On November 17, 2016, the IRS filed its Petition for Leave to Serve a broad John Doe subpoena on Coinbase. The subpoena included a request for a broad swath of data regarding all US persons who used the exchange from 2013–2015. Despite its breadth, the statute under which the IRS travels for John Doe Subpoenas (26 USC s.7906) is remarkably permissive, and is used primarily for investigation. 4th and 5th amendment privileges are limited, invocations of common law privileges (like attorney client or work product) rarely prevail, and the Powell test (from U.S. v. Powell, 379 U.S. 48, 57–58 (1964)), under which these subpoenas are scrutinized, creates a very low bar:
- The investigation must be conducted for a legitimate purpose;
- The information sought must be relevant to that purpose;
- The IRS must not already possess the information; and
- All required administrative steps must have been taken.
Although the IRS bears the initial burden of establishing that these requirements have been satisfied, a mere affidavit reciting that the Powell factors have been satisfied is sufficient. Absent a defect in the affidavit, the burden shifts to the party contesting the subpoena to show (a) an abuse of process, (b) some legally recognized privilege over the materials sought, or (c)that the Powell factors were not satisfied.
The IRS appears to be is overwhelmingly successful in enforcing John Doe subpoenas; in 2012–2013, the IRS issued 117 such summonses, 56 of which were challenged; the IRS prevailed on 111 of them, with 2 subpoenas modified and only 4 outright defeated. (see: http://www.taxpayeradvocate.irs.gov/2013-annual-report/downloads/Summons-Enforcement-Under-IRC-7602-a-7604-a-and-7609-a.pdf)
Coinbase may credibly argue that the subpoena is overbroad; caselaw suggests that the subpoenas may be limited for overbreadth. (“The Government is not entitled to go on a fishing expedition through appellant’s records. It must identify with some precision the documents it wishes to inspect.” First National Bank of Mobile v. United States, 160 F.2d 532, 534 (5th Cir. 1947); United States v. First National Bank of Fort Smith, Ark., 173 F.Supp. 716, 720 (W.D.Arkansas 1959)).
The affidavit provided in support of the subpoena relies upon (a) three admitted tax cheats, (b) a Huffington Post article from 2013, (c)IRS studies of Tax Gap Estimates for Tax Years 2008 — 2010, and (d) and “the information and experience of the IRS,” to conclude that “ [b]ecause there is no third-party reporting of virtual currency transactions for tax purposes, the risk/reward ratio for a taxpayer in the virtual currency environment is extremely low, and the likelihood of underreporting is significant,” and thus legitimate the broad subpoena. This author views this support as flimsy, but reminds the reader that the Powell standard is very lax. Ultimately, these arguments may lead to modification of the scope of the subpoena, but is not likely to lead to the outright quashal (that’s legalese for full avoidance) of the subpoena.
So, in summary, because the law is very permissive, the smart money is with the IRS and some narrowed form of Subpoena is likely to issue over Coinbase’s objections.
Why did this happen at all? Why did the IRS suddenly ask Coinbase for all of its data about US persons? This report issued by the Treasury Inspector General for Tax Administration, dated September 21, 2016, entitled “As the Use of Virtual Currencies in Taxable Transactions Becomes More Common, Additional Actions Are Needed to Ensure Taxpayer Compliance” probably has a lot to do with it.
In the Report the Treasury Inspector noted that:
“ … third-party methods of reporting taxable transactions to the IRS do not separately identify transactions related to virtual currencies. While employers and businesses are required to report taxable virtual currency transactions, current third-party information reporting documents do not provide the IRS with any means to identify that the taxable transaction amounts being reported were specifically related to virtual currencies”
“In an October 2014 news article related to virtual currency, Bloomberg Bureau of National Affairs quoted Criminal Investigation management as saying that ‘agents will be targeting the use of the [virtual] currency to dodge taxes.’ When we followed up with Criminal Investigation management to determine what steps have since been taken to identify taxpayers that are using virtual currency to ‘dodge taxes,’ we were told that nothing specific has been done”
The Treasury Inspector recommended that
“…the IRS should prepare a comprehensive virtual currency strategy that will assist taxpayers lawfully engaged with virtual currencies to voluntarily comply with the tax laws while seeking to identify individuals unlawfully engaged in their use…. 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 currency. 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 develops the overall “big picture” associated with taxpayer use of virtual currencies. However, according to Large Business and International Division management, in January 2016, a subgroup of the VCIT was established to look at the feasibility of creating a campaign around how the IRS should address tax noncompliance related to virtual currency. This work is still in the discussion stages.”
There it is. The IRS was looking for the cheapest and most effective way to get third party information about bitcoin transactions.
Of course, there are other ways to require third parties to report on the actiivities of others. Form 1099-MISC, 1099-B, W-2, et al. require third parties to report the transactions of others. In fact, the Treasury Inspector recommended third party data collection of this sort to the IRS:
“… should revise third-party information reporting documents to identify the amounts of virtual currency used in taxable transactions”
The IRS, citing budget constraints, resisted the recommendation to modify its forms to ease taxpayer reporting:
“the IRS does not consider modifying information reporting documents to capture virtual currency amounts as a priority at this time.”
Consequently, the IRS, rather than revising a form to provide a space for Coinbase and others to report their customers’ virtual currency gains and losses, instead issued a subpoena in the hopes that Coinbase would hand over most of their consumer records.
What does this mean? In short, Coinbase and others engaged in similar services could find themselves on the receiving end of repeated subpoenas, or (if the IRS finds room in its budget) required to issue 1099-B forms or similar for each US customer. This could lead to a future of AURs, where bitcoin users are retroactively assessed fines for failure to report their trading gains. Coinbase and others could also quietly decide to cooperate with law enforcement like AT&T did after 9/11.
However accomplished, users of virtual currencies should expect that, from now on, the tax man/woman is watching.