Thursday, December 14, 2017
Many people have gotten involved in the current Bitcoin “craze.” But, just what is Bitcoin, and what are the tax implications of Bitcoin transactions? The IRS is interested in making sure that all Bitcoin transactions are fully reported and the tax paid. It is also certain that underreporting is occurring. A recent case makes that last point clear.
Today’s blog post looks at the Bitcoin phenomenon, and the interest of the IRS in making sure that Bitcoin transactions are reported properly.
What is Bitcoin?
Bitcoin, is a digitalized currency (a type of cryptocurrency) that serves as a worldwide payment system. A bitcoin is not a tangible item of property, it’s just a balance that is maintained on a public ledger in the digital cloud along with all Bitcoin transactions as a decentralized digital currency. The Bitcoin network operates as “peer-to-peer” with transactions occurring directly between users. That means that the transactions are anonymous, but can be verified by network “nodes” and are recorded in a “blockchain” ledger.
A bitcoin results from a “mining” process and can be exchanged for other currencies as well as products and even services. A Bitcoin balance is maintained by the use of “public” and “private” “keys.” These keys are simply long strings of numbers and letters linked through the mathematical algorithm that was used to create them. The public key (comparable to a bank account number) is the public address to which others may send bitcoins. The private key (comparable to an ATM PIN) is meant to be a guarded secret, and is only used to authorize Bitcoin transmissions.
In addition, a bitcoin is not issued by a bank or government and has no intrinsic value by itself. A bitcoin is not legal tender. But, in spite of all of this, Bitcoin is popular and other digital currencies (known as “Altcoin”) have developed. Data exists showing that, as of early 2015, there were more than 100,000 merchants and vendors that accepted bitcoin as payment. There are millions of users, and the amount presently in circulation is estimated to exceed $7 billion.
Bitcoin can be an effective way of transferring money, but that is different from being a sound investment because of its lack of intrinsic value. It is highly volatile, and since its emergence in 2009, Bitcoin has gone through numerous cycles of spikes and valleys in value. It is much more volatile as gold or the U.S. dollar. These significant swings in value can produce big “winners” when the pendulum swings upward, but big “losers” are also produced when the pendulum swings wildly the other way.
Reporting Cash Transactions
What does the Code say about reporting Bitcoin transactions? If bitcoin is cash, I.R.C. §6050I requires a person engaged in a trade or business to report via Form 8300 a transaction in which more than $10,000 in cash is received. Reporting is also required if more than $10,000 in cash is received during any 12-month period in two or more related transactions. But, is bitcoin cash? Not according to the IRS. In March of 2014, the IRS stated that all virtual currencies, including bitcoins, would be taxed as property rather than currency. IRS Notice 2014-21, 2014-16 I.RB. 938. Thus, gains or losses from bitcoins held as capital will be realized as capital gains or losses, while bitcoins held as inventory will incur ordinary gains or losses.
In United States v. Coinbase, Inc., No. 17-cv-01431-JSC, 2017 U.S. Dist. LEXIS 196306 (N.D. Cal. Nov. 28, 2017), the IRS served a summons on the defendant, a virtual currency exchange, seeking records of the defendant’s customers for multiple years. The defendant (America’s largest platform for exchanging bitcoin into U.S. dollars) didn’t comply with the request, and the IRS sued to enforce the summons in accordance with I.R.C. §§7402(b) and 7604(a). The IRS later narrowed the scope of the summons so that it applied to fewer of the defendant’s account holders. Nevertheless, the summons still applied to more than 10,000 account holders.
The reason for the summons, of course, was because the IRS believes that many taxpayers engaged in Bitcoin transactions are not properly reporting the resulting gain or loss, or are not reporting anything at all. In its petition to enforce the summons, the IRS provided data showing that approximately 84 percent of taxpayers file returns electronically and that capital gain or loss for property transactions (such as Bitcoin) is reported on Form 8949 that is attached to Schedule D (Form 1040). The IRS noted that Form 8949 includes a space where the taxpayer is to report the type of property sold. The IRS also noted that its analysis of its data showed that only 800-900 taxpayers electronically filed a Form 8949 that included a property description that is “likely related to bitcoin” in each of the years at issue – 2013-2015.
