IRS Notice 2014-21, issued on March 25, 2014, made it clear that the IRS would treat virtual currencies that can be converted into traditional currency as property for federal income tax purposes (http://bit.ly/2C5pFzq). This means that gain from the sale and exchange of virtual currency is subject to taxation. Given that many are attracted to virtual currency because of its anonymous nature, tax preparers should expect that individual clients might not volunteer information about virtual currency transactions at tax time. Recent events suggest, however, that the IRS is not sitting back and waiting for taxpayers to fully disclose their virtual currency activities. Failure to report such transactions may result in penalties and, potentially, criminal prosecution.
On March 23, 2018, the IRS issued a reminder that income from virtual currency transactions is reportable (“IRS Reminds Taxpayers to Report Virtual Currency Transactions,” http://bit.ly/2vpWHer). While the 2014 notice mentioned potential accuracy-related and information reporting penalties and noted that “penalty relief may be available” due to reasonable cause, it did not reference potential criminal penalties. The 2018 reminder states:
Taxpayers who do not properly report the income tax consequences of virtual currency transactions can be audited for those transactions and, when appropriate, can be liable for penalties and interest. In more extreme situations, taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions. Criminal charges could include tax evasion and filing a false tax return (emphasis added).
This change in the IRS’s position on virtual currency reporting should set off alarm bells for taxpayers who thought they could avoid reporting these transactions. It should also encourage CPAs to ask individuals about their virtual currency activities.
IRS Efforts to Obtain Virtual Currency Users’ Information
Taxpayers should be mindful of the fact that the IRS has a number of effective enforcement tools available, such as the “John Doe” summons that, pursuant to Internal Revenue Code (IRC) section 7602(a), can be issued by the IRS only after approval by a district court. Such a summons allows the IRS to investigate the tax liability of a specific unidentified taxpayer or group of taxpayers. The John Doe summons has been used with great success in the IRS’s enforcement of undisclosed offshore bank accounts, starting with the summons issued to UBS in 2008 (“IRS to Receive Unprecedented Amount of Information in UBS Agreement,” Aug. 19, 2009, http://bit.ly/2HfbFFq). No doubt because of this success, the IRS is now using the John Doe summons in matters related to virtual currency.
In 2016, the IRS issued a John Doe summons to Coinbase, one of the world’s largest virtual currency exchanges, seeking the identities of all of its customers and account records for 2013, 2014, and 2015. When Coinbase failed to comply with the summons, the IRS initially agreed to narrow the scope, then moved to compel disclosure. In support of its petition, the IRS submitted an affidavit from an IRS agent stating that it believes that virtual currency gains are not being reported, in part because only 800 to 900 taxpayers had filed an IRS Form 8949 in 2015 to report virtual currency gains or losses, while Coinbase had 5.9 million users [U.S. v. Coinbase, 2017 WL 5890052 (N.D. Cal. Nov. 28, 2017) (JSC)]. After Coinbase objected to the summons and a Coinbase customer moved to intervene and quash it, the court issued an order in November 2017 limiting the summons to only those customers of Coinbase who bought, sold, sent, or received more than $20,000 of bitcoin in any one year during 2013–2015. Pursuant to the court’s order, Coinbase is required to turn over taxpayer identification number, name, date of birth, address, records of account activity, and all periodic statements of account or invoices relating to the narrowed class of customers. On February 23, 2018, Coinbase sent an e-mail to approximately 13,000 of its customers notifying them that it will be complying with the court order (“IRS Notification,” http://bit.ly/2qHMe8y). The IRS is therefore in the process of learning the identity of Coinbase customers who may not have properly reported their virtual currency transactions on their tax returns.
Taxpayers who have received notification from Coinbase that their data is being turned over to the IRS should realize that they must notify their tax preparer of the situation. They should also consider filing amended returns to report their transactions in accordance with the IRS’s 2014 notice. While additional taxes may be due, these taxpayers may be able to avoid penalties if they can show reasonable cause for their failure to report.
Taxpayers who engaged in unreported virtual currency transactions but are not affected by the Coinbase summons have several options available to them, which should be discussed with a tax professional. First, and most unlikely, in the case of a taxpayer whose failure to report virtual currency transactions is due to reasonable cause, filing qualified amended returns may be an option. In general, a qualified amended return is an amended return that is filed by a taxpayer before—
- the taxpayer is contacted by the IRS with respect to the return,
- a person who promoted a tax benefit claimed by the taxpayer is contacted by the IRS,
- a pass-through entity in which the taxpayer holds an interest is contacted by the IRS,
- a John Doe summons relating to the taxpayer’s liability is served, or
- an IRS settlement initiative with respect to a listed transaction reported on the return is announced.
