On July 26, 2019, the Internal Revenue Service issued a press release, IR-2019-132, announcing that it has begun sending letters to taxpayers with virtual currency transactions, advising them to pay back taxes and file amended returns. By August 2019, more than 10,000 taxpayers will receive these letters.
These letters are part of the IRS’s larger efforts to expand its oversight of transactions involving virtual currency. In 2018, the IRS launched a Virtual Currency Compliance campaign of outreach and examinations. The IRS has begun training staff on virtual currency and intends to remain actively engaged in addressing noncompliance through a variety of efforts, ranging from taxpayer education to audits to criminal investigations.
According to the IRS, virtual currency (including cryptocurrencies, such as Bitcoin, Ether, and Ripple) is not “currency” for tax purposes. Instead, the IRS treats virtual currency that can be converted into traditional currency as “property” for tax purposes, resulting in tax consequences that may not be intuitive to a lay person. For example, a typical exchange of one virtual currency for another (e.g., Bitcoin for Ether) is a taxable transaction (at least for exchanges after December 31, 2017, which under tax reform are not eligible for tax-deferred like-kind exchange treatment), creating gain or loss to the taxpayer and a reporting obligation on IRS Form 8949. Other transactions, such as mining of virtual currency or receipt of units like Bitcoin Cash in the August 2017 hard fork, can also create current tax obligations. Unfortunately, the IRS has issued only limited guidance on the tax treatment of virtual currency, resulting in a trap for the unwary.
The IRS’s increased focus on virtual currency stems in part from a significant reporting gap identified in 2017 between the number of virtual currency users and the significantly smaller number of users reporting gains or losses to the IRS. As part of a federal “John Doe” summons on Coinbase, Inc., the IRS has received, or will receive, names and personally identifiable information of more than 14,000 virtual currency account holders. The John Doe summons was the same tool the IRS utilized to discover foreign bank accounts that drove over 45,000 U.S. taxpayers to self-disclosure, culminating in the Offshore Voluntary Disclosure Program (“OVDP”) for taxpayers to mitigate their criminal and civil exposure.