered Coinbase to respond to the summons, which was further narrowed by the court. In February 2018, Coinbase informed approximately 13,000 of its customers that it was providing the IRS with their taxpayer ID, name, birthdate, address, and historical transaction records during 2013 through 2015. The narrowed summons requested information on U.S. customers who had accounts which engaged in transactions worth $20,000 or more.

Before the John Doe Summons, the only true guidance issued by the IRS related to taxation of virtual currencies was Notice 2014-21 where the IRS provided, among other things, that cryptocurrency is to be treated as property rather than currency. Since then, there have been many comment letters submitted by both the AICPA and the ABA requesting additional guidance from the IRS. There have been other requests for guidance by the IRS and the IRS has promised to issue such guidance in a variety of replies.

In September 2016, Treasury Inspector General for Tax Administration (TIGTA) issued a report “As the Use of Virtual Currencies in Taxable Transactions Becomes More Common, Additional Actions Are Needed to Ensure Taxpayer Compliance Currencies.”  The objective of the September 2016 report was to review the IRS’s strategy for addressing income produced through virtual currencies. TIGTA found that even though

“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. Although the IRS requested comments to Notice 2014-21 from the public, no actions were taken to address the comments received. TIGTA reviewed all the comments and found several examples of information requested by the public that would be helpful in understanding how to comply with the tax reporting requirements when using or receiving virtual currencies.”

TIGTA made three recommendations: 

1. Develop a coordinated virtual currency strategy that includes outcome goals, a description of how the agency intends to achieve those goals, and an action plan with a timeline for implementation;
2. Provide updated guidance to reflect the necessary documentation requirements and tax treatments needed for the various uses of virtual currencies; and
3. Revise third-party information reporting documents to identify the amounts of virtual currencies used in taxable transactions.

In May 2017, in response to the John Doe Summons issued to Coinbase, members of the Senate Finance Committee and the House Ways and Means Committee wrote to then IRS Commissioner John Koskinen, questioning both the breadth and intrusiveness of the summons and also requesting that the IRS answer questions related to the IRS’s policies and procedures relating to cryptocurrency.

In March 2018, IR-2018-71, March 23, 2018, the IRS reminded taxpayers that income from virtual currency transactions is reportable on their income tax returns.

Taxpayers who do not properly report the income tax consequences of virtual currency transactions can be audited for those transactions and, when appropriate, can be liable for penalties and interest. The IRS continues that taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions. Criminal charges could include tax evasion and filing a false tax return. Anyone convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Anyone convicted of filing a false return is subject to a prison term of up to three years and a fine of up to $250,000.

In July 2018, the IRS announced as one of their five Large Business and International Compliance Campaigns, the Virtual Currency Compliance campaign. The Virtual Currency Compliance campaign will address noncompliance related to the use of virtual currency through multiple treatment streams including outreach and examinations. The compliance activities will follow the general tax principles applicable to all transactions in property, as outlined in Notice 2014-21. Taxpayers with unreported virtual currency transactions are urged to correct their returns as soon as practical. The IRS is not contemplating a voluntary disclosure program specifically to address tax noncompliance involving virtual currency.

In May 2019, IRS Commissioner Charles P. Rettig, in reply to Representative Tom Emmer’s request dated April 2019 for further guidance on reporting cryptocurrencies, responded the IRS is working on developing appropriate guidance and there would be guidance issued in the near future.

 “I share your belief that taxpayers deserve clarity on basic issues related to the taxation of virtual currency transactions and have made it a priority of the IRS to issue guidance,” said Rettig, in this letter, adding guidance on these and other issues will be published “soon.”

There has been internal training within the IRS/Criminal Investigations regarding virtual currency transactions, usage, etc., and the IRS has also posted webinar presentations for taxpayers, professionals, etc. on the IRS website. The IRS has not been ignoring this issue of cryptocurrency; rather it seems it has been gearing up for the next round of compliance initiatives. 

So again, the letters issued in July should not be a shock to anyone who has been following this area.

Back to the IRS Letters

All three versions are designed to help taxpayers understand their tax and filing obligations and how to correct past errors. Each letter has a specific purpose and also may provide a hint as to the knowledge that the IRS may have regarding a taxpayers cryptocurrency transactions.