A qualified amended return will not, however, help the taxpayer avoid fraud penalties with respect to fraudulent positions taken on the original return (IRS Notice 2004-38, http://bit.ly/2JS5VU5). Accordingly, if there is any indication of fraud (e.g., the taxpayer chose not to inform the tax return preparer in response to a specific question about virtual currency), filing qualified amended returns would be a risky approach.
Second, a taxpayer may be able to file amended returns pursuant to the Internal Revenue Manual’s (IRM) voluntary disclosure provisions (IRM section. 9.11.9). This is accomplished by submitting a letter from an attorney, providing amended returns that are complete and accurately report previously omitted legal source income, and offering to pay the tax, interest, and any penalties determined to be applicable by the IRS. While this is a simple process, it does not provide any specific penalty protection and does not result in the IRS issuing a closing agreement. Furthermore, even if the returns and payment are processed, the filing may still result in an audit or even a criminal investigation.
Third, a taxpayer may be able to participate in the IRS’s formal domestic voluntary disclosure program (IRM section 9.11.9), thereby possibly eliminating the risk of penalties, including criminal prosecution. Sometimes referred to as a “noisy disclosure,” this is likely the best option for any taxpayer who the IRS may conclude filed a fraudulent return that failed to report virtual currency transactions. In order to initiate a domestic voluntary disclosure, the tax representative should fax a power of attorney along with the taxpayer’s name, date of birth, Social Security number, and address to the IRS Criminal Investigation Division (CID). CID then will review its databases to determine whether or not the taxpayer is eligible to participate in the domestic voluntary disclosure (i.e., the disclosure is timely). If the taxpayer is precleared to participate, he must comply with IRM section 9.11.9 by submitting truthful and complete returns and agreeing to cooperate with the IRS. If the IRS accepts the voluntary disclosure, it will issue a Form 906 closing agreement setting forth the amount of tax, interest, and penalties due for the tax period at issue, which will bring an end to the process.
Taxpayers who do not file amended returns, either because they are no longer eligible or because they decline professional advice to do so, still may be able to avail themselves of certain arguments to try to avoid civil penalties. If, for example, taxpayers disclosed to their accountant that they were involved in virtual currency transactions, and the accountant did not inquire further or advise the taxpayers to make full disclosure, the taxpayers may be able to assert that they relied in good faith on their accountant’s advice. Since the IRS did not take a public position on the taxation of virtual currency until early 2014, it would be difficult for the IRS to penalize failure to report virtual currency transactions before that time. The IRS will, however, undoubtedly take a contrary position.
In addition, IRS Notice 2014-21 is simply the IRS’s position regarding the taxation of virtual currency; while it is prudent to comply with that notice, it does not have the force of law. As a result, taxpayers with unreported virtual currency transactions may be able to argue that the IRS’s position is wrong and different tax principles should apply to this new technology. After all, when the tax law is uncertain or ambiguous, a taxpayer may have reasonable cause for failure to properly report in accordance with an unclear law [see Treasury Regulations section 1.6664-4(b)(1)]. A taxpayer who knowingly takes a position contrary to published IRS guidance may, however, want to file a Form 8275 with her return, as positions that have a reasonable basis and are adequately disclosed are not subject to substantial understatement penalties [IRC section 6662(d)(2)(B)(ii); Treasury Regulations section 6662-4].
Some commentators have suggested that taxpayers can take advantage of the IRS’s Offshore Voluntary Disclosure Program (OVDP) to report previously unreported virtual currency transactions. The purpose of the OVDP is for taxpayers to report previously unreported foreign bank accounts and earnings from those accounts. The IRS’s position to date has been that taxpayers do not have to report virtual currency on FinCEN Form 114, Report of Foreign Bank and Financial Accounts (Allison Bennett, “IRS: No Bitcoin Reporting on FBARs for This Filing Season, but Future Changes Possible,” BNA.com, June 5, 2014, http://bit.ly/2HtFl5c). Accordingly, the OVDP does not seem to be available to a taxpayer who is solely reporting virtual currency transactions. The taxpayer may also have an unreported foreign bank account that has been used to receive funds related to virtual currency transactions; in such a case, the OVDP may be available to report not only the existence of and income from the foreign bank account but also the previously unreported virtual currency transactions.
Virtual Currency, Real Consequences
Since 2014, the IRS has made clear its position that the sale and exchange of virtual currency is subject to tax, and any grace period for reporting such transactions appears to be coming to a close. Taxpayers and their professional advisors should take action to correct any previous nonreporting of virtual currency transactions in a way that will mitigate potential penalties. The clock is ticking, and the IRS’s patience for nonreporting seems to be running out.