On July 26, 2019, the IRS announced that it has begun to send letters to more than 10,000 taxpayers who might have failed to report income and pay the resulting tax from virtual currency transactions or who did not report their transactions properly. The IRS previously estimated that only 800-900 taxpayers reported gains regarding virtual currency in the 2013-2015 period. Through a judicially enforced subpoena, which was aimed at identifying taxpayers who were not reporting their virtual currency dealings, the IRS received detailed information for approximately 13,000 customers of the popular cryptocurrency exchange Coinbase. This announcement is a sign of the IRS’s increased focus on civil and criminal enforcement regarding virtual currency, and is a message to all taxpayers dealing in virtual currency to make sure that they have reported, and continue to report, such transactions correctly.
I. The IRS’s Warning Letters
On July 26, 2019, the IRS announced that it has started sending “educational” letters to taxpayers regarding virtual currency reporting, and that it expected more than 10,000 taxpayers to receive such letters by the end of August. The IRS stated in its announcement that it received the names of these taxpayers through various ongoing IRS compliance efforts. In connection with the announcement, IRS Commissioner Charles (Chuck) Rettig stated that “Taxpayers should take these letters very seriously by reviewing their tax filings and when appropriate, amend past returns and pay back taxes, interest and penalties.” There are three variations on the IRS’s letters: Letter 6173, Letter 6174, and Letter 6174-A.
Letter 6173: Letter 6173 requires a direct response from the taxpayer. In this letter, the taxpayer is told that the IRS has “information that you have or had one or more accounts containing virtual currency and may not have met your U.S. tax filing and reporting requirements for transactions involving virtual currency.” The IRS further notes in the letter that “[f]or one or more of tax years 2013 through 2017, we haven’t received either a federal income tax return or an applicable form or schedule reporting [the] virtual currency transactions.” Accordingly, Letter 6173 requires that the taxpayer take one of three actions: (1) file delinquent returns, reporting any virtual currency transactions; (2) amend returns to properly report any virtual currency transactions; or (3) provide a statement that explains why the taxpayer believes it is in full compliance, signed under penalties of perjury. The letter contains a “respond by” date, and states that if the IRS does not hear from the taxpayer by that date, “[w]e may refer your tax account for examination.”
Letters 6174 and 6174-A: Letters 6174 and 6174-A tell the taxpayer that the IRS has “information that you have or had one or more accounts containing virtual currency.” These letters provide detailed information to the taxpayer about the taxation of virtual currency and how to report transactions involving virtual currency. Both letters advise the taxpayer that if, after reviewing this information, “you believe you didn’t accurately report your virtual currency transactions on a federal income tax return, you should file amended returns or delinquent returns.” But Letter 6174 differs from Letter 6174-A, in that Letter 6174 suggests the IRS believes the taxpayer “may not know the requirements for reporting transactions involving virtual currency,” while Letter 6174-A suggests the IRS believes the taxpayer “may not have properly reported your transactions involving virtual currency.” Further, while both letters state that the taxpayer is not required to respond, Letter 6174-A also contains the caveat that the IRS “may send other correspondence about potential enforcement activity in the future.”
|Eversheds Sutherland Observation: The three variations on the letters show that the IRS is mining the information it has in its possession and forming views about which virtual currency holders it believes are noncompliant, and to what degree. Although the IRS stated in its announcement that “all three versions of the letters strive to help taxpayers understand their tax and filing obligations and how to correct past errors,” Letter 6173 seems to presume that the taxpayer in question already understands the virtual currency reporting requirements and has chosen not to comply with them. Letter 6174-A is a step down from Letter 6173, but still assumes a higher level of knowledge on the part of the taxpayer than Letter 6174.
II. The IRS’s Prior Guidance and Enforcement in This Area
A. Notice 2014-21
In 2014, the IRS issued Notice 2014-21, which describes how the IRS applies US tax laws and general tax principles to transactions involving virtual currency. In that notice, the IRS stated its position that virtual currency is treated as property for federal tax purposes. Accordingly, a taxpayer can have a gain or loss on the sale or exchange of a virtual currency, depending on the taxpayer’s cost to purchase the virtual currency (that is, the taxpayer’s tax basis). As with other property transactions, taxpayers must track their basis in their virtual currency in order to determine gain or loss on the subsequent transfer of the coins, whether exchanged for services or property, or sold after being held for investment. Additionally, Notice 2014-21 requires taxpayers who “mine” virtual currency to realize gross income upon receipt of the virtual currency, equal to the fair market value as of the date of receipt.
The IRS has stated that it intends to issue additional legal guidance regarding virtual currency in the near future. Additionally, some members of Congress have indicated a desire for further administrative guidance or legislative safe harbors (in the case of hard forks).
B. John Doe Summons to Coinbase
In November 2016, the IRS issued a “John Doe summons” to Coinbase, one of the largest platforms for exchanging bitcoin and other forms of virtual currencies. A John Doe summons is issued to a third party seeking information of a person whose name is unknown. Here, the IRS sought information regarding all Coinbase customers who conducted transactions on the Coinbase platform between 2013 and 2015. Coinbase resisted the summons and sought to narrow its scope. The IRS agreed to narrow the scope to accounts with at least $20,000 in any one transaction type (buy, sell, send or receive) in any one year during 2013-2015 period.
In late 2017, the US District Court for the Northern District of California permitted the enforcement of the summons in a more narrowed fashion. The court ordered Coinbase to produce the taxpayer identification number; name; birthdate; address; records of account activity; and all periodic statements of account or invoices. Ultimately, Coinbase produced documents for approximately 13,000 customers (roughly in line with the number of letters the IRS now plans to send out).
|Eversheds Sutherland Observation: While it is widely speculated that the IRS identified the initial group of more than 10,000 taxpayers using the data provided by the Coinbase subpoena, any taxpayer with dealings in virtual currency should anticipate increased IRS scrutiny. For example, if taxpayers transacted on other virtual currency exchanges or their Coinbase transactions fell outside the narrowed scope of the Coinbase subpoena, they may not immediately receive a letter. However, that does not mean the IRS will not seek further information regarding their virtual currency transactions.
C. Other Compliance and Enforcement Efforts
Additionally, in 2018, the IRS Large Business and International division announced a Virtual Currency compliance campaign, which the IRS stated would address noncompliance related to the use of virtual currency through outreach and examinations of taxpayers. The same year, the IRS teamed up with tax authorities in four other countries to launch the Joint Chiefs of Global Tax Enforcement (J5), which is reportedly investigating international tax evasion using cryptocurrencies. And earlier this month, the Chief of the IRS Criminal Investigation division, Don Fort, stated that the IRS was building criminal tax evasion cases involving cryptocurrency, and details on those cases are expected to be made public soon.
III. What the IRS’s Letters Mean
The IRS’s warning letters signal that the IRS is closing in on taxpayers who have not properly reported their virtual currency transactions. While the IRS has described the letters as educational, the letters serve more than merely an educational function. All of the letters require taxpayers to take action, whether by responding to the letter directly, or by reviewing their tax filings for accuracy and correcting any errors. Further, a taxpayer receiving a letter in which the IRS has specifically detailed the proper reporting methods for virtual currency will likely find it much more difficult to claim ignorance going forward. Actual knowledge about reporting requirements may defeat certain defenses and form the predicate for certain enforcement actions. Additionally, if a taxpayer does not receive a warning letter, it does not mean the taxpayer is in the clear as the IRS may still look at their virtual currency transactions, whether now or at a later date. The IRS’s warning letters and announcement are thus relevant to all taxpayers who have transacted in virtual currency in the past and who may decide to transact in it in the future.