Letters 6174 and 6174-A basically put taxpayers on notice that the IRS has information regarding the taxpayers’ account(s) which contain virtual currency and also provide an explanation as to the various activities which can trigger tax reporting requirements. Although neither letter requires a response, letter 6174-A warns in the last sentence, that additional correspondence about potential enforcement activity may be follow. Both of these letters have put the taxpayer in receipt on notice about their applicable reporting obligations, i.e., they have been warned.

A taxpayer who has received either one of these notices must take it seriously and review their virtual currency transactions, determine if they have been reported correctly, i.e., as provided in the letter, and, if any errors found, should file an amended return (or maybe not; see below for Voluntary Disclosure options) to assure the virtual currency transactions are reported correctly. On the first page of such an amended return, Letter 6174/6174-A must be written on top of first page.

Letter 6173 is different in that the IRS is requesting a response. The IRS is advising the recipient that it has information regarding virtual currency transactions and for the years 2013 – 2017, they do not see this reported on the recipient’s income tax return, if filed at all. This letter gives the recipient three options: file delinquent tax return and report the virtual currency transactions; file an amended tax return and properly report the virtual currency transactions; or provide a statement of facts, under penalties of perjury (the letter provides such language) explaining his/her position if recipient thinks he/she is in compliance with the tax reporting obligations relating to virtual currency.

There was a second set of letters sent by the IRS in August 2019, the CP 2000 Notices, received by some cryptocurrency investors. These letters are advising recipients that their federal tax returns don't match the information received from virtual currency exchanges. These letters acknowledge that trading exchanges, not the taxpayers, may have made the errors. This is a strong sign that the IRS is monitoring the industry.

If a taxpayer is in a noncompliant situation, either intentionally or unintentionally, it may not be as simple as just amending the returns to now report these transactions. Materiality of the tax error also must be taken into account. How to correct the prior tax noncompliance is an important step and the IRS is now starting to take notice and is beginning to collect information to review and compare. Each individual needs to consider their position and then determine whether they simply file an amended return to correctly report the virtual currency transactions, or do they contact a lawyer and discuss the next steps. A taxpayer may consider entering into the voluntary disclosure program, which was recently amended in November 2018. The IRS has said there will not be a special Voluntary Disclosure program for cryptocurrencies as there was for the offshore accounts. It should be no surprise that the IRS is now contacting taxpayers as they did collect information for 13,000 U.S. taxpayer/ Coinbase account holders. The IRS’s Offshore Voluntary Disclosure Program, which ended in September 2018, offered taxpayers the opportunity to avoid criminal penalties and to settle outstanding tax charges stemming from noncompliance relating to foreign assets. In November 2018, the IRS added new voluntary compliance procedures which are applicable to both domestic and international issues. Voluntary disclosure is a long-standing practice of the IRS which provides taxpayers with criminal exposure a path to come into compliance with the law and potentially avoid criminal prosecution. Typically, taxpayers who seek voluntary disclosure are willful and want to avoid any criminal charges. Although with the offshore voluntary disclosures, there were also many taxpayers who were not willful, but instead wanted to avoid potentially high penalties which could have been imposed if they did not enter the offshore voluntary disclosure program and utilize the one offshore miscellaneous penalty.  

Every situation is unique and should be reviewed independently. Same logic applies here as with the offshore voluntary disclosures—the longer a taxpayer waits to come into compliance, the harder it will be to tell the IRS they were not aware of the tax reporting obligations of cryptocurrency. Also, the IRS does not want to have to find the taxpayer; they want taxpayers to come forward voluntarily in order to correct any past reporting noncompliance issues.

We may want to look back to June 2008, when the John Doe Summons was issued to UBS. There were various warnings and “minimal” guidance issued as well, including a 2003 Offshore Voluntary Compliance Initiative with a focus on offshore banks. We had Regulations for reporting foreign bank accounts under Title 31 of the C.F.R, and guidance for the taxability of these accounts was found under Title 26, of the C.F.R but, still, many were somehow caught off guard. The foreign bank account reporting (FBAR) requirements has been in existence since 1970 but it was known, as the ”sleeper” form; not many filed this form and the IRS became increasingly aware in the early 2000s of this “underreporting.” Remember the thousands of taxpayers who entered into one of the four Offshore Voluntary Programs which followed that John Doe Summons. Remember, not only was there the reality that the offshore bank account was subject to reporting, if it met the statutory reporting threshold, but the fact that the earnings were also subject to U.S. taxation was a ”new concept” for many. The complexities of applying U.S. tax laws to various foreign: investments, companies, pensions, retirement accounts, real estate, mutual funds, etc. came to light. In addition, many taxpayers, and tax professionals, realized that there was U.S. tax filing requirement if the taxpayer was an American citizen or green card holder residing abroad or even if you were the “accidental American” and never even resided in the U.S. there were still applicable filing requirements. Many had no idea they were still subject to U.S.. taxation and filing requirements even if residing outside of the United States. Due to the fact and growing reality as to how many taxpayers were not in compliance with either the reporting obligations under 31 C.F.R and/or the taxation requirements under 26 C.F.R, the IRS continually offered various Offshore Voluntary Disclosure programs so these taxpayers could find an “easy,” and, at times, expensive path, to come into compliance with their prior “noncompliant” behavior. The various penalties outside of these programs were often very steep and the fear of criminal prosecution was enough for many taxpayers to enter into these programs. Reality is, many taxpayers did not need all of the protections that these programs offered but many wanted closure so they entered the program and paid the penalties, etc. Each program became a bit more succinct and efficient and also more expensive. As stated above, the last of those Offshore Voluntary Disclosure Programs closed in September 2018; and in November 2018, the IRS revised its Voluntary Disclosure procedures to account for both offshore and domestic issues and is now the avenue for such foreign noncompliant disclosures. There are also the two Streamlined programs offered to report “non-willful” matters of prior non-reported foreign bank accounts and previously non-reported foreign income. Remember, as these programs evolved, the focus on willful or non-willful also became obvious and the reality was many taxpayers who were not acting intentionally to hide any offshore assets or to evade U.S. taxation were being caught in this very wide punitive net the IRS had casted in order to bring all into compliance. The IRS had started offering ways for these taxpayers to come into compliance as well and this culminated with the two remaining Streamlined Programs, which can close at any time.    

Where are we now?

Today, we have minimal guidance regarding taxation of virtual currency but enough to know they are subject to taxation. There have been warnings and announcements by both the IRS and FinCEN  and the world of virtual currencies has exploded in the past years. Both the IRS and FinCEN will be seriously monitoring the usage of  virtual currencies, MSBs, Exchanges, etc. because, as with the offshore bank accounts, this is an area where there is there is a concern for criminal activity such as money laundering, terrorist financing, and drugs; it is not just about tax evasion. This is serious and it is being addressed.

With the IRS Commissioner advising guidance coming soon coupled with the enforcement actions taken in the past few months, and the knowledge that the first John Doe Summons was enforced and certain information of 13,000 Coinbase account holders was provided to the IRS, I would say we are at the beginning of a long road of taxpayers trying to find a way to come into compliance with the IRS. Tax professionals should, once again, revise their annual tax organizers and add language which puts taxpayers on notice regarding their requirement to report virtual currency transactions—as in the past, tax professionals may again find themselves in the position to protect themselves. Questions such as: “Did you ‘mine,’ buy, sell, or exchange a virtual currency; use a virtual currency to pay for goods or services; or receive a virtual currency as payment for goods or services?” will need to be asked. Be ready to explain the importance of virtual currency record keeping in order to satisfy the IRS reporting requirements and be ready to identify and record al virtual currency transactions. Be sure to document files for any activity relating to virtual currency ownership and usage of the client. 

As of now, it seems that these virtual currency accounts are not reportable on either the FBAR or the Form 8938. The only definitive guidance to FBAR reporting was made back in 2014 when an IRS agent provided for 2014, these accounts were not reportable on the FBAR; and more recently, FinCEN, in response to one of the AICPA letters where it specifically requested such guidance, the response was the regulations as found under 31 C.F.R  § 1010.350 and does not include virtual currency as a reportable account. To be safe, taxpayers may just want to include on both forms if in doubt; when it doubt, fill it out.