The Federal Lawyer - January/February 2020

We have all heard the stories. Romeo and Juliet, Cleopatra and Mark Antony, and my personal favorite, Illsa Lund and Rick Blaine. Everyone loves a great love story. A developing romance leading to an emotionally pleasing and heartwarming ending where love triumphs all. Unfortunately, not all love stories end with happiness. Love can wilt over time, it can fade, or even worse, it can fizzle out before it even begins.

This is a story about the history of Bitcoin, recent efforts by the Internal Revenue Service (“IRS” or the “Service”) to identify non reporters, how the IRS will proceed in the future, and why the Service and Bitcoin lost their moment in time.

1. The Beginning

In 2009, Satoshi Nakamoto, a pseudonym for a computer programmer or group of computer programmers, created the first peer-to-peer electronic cash system.[i] The idea was to allow online payments to be sent directly from one party to another, without the need for a financial intermediary.[ii]

More relevant to our analysis, transactions of Bitcoins, and other virtual currencies, create a blockchain.[iii] A blockchain is a shared public ledger and the record keeping technology behind virtual currencies.[iv] After a transaction occurs in which a virtual currency is used, the blockchain provides a line by line report containing information such as the date of the transaction, the amount spent on the transaction, and a user identification number.[v] The user identification number takes the place of the individual’s name. As a result, the transactions cannot be linked to a specific individual without additional information linking the user to the identification number.[vi] Thus, virtual currency transactions are anonymous.

To provide an example, imagine I purchase a piano for my daughter and send the seller Bitcoins in exchange. The Bitcoins leave my virtual wallet and are deposited in the seller’s virtual wallet. Thereafter, the transaction is recorded on the general ledger detailing the payment of $500, the date of May 5, 2020, and a user identification number of 114487. The blockchain is available for public consumption, so everyone knows the transactions occurred. However, no one knows that I actually purchased the piano.

2. How Bitcoin and the IRS could have worked together

The blockchain provides a detailed history of reportable transactions. If the IRS used blockchain to its advantage, the Service could calculate income, capital gains, gifts, offshore disclosures and many other reportable transactions without ever contacting the end user. Just as important, by sorting the blockchain to a specific period of time, the IRS could accurately determine all of the reportable transactions and then compare that information to individual tax returns and disclosures. Thus, identifying non reporters and inaccurate reporting.

Unfortunately, Bitcoin got off to a rocky start.

3. Mt. Gox

Opened in 2010, Mt. Gox was one of the world’s first Bitcoin exchanges, located in Tokyo, Japan.[vii] A Bitcoin exchange is comparable to a brokerage account, providing the opportunity for customers to buy and sell virtual currencies through an online interface. It is estimated that 70% of all Bitcoin transactions worldwide were handled on Mt. Gox.[viii]

In June of 2011, Mt. Gox was hacked.[ix] Allegedly, the hackers were able to compromise a computer owned by an auditor of Mt. Gox. Thereafter, the hackers manipulated the price of each Bitcoin and purchased them through anonymous accounts. In a matter of minutes over 850,000 Bitcoins were stolen valued at over 300 million dollars.[x]

Not a great start. And, even more disconcerting, the trend continued.

4. Silk Road

Silk Road, named after the historical trade route between Europe and East Asia, was an online market where nearly anything could be purchased through the use of Bitcoins. That’s right, an website where you can purchase drugs, guns, and forged documents, completely anonymous. Adding even more intrigue, the founder Ross Ulbricht, was only known as “Dread Pirate Roberts” while the website was in operation. [xi]

Silk Road only lasted for three years, but it made Ulbricht a multi-millionaire and ultimately a convict. Again, Ulbricht, as well as users of Silk Road, believed everything was anonymous. In addition to Silk Road only accepting Bitcoin, it also operated through Tor.

Tor is a free software program used for browsing and communicating on the internet. Tor directs internet traffic through a volunteer overlay network, consisting of relays, used to conceal the user’s location and usage from anyone surveilling the network.[xii]

Eventually, the FBI caught Ulbricht and charged the 29 year old with narcotics trafficking, computer hacking, and money laundering. It is alleged that Ulbricht was linked to Silk Road and eventually caught because he publicly advertised for an IT specialist to help launch the website. In the advertisement Ulbricht provided his personal email.

Ulbricht and Silk Road generated over 9.5 million Bitcoins in sales revenue and over 600,000 in commissions for its owner.[xiii] Depending on the value of the currency at the time of sale, this means Silk Road had about $1.2 billion in sales and $80 million in commissions.[xiv]

Unfortunately, the perception of Bitcoin was forever tarnished.

5. The Results

So what started out as a viable business venture, which provided increased transparency for all users, lost its momentum, due to abuse. Put succinctly, the moment when the IRS and virtual currencies could have worked together to achieve a more efficient and effective system was forever lost. After Mt. Gox, Silk Road, and other similar issues, Bitcoin was no longer a viable alternative to cash. Rather, Bitcoin was identified as an enemy of the State. A currency easily susceptible to hacking, purchasing illicit services and goods, and a breeding ground for corruption.

Naturally, the IRS went on the offensive. In addition to the issues described above, many users believes that due to the inherently anonymous characteristics of Bitcoin, their transactions did not have to be reported on tax returns. I am not going to bore you with the “virtual currencies are property” explanation. All you need to know is that virtual currencies are treated as property and as a result their use can create reportable transactions.[xv] Moreover, gifting, leveraging, and holding virtual currencies in offshore accounts can trigger reporting requirements to the IRS and FINCEN.

6. Coinbase and the John Doe Summons

Coinbase, like Mt. Gox, is a virtual currency exchange and one of the largest in the world. It is estimated that Coinbase served 5.9 million customers and exchanged $6 billion in Bitcoin.[xvi] Just as important, Coinbase is a United States based company and headquartered in San Francisco, California.[xvii]

In 2016, a federal court in the Northern District of California entered an order authorizing the IRS to serve a John Doe Summons on Coinbase.[xviii] The summons sought records and information about U.S. taxpayers who conducted transactions from 2013 through 2015.

The goal of the summons was to identify and obtain information of virtual currency traders who had reportable transactions.

At first, Coinbase refused to comply. Coinbase noted that the request covered 89 million transactions and over 14,355 account holders.[xix] However, the IRS issued a “Notice of Narrowed Summons Request for Enforcement” that sought information related to transactions of $20,000 in any one transaction type (buy, sell, send, or received).[xx]

Ultimately, the court held that the narrowed summons served the legitimate purpose of investigating the “reporting gap between the number of virtual currency users Coinbase claims to have had during the summons period”.[xxi] The court further reasoned that the discrepancy creates an inference that more Coinbase users are trading Bitcoin than reporting gains on their tax returns. Thus, the IRS has a legitimate interest in investigating these taxpayers.[xxii]

7. Current Enforcement Efforts: IRS Letter 6173, 6174, and 6174-A

Over the next few months the IRS will mail out over 10,000 letters to cryptocurrency and virtual currency account holders. The notices will encourage investors to report cryptocurrency and non-crypto virtual currency transactions that were either missing or filed incorrectly on their 2013 through 2017 federal tax returns.

The letters will have three variations: Letter 6173, Letter 6174, and Letter 6174-A (collectively “The Letters”). The Letters are designed to help taxpayers understand their tax and filing obligations, including how to correct past errors.

Unfortunately, accurately reporting virtual currency capital gains or losses is not always an easy task. Often, trading platforms do not provide a summary of capital gains or losses to the account holder. As a result, investors are forced to scour through pages and pages of transactions to calculate capital gains and losses. Also, due to errors in the application of inventory methods, the basis of the virtual currency being exchanged is often calculated incorrectly.

To further complicate the issue, virtual currency traders routinely leverage one virtual currency to purchase another. An example would be using a Bitcoin to purchase Ethereum (ETH), Monero (XMR), or Ripple (XRP). To accurately report the capital gain or loss, the investor must apply the exchange rate between two currencies and apply the appropriate inventory method.

8. The IRS and Big Data

The question remains whether the Letters will be sent to individuals previously identified in the John Doe Summons described above, or if the information was found through the IRS analyzing and sorting data it obtains from third parties or “big data”. Although, this question is left unanswered, it is slightly irrelevant.

Moving forward, it is likely the IRS will leverage information already warehoused by internet conglomerates such as Amazon, Google, and Apple, to further enhance the automated corrections of tax returns and further refine the audit selection process. This will likely have a large effect on small businesses and non-filers.

To provide an example: Taxpayer A regularly purchases widgets for her business from Amazon. Thereafter, Amazon creates an internal document which details the dollar amount of Taxpayer A’s widget purchases, the date and time of each purchase, and where the item was shipped. The IRS requests this internal document from Amazon to verify Taxpayer A’s cost of goods sold and thereafter adjusts the amount claimed, if necessary. All of this occurs automatically and without Taxpayer A’s knowledge or approval.

The scenario outlined above may seem distant, but the automated correction process the IRS currently utilizes has already been enhanced as it relates to health insurance benefits (Form 1095-B), mortgage payments (Form 1098), and retirement benefits (Form 5498) and now virtual currency transactions. Leveraging the information described above will also help the IRS further refine their audit selection process.

Be that as it may, this leads to the question: Should the IRS have the right to this information? On one hand, the information is absolutely relevant in determining whether the taxpayer is accurately reporting their tax returns. On the other hand, this seems to be a fairly intrusive process that will not only track an individual taxpayer’s internet activity, but will also house a wide array of information that is completely irrelevant to tax administration.

9. Conclusion

So, the love was lost. Bitcoin had too many problems shortly after its inception to ever become a viable alternative to cash. Thereafter, the IRS saw Bitcoin as a threat rather than a tool that could be used to increase reporting consistency and accuracy. Moving forward, it is likely the IRS will use third party data to further identify non-reporting and inaccurate reporting.