If you think the IRS will not find out about your cryptocurrency, think again. With Coinbase making its securities debut with a $85 billion valuation on April 14, 2021, and Dogecoin’s value increasing 85 percent essentially overnight, the news spotlight will be on bitcoin, Ethereum and other digital currencies for the foreseeable future. However, cryptocurrency has been in the spotlight for the IRS for the past few years and virtual currency continues to be at the forefront of IRS investigations and enforcement priorities.
Do you think the IRS is not watching? See the new question at the top of the Form 1040 individual income tax return. Specifically, page one of Form 1040 asks taxpayers: “At any time during 2020, did you receive, sell, send, exchange, to otherwise acquire any financial interest in any virtual currency?” An incorrect answer can be seen as evidence of fraudulent intent by the taxpayer, suggesting that the return itself is fraudulent, and potentially exposing the taxpayer to a three-year felony charge.
Taxpayers with cryptocurrency should heed the warnings that the recent steps taken by the IRS are meant to imply. With the actions being taken by the IRS, the IRS is signaling its intent to ensure that taxpayers comply with their tax reporting and payment obligations as it relates to virtual currency.
Enforcement Efforts
First, the IRS is using John Doe summonses to obtain information on US taxpayers that have or had cryptocurrency. A John Doe summons allows the IRS to obtain information on a group of currently unnamed persons, including the names, records and documents relating to those persons. In 2016, the IRS issued its first John Doe summons on Coinbase. At that time, Coinbase was the largest virtual currency exchange for bitcoin, purportedly serving almost six million customers and having exchanged $6 billion in bitcoin. In 2018, this summons was approved but narrowed by the District Court to require Coinbase to provide the taxpayer identification number, taxpayer name, birthdate, address, records of account activity, and all periodic statements of account for accounts, for accounts subject to the narrowed summons. This cast a wide net covering almost nine million transactions and over 14,000 account holders. As a result, in 2019, the IRS issued soft letters to various taxpayers encouraging those taxpayers to properly report their transactions in cryptocurrency to the IRS, if they had not already done so.
Fast forward to 2021. On April 1, a Massachusetts District Court upheld a John Doe summons issued to Circle Internet Financial Inc., a cryptocurrency exchange in Boston, seeking information related to US taxpayers with at least $20,000 in cryptocurrency transactions during the years 2016-2020. The IRS is also pursuing a John Doe summons against Payward Ventures Inc dba Kracken, a California cryptocurrency exchange. The issuance of this latest round of John Doe summonses will certainly ensnare even more US taxpayers for the IRS’s investigation efforts.
Further, in March 2021, the IRS Office of Fraud Enforcement launched “Operation Hidden Treasure.” This is a joint effort between the Office of Fraud Enforcement and the Criminal Investigation Division of the IRS. The goal of this operation is to search for unreported income related to cryptocurrency, by using extensive data analytics to search out tax evasion among cryptocurrency holders.
Tax on Virtual Currency
Generally, when a taxpayer buys, sells, mines, or uses cryptocurrency to pay for things, this can trigger a taxable event. An easy example is when a taxpayer is paid in virtual currency for services by an employer or customer. In this example, the payment is considered to be taxable income and must be reported in the tax year received. Reporting is done in US dollars, so the taxpayer will need to convert the value of the cryptocurrency to USD.
But what about the purchase, sale or mining of cryptocurrency? In Notice 2014-21, the IRS declared that for tax purposes, cryptocurrency is property. As a result, the taxpayer must report these transactions in virtual currency when there is a realization event. Pursuant to Notice 2014-21, when a taxpayer successfully mines virtual currency, the taxpayer must include the fair market value of the virtual currency as of the date of receipt in his/her gross income. In addition, if a taxpayer disposed of or used virtual currency by cashing it in on an exchange or using it to buy goods or services, then taxes could be due if the realized value of the sale is greater than the price at which the virtual currency was acquired. Alternatively, the taxpayer may be entitled to claim a loss on the sale or exchange of virtual currency.
If you have virtual currency transactions that need to be disclosed, you need an experienced tax attorney to represent you in your dealings with the IRS or the Department of Justice. An accountant or enrolled agent is not protected by the attorney/client privilege. Please contact Eric Nemeth on Varnum’s Tax Team with any questions.