When the IRS narrowed its summons, it sought information of the defendant’s account holders having accounts “with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013-2015 period.” That excluded the defendant’s customers who only bought and held bitcoin during 2013-2015 or for which the defendant filed Forms 1099-K during that same timeframe. The narrowed summons still applied to 14,355 of the defendant’s account holders and 8.9 million transactions. For those accounts, the IRS wanted registration records for each account, the name, address, tax identification number, date of birth, account opening records, copies of passport or driver’s license, all bitcoin wallet addresses, and all public keys for all accounts. The IRS also wanted the records of “Know-Your-Customer” diligence, as well as agreements or instructions granting a third-party access, control or transaction approval authority. The IRS also sought all information that would identify transactions, their balances and how they were conducted, and any correspondence that the defendant had with the user or any third party with account access. The IRS was also after all periodic statements of account or invoices.
The defendant still refused to comply with the summons, narrowed as it was. However, as time went on, the parties started negotiating. But, they couldn’t come to an agreement and the defendant claimed it was too difficult to comply with the summons. The IRS pressed on in court.
The issue before the court was the reasonableness of the IRS narrowed summons. The court noted that it was reasonable to the extent it sought information that would aid the IRS in closing the reporting gap between the number of the defendant’s virtual currency users and bitcoin users that reported gains or losses to the IRS during the 2013-2015 time period. In other words, the difference between the defendant’s 5.9 million customers, six billion transactions, and only 800-900 e-filed returns with a property description related to bitcoin. That created, the court noted, an inference that more of the defendant’s customers were trading bitcoin than were reporting gains on their returns. The court determined, based on this data, that the IRS had met the standard of making a minimal showing of meeting the good faith requirement for issuing a summons. In addition, the court rebuffed the defendant’s arguments that the IRS expert was not qualified to testify on the matter. After all, the court pointed out, he was the senior manager on the IRS virtual currency investigation team and personally supervised the analyst who performed the search that generated the data to support the summons. Neither the statute nor applicable caselaw required the IRS to do anything more for the summons request to be granted. In addition, the defendant’s claim that their customers filed paper returns in a greater proportion that the general population was unfounded. In addition, the court held that the narrowing of the summons was not arbitrary, but was based on information gleaned from the defendant during negotiations over the summons request. Importantly, the court held that the IRS summons request involved compliance and not general research into bitcoin data. So, the court approved the narrowed summons request and determined that the IRS had not abused the process or showed a lack of good faith. However, the court determined that certain documents were not required to be provided to the IRS. Those included the defendant’s records of “Know-Your-Customer” diligence; agreements or instructions granting a third-party access, control or transaction approval authority; and correspondence between the defendant and the user or any third party with access to the account with transaction activity.
Bitcoin seems to be all the rage. The current speculative bubble will burst at some point, but then another bubble is likely to pop back up. Clearly, the IRS is aware of the virtual currency world and is quite interested in making sure that gains (and losses) are reported properly. In addition, they are interested in assessing penalties for not filing appropriate information returns. The penalty is assessed on each instance of a failure to file the appropriate return. If the failure to file the required information return is determined to be an intentional disregard of the requirement, the penalty (for the years at issue in the case) is $250 per return with no maximum total limit. That could be a huge sum for the defendant, and it’s probably what the IRS is actually after. They simply don’t have the resources to go after very many individual taxpayers that aren’t reporting Bitcoin gains. But, they will certainly make a show of a few of the more prominent individual taxpayers.
In any event, practitioners would be wise to ask clients about any virtual currency transactions, make sure Form 1099-K is filed when required, and maintain good records.