IRS Subpoenas and Crystal Balls

Part 2:


1. What could a narrowed IRS John Doe subpoena to Coinbase look like?

The subpoena could seek records for (A) a subset of US persons, (B) over a limited time frame, (perhaps 1 year, strategically situated around a period of extreme volatility in bitcoin valuation) and (C)specifically ask for anonymized records of users based in the United States who (D) both bought and sold virtual currency assets within that time frame.

If the point is to locate taxpayers who are evading obligations to pay taxes, then mere purchasers of bitcoin who did not sell their bitcoins during the relevant time period would likely not give rise to any evidence of tax evasion. Buying bitcoin is a taxable event (US dollars are used to obtain property). In a USD for Bitcoin transaction, the property acquired (i.e. the bitcoin) has a basis independent of the cost paid to acquire it (under IRS valuation guidance found in IRS Notice 2014-21, which is in drastic need of update/clarification). A gain or loss on the bitcoin does not occur until a subsequent trade or sale of the bitcoin for either US dollars or some other item of value. At that time, based upon the value of what’s received in exchange for the bitcoin, the bitcoin holder has a gain or loss which the IRS seeks to tax. Coinbase and other similar providers do not facilitate trades of bitcoin for things other than USD (and of late, for other cryptoassets, which the author will ignore for now). The IRS logically would probably look for purchases of virtual currency at basis A, and the subsequent sale, trade or transfer into USD at later value B, within a relevant time period.

The IRS may ask Coinbase to produce anonymized records (i.e. records with customer identity removed) to detect patterns of behavior suggestive of bitcoin trading that would yield taxable gains or losses. Undoubtedly the IRS has assembled the number of taxpayers who declared gains or losses from virtual currency trading (hypothetically 100 taxpayers) and could request a number of records exceeding that amount (500 records) and review those records for evidence of transactions that would have rightly led to a taxable gain or loss. By anonymizing its records, Coinbase could protect its users’ identity while complying with the IRS’s subpoena.

If the IRS found widespread evidence of underreporting, then it may have stronger grounds to demand full disclosure of all trading activity of US persons.

I pause to re-emphasize that crypto-currency valuation is in desperate need of clarification.

2. Should we believe the IRS when it claims that it can’t afford to require Coinbase, Bitpay and other similar businesses to become third party reporters?

Yes. At first blush, the statement in the Treasury Inspector report that the IRS can’t afford it (“based on the IRS’s current fiscal climate, the IRS is faced with competing funding priorities requiring a need-based prioritization of information technology expenditures”) seems silly; if tax evasion is rampant, wouldn’t the resulting payment of taxes and penalties more than cover the costs? However, prevailing political winds seem to favor smaller, cheaper government, and undoubtedly, the IRS has many priorities beyond bitcoin. Creating new third party reporting carries significant costs and the subpoena may be the IRS’ attempt to get the same information more efficiently.

The costs associated with creating a new third party reporting obligation is undoubtedly significant. First, the Service must specifically identify all businesses that provide services qualified for reporting, and mandate that they report, which likely requires administrative rule-making, which itself is time consuming, political, and expensive.

Locating these businesses may be deceptively difficult. Coinbase, Bitpay and others who market their services and regularly interact with the conventional banking system are easy to locate. However, off market bitcoin traders who deal in cash or other value, with no interface into domestic bank accounts may be transparent to the IRS. (This distinguishes the bitcoin industry from securities and equities trading platforms that provide third party reporting to the IRS- those trading houses are required to be registered and licensed to perform equities trades, and equities trading systems themselves are permissioned. Public blockchains facilitating transactions of cryptocurrency do not require permission or registration.) Thus, OTC bitcoin changers may evade detection and continue to function outside of any regulations that would apply to more visible and established service providers. Market knowledge of a third party reporting requirement may drive customers to providers that do not interface with the conventional banking system ( and darker markets that make the identification of tax evasion more difficult for the IRS.

Assuming that the IRS puts together its list of domestic exchanges that change bitcoin into USD, and requires third party reporting, the IRS then needs to build a database to handle this data, hire people to run the database, hire people to compare the data from the third party reports against personal tax returns, and create a new version of the AUR program to contact parties who appear to have under-reported and collect taxes and impose penalties. The costs would mount quickly.

Thus, instead of engaging in rulemaking, imposing a 1099-B-like form requirement on some subset of active exchanges, creating a database, staffing the program and instituting a new system of AUR to collect fines and penalties, and incidentally pushing more bitcoin users toward darker means of cashing out, the IRS appears to be using this subpoena to verify their assumption of pervasive tax fraud based on their current de minimisinformation before engaging in the expensive process crudely outlined above, or taking other approaches compel compliance with the tax code.

3. Can’t the IRS get this data from other places?

No. Public blockchains display transaction history, but only show the transaction of bitcoin from user to user, and do not show any consideration paid to the transferor for the transfer. Although bank statements may demonstrate payment to a bank account from Coinbase or another similar processor, there is no data that suggests the basis paid for those bitcoins that were accepted by Coinbase in exchange for the wire transfer out to that bank account. Assuming that Coinbase and others fully complied with their AML/KYC/BSA obligations, they have reported transactions over $10k, or structured transactions, or other data required to be collected and reported, but that data itself is likely not useful for identifying tax fraud because it fails to identify the value underlying the transaction from bitcoin to USD that would establish a taxable gain or loss.

4. What happens if large scale tax fraud is discovered?

For taxpayers:

If Coinbase’s response to a modified subpoena results in the discovery of evidence of widespread tax fraud, the IRS could initiate a civil audit of each taxpayer, or refer the matter to the Department of Justice for potential criminal investigation and potential prosecution. Widespread amnesty is possible but improbable.

For processors:

Coinbase and similar platforms could, in what would be understood to be a worst case scenario, be charged with aiding and abetting tax fraud under a theory similar to that applied against UBS when it was prosecuted for aiding and abetting tax fraud for inducing taxpayers to move funds to Switzerland to avoid US tax law.

This would be an extreme outcome distinguishable on its facts. UBS apparently actively solicited American tax payers based upon the avoidance of US Tax law, and there is no evidence available to this author that suggests that Coinbase or (any other similar processor) has encouraged tax avoidance as a reason to use their service. To the contrary, Coinbase’s User Agreement clearly notifies its users that they are responsible to “ withhold, collect, report and remit the correct amounts of taxes to the appropriate tax authorities.” However, criminal action, if only to induce settlement, is within the realm of possibility. I expect that Coinbase would strongly resist any criminal allegation of wrongdoing.

Alternatively, the IRS could negotiate a modified form of third party reporting which permits the IRS to access a “backdoor” into Coinbase’s production database to monitor trading activity by US persons to potentially offset costs to create their own databases. Less likely, but still possible, Coinbase could actually modify their system to assess taxes within the platform to ensure compliance. Again, however, this brings up significant questions of valuation, which need to be timely addressed.