The accurate reporting of cryptocurrency transactions has become an important IRS priority. Just this year, for example, the IRS added a prominent question on page 1 of Form 1040: just below the taxpayer’s name and address, Form 1040 now asks, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
Taxpayers who traded virtual currency should ensure that their transactions have been accurately reported to the IRS.
The IRS has taken significant proactive measures to collect cryptocurrency trading information. Notably, it issued several “John Doe” summonses, which is a tool authorized by Internal Revenue Code (IRC) Section 7609(f). A John Doe summons does not list the name of the taxpayer under investigation because the taxpayer is unknown to the IRS. Rather, it seeks information about a class of individuals. The IRS uses the information collected by John Doe summonses to consider whether to commence an audit or criminal investigation.
One well-known John Doe summons was issued to UBS AG, which resulted in the bank handing over the names of about 4,000 U.S. account holders.
The IRS has begun using John Doe summonses to locate cryptocurrency accounts. In early 2018, in response to a John Doe summons, San Francisco-based Coinbase Inc. provided information to the IRS about 13,000 customers who bought, sold, sent, or received at least $20,000 worth of cryptocurrency between 2013 and 2015.
Recently, the IRS served John Doe summonses on Circle Internet Financial Inc., which administers Poloiex and on Payward Ventures Inc. (doing business as Kraken). Each summons seeks to identify cryptocurrency transactions. Kraken and Poloiex conduct customer due diligence when customers open their accounts, so in nearly all cases they can identify the individuals making the underlying trades.
John Doe summonses are an important tool for the IRS because Poloiex, Kraken, and others in the cryptocurrency wallets (i.e., institutions that hold accounts for third parties) do not issue Forms 1099 to account holders. In general, as the General Accounting Office has reported, the extent to which taxpayers accurately report their income is closely aligned with the amount of income that third parties report to the IRS through information reporting.1 The IRS believes that identifying these cryptocurrency accountholders will likely lead to the discovery of unreported income. For their part, taxpayers may erroneously believe that they are not required to report cryptocurrency on their tax returns because these institutions do not issue Forms 1099.
Of note to practitioners, the IRS chief counsel issued Memorandum No. 2021240082 on June 8, 2021. It concludes that for trades completed before Jan. 1, 2018, most exchanges of cryptocurrency were not like-kind exchanges. The memorandum specifically noted that the three most common cryptocurrencies – Bitcoin, Ethereum, and Litecoin – are not of the same “nature” or “character” as one another. Therefore, exchanges of one of these cryptocurrencies for the other two do not qualify for like-kind treatment under IRC Section 1031.
Individuals who own cryptocurrency that has not been reported on their tax returns should consult with a tax professional to determine the best method by which to come into compliance. Individuals who have substantial understatements of income may need to enter the IRS Voluntary Disclosure Program, which requires filing six years’ worth of amended tax returns and submitting to an audit. Other individuals may determine that they can simply file a qualified amended tax return. Tax professionals are reminded that statements made to them by their clients may not be protected by a confidentiality privilege. Therefore, if a tax professional believes that his or her client may need to file amended tax returns where there is the potential for civil fraud or criminal liability, an attorney should be engaged to ensure that the communications remain confidential.
Regardless of the path they plan to take, individuals with undeclared cryptocurrency holdings should consult with a tax professional, especially those individuals who traded at Kraken and Poloiex.
1 GAO, “Tax Gap: Multiple Strategies Are Needed to Reduce Noncompliance,” GAO-19-558T (Washington, D.C.: May 9, 2019).
“Cryptocurrency Transactions, John Doe, and the IRS,” by Jed M. Silversmith was published on July 30, 2021, in CPA Now, a blog of the Pennsylvania Institute of Certified Public Accountants. Reprinted with permission from CPA Now.