By Tim Cotter, CPA, J.D., and Casey Daderko, CPA, Wilkes-Barre Pa. Editor: Mark Heroux, J.D.
Along with most of the population, the IRS has been trying to figure out cryptoassets for more than a decade. In Notice 2014-21, the IRS describes cryptoassets — which it calls virtual currency — as "a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value," other than a representation of the U.S. dollar or a foreign currency. The IRS made clear in the notice that cryptoassets are property for tax purposes and that taxpayers have gain or loss upon an exchange of cryptoassets for other property.
Cryptocurrency is a type of crypto-asset that uses cryptography to secure transactions digitally recorded on a distributed ledger, such as a blockchain, in units typically referred to as coins or tokens. Income reporting issues arise with cryptoassets because of the lack of reporting requirements compared to, for instance, a traditional brokerage house that provides Forms 1099 for reporting income derived from those investments. Due to cryptoassets' largely unregulated nature and the lack of reporting, along with a continued growth in both users and market capitalization, the IRS has dramatically ramped up its focus on cryptoassets.
This item describes the Service's recent efforts to increase enforcement against taxpayers who fail to report income from transactions in cryptoassets.
In frequently asked questions (FAQs) on its website, the IRS discusses a number of instances where a taxpayer will recognize income or loss from a cryptoasset transaction, including:
- Selling cryptoassets for real currency;
- Providing services and receiving cryptoassets as payment;
- Cryptoassets paid by an employer as remuneration for services constituting wages;
- Exchanging cryptoassets for other property or vice versa; and
- Cryptocurrencies going through a "hard fork" followed by an "airdrop" when the taxpayer receives new cryptocurrency (see also Chief Counsel Advice 202114020).
The IRS Criminal Investigation (CI) division has increased its initiatives to understand and properly address cryptoassets over the last several years. Interestingly, as cryptoassets have grown in popularity over the past decade, the IRS has noticed a negative correlation between the customer base listed on cryptoasset company websites and the number of taxpayers reporting income related to cryptoasset transactions on their income tax returns.
Use of John Doe summonses
The first IRS attempt at identifying cryptoasset transactions and users came against California-based cryptoasset trading platform Coinbase. By the end of 2015, Coinbase had 5.9 million customers and almost $6 billion traded. In stark contrast, only 800 to 900 taxpayers reported cryptoasset transactions annually to the IRS during the period of 2013 through 2015.
The IRS served a so-called John Doe summons on Coinbase in 2016 in an attempt to identify the first group of taxpayers who may have failed to report income from cryptoasset transactions. Once the IRS narrowed the request for information, a federal district court granted enforcement of the summons for tax years 2013 through 2015. Coinbase was ordered to comply and provide financial records for any taxpayers that conducted transactions through Coinbase in excess of $20,000 during those specific years. This summons covered approximately 14,000 customer accounts that were handed over to the IRS. Identified taxpayers were sent letters advising them to file amended returns for the years in question and to report their cryptoasset transactions.
In concert with the John Doe summons efforts, the IRS announced a cryptoasset compliance campaign in July 2018. The stated goal of the campaign was to use multiple streams of delivery including exams and taxpayer outreach to address noncompliance related to the use of cryptoassets. Interestingly, the IRS also noted that it was not contemplating a voluntary disclosure program specifically to address tax noncompliance involving cryptoassets.
In 2019, taxpayers with cryptoasset transactions who potentially failed to report income from the transactions or did not report the transactions properly began to receive IRS letters. The letters revealed the IRS had information that showed the taxpayer had an interest in a cryptoasset account but that the transactions were not adequately reported, and advised the taxpayer to file an amended or delinquent return as soon as possible.
In April 2021, a Massachusetts court upheld a second John Doe summons against Circle Internet Financial, a cryptoasset trading platform operating out of Boston. That was followed by a third John Doe summons filed against Payward Ventures Inc. and subsidiaries d/b/a Kraken for tax years 2016 through 2020. The information the IRS receives from these summonses will likely produce more IRS letters to taxpayers holding cryptoassets — and the expectation that more taxpayers will be amending their tax returns to report cryptoasset transactions.
Operation Hidden Treasure
In response to tax evasion concerns with the use of virtual currencies, in 2021 the IRS established a new program titled "Operation Hidden Treasure." The operation is a partnership between two IRS internal divisions, the Office of Fraud Enforcement and the CI unit. The Office of Fraud Enforcement was created in 2020 to support the national fraud program, as well as existing IRS operations, while the IRS CI unit investigates potential criminal violations and related financial crimes.
Agents in Operation Hidden Treasure are specially trained in virtual currencies with a primary focus on identifying areas of tax evasion on both civil and criminal levels. Specific items relating to money laundering and intentional evasion techniques, such as structuring transactions below future anticipated reporting thresholds or the use of shell companies, are of particular interest to Operation Hidden Treasure agents.
President Joe Biden's tax plan proposal would increase resources to combat tax evasion relating to cryptoassets. Furthermore, Treasury's Financial Crimes Enforcement Network (FinCEN) plans to propose an amendment to the regulations with respect to the Bank Secrecy Act to include cryptoassets as a type of reportable account. This amendment would require banks and money services businesses to increase their recordkeeping, gather appropriate information on their customers, and submit reporting to FinCEN.
In early June 2021 in testimony to a Senate committee, IRS Commissioner Charles Rettig requested Congress grant the IRS more authority to require reporting in the cryptoasset market as well as additional tools and resources. Rettig mentioned in his statement that there are more than 8,600 cryptoasset exchanges worldwide and made it clear that the authority to collect that information is critical.
It is fair to say cryptoasset platforms can expect more John Doe summonses — along with increased reporting — in the future. Taxpayers holding crypto-assets can also expect more IRS letters and increased enforcement in future years. Tax preparers could see a large influx of amended returns for prior-year cryptoasset transactions. Tax preparers should have a discussion with their clients informing them of the increased scrutiny surrounding virtual currencies. Taxpayers need to understand their responsibility of reporting income derived from virtual currencies.
Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly US, LLP.