As part of “Operation Hidden Treasure,” the Internal Revenue Service (IRS) has once again launched an initiative to identify noncompliance and determine the correct federal income tax liabilities of those individuals transacting in cryptocurrency.
Earlier this year, the IRS, through the Department of Justice, requested court approval to issue a “John Doe” summons to the cryptocurrency exchange Payward Ventures Inc. d/b/a/ Kraken, or its predecessors, subsidiaries, divisions or affiliates (collectively, “Kraken”) pursuant to 26 U.S.C. § 7609(f). This is not the IRS’s first rodeo in the crypto world. In 2017, the IRS served a John Doe summons on Coinbase Inc. in United States v. Coinbase, Inc., No. 17-cv-01431-JSC, 2017 WL 5890052, at *6–7 (N.D. Cal. Nov. 28, 2017).
The IRS has dedicated substantial resources in its quest to identify tax cheats in the crypto space. This ongoing and extensive investigation has proven successful for the IRS. To date, the IRS has recovered millions of dollars in previously unreported and unpaid taxes surrounding cryptocurrency transactions, and the IRS continues to make headway in its mission to root out this area of noncompliance. May 5, 2021, marked another breakthrough when the U.S. District Court for the Northern District of California granted the IRS’s petition to serve Kraken with a John Doe summons.
The revised summons requests Kraken to produce four categories of records on U.S. account holders for the period 2016 through 2020, whose transactions were worth at least $20,000, specifically: 1) account registration records; 2) know-your-customer due diligence; 3) anti-money-laundering exception reports and 4) records of account activity.
The IRS contends that taxpayers being investigated have failed or potentially have failed to comply with federal tax laws requiring the reporting of taxable income from cryptocurrency transactions. In furtherance of this investigation, the IRS sought permission to serve the administrative John Doe summons targeting those taxpayers, who directly or indirectly had authority over any combination of accounts held with Kraken, with at least the equivalent of $20,000 in value of transactions (regardless of type) in cryptocurrency during the period Jan. 1, 2016, through Dec. 31, 2020. The IRS’s goal is to analyze the requested records to aid in assessing the potential tax liability of Kraken users.
For almost a decade, the agency has focused on this emerging issue. The IRS has instituted a variety of efforts, ranging from taxpayer education to civil and criminal enforcement actions. In its education campaign, the IRS has issued a number of notices, revenue rulings and periodic updates to its FAQ on virtual currency transactions. In 2014, the IRS issued Notice 2014-21, 2014-16 I.R.B. 938, explaining that cryptocurrency is treated as property for federal income tax purposes and provided examples of how longstanding tax principles applicable to transactions involving property apply to cryptocurrency. In 2019, the IRS included a question related to cryptocurrencies on the Form 1040, Schedule 1, Additional Income and Adjustments to Income, and in 2020, the question was moved to page 1 of the Form 1040. Also during 2019, the IRS issued additional guidance on cryptocurrency transactions in its release of Revenue Ruling 2019-24. This Revenue Ruling addresses the tax implications of two previously unsettled areas of tax law: “hard forks” and “air drops.” Although both are methods of acquiring new coins, they have slightly different tax implications.
Another interesting change in the crypto space was the expansion of the definition of “financial institutions” in the Anti-Money Laundering Act of 2020 (AMLA).
The definition was broadened and now includes businesses that exchange or engage in the transmission of cryptocurrency. Similarly, the AMLA amended 31 U.S.C. 5312(a)(3), the definition of “monetary instruments” in the Bank Secrecy Act (BSA), on which the Treasury Department proposed to determine that convertible virtual currency (CVC) and digital assets with legal tender status (legal tender digital assets or LTDA) are monetary instruments. Under a new proposed Financial Crimes Enforcement Network (FinCEN) regulation, banks and money service businesses (MSBs) would be required to submit reports, keep records and verify the identity of customers in relation to transactions greater than $10,000, or aggregating to greater than $10,000, involving CVC or LTDA that involve unhosted wallets or wallets hosted in a FinCEN-identified jurisdiction. These proposed reporting requirements would make it much easier for the government to track crypto transactions but would also create additional compliance requirements for the impacted institutions
The Criminal Investigation (CI) division of the IRS has attempted to adapt to the rise of cryptocurrency and has made it clear it is focusing on the abuse of cryptocurrencies that further tax evasion, money laundering and other offenses including those involving cross-border transactions. Circa 2015, CI established its Cyber Crimes Unit (CCU) and has spent significant time and resources to train special agents to investigate cryptocurrency-related crimes. Special agents continue to sharpen their expertise in cryptocurrency and have adapted their ability to follow the money into the cyber arena. Part of the success stems from the IRS’s public-private partnerships. Through these partnerships, CI has developed sophisticated techniques and technologies for tracing blockchain transactions, enhancing its investigative capabilities. Over the last decade, the agency has positioned itself to be on the forefront of de-anonymizing cryptocurrency transactions. As a result, other federal agencies are now tapping CI's expertise in cryptocurrency to assist in investigations ranging from child exploitation, terrorism, darknet marketplaces to North Korean hacking.
Cryptocurrency has evolved since it first emerged in 2009. Interest surrounding cryptocurrency continues to grow and it has gained considerable traction in its uses which now include lending and borrowing, stored value, gaming and tokenization. Hundreds of companies now accept cryptocurrency as a valid payment method. Those noncompliant U.S. consumers that use crypto as a means of making retail payments, now face potential exposure as it is reasonable to expect that transactions among the wallets, such as those in Kraken and Coinbase, will likely be identified when the requested records in the John Doe summons are produced.
The moral of the story is the IRS continues to close in on those who may have attempted to take advantage of the perceived anonymity of these transactions. Those taxpayers who purchased, transferred, are currently holding, or exchange crypto (i.e., shapeshifting) should review their reporting positions and, if appropriate, consider correcting past noncompliance now.
Baker Tilly has experience advising clients through a variety of IRS controversy matters, including voluntary disclosures, civil audits and criminal investigations. Similarly, Baker Tilly is well versed in evaluating cryptocurrency-specific tax issues.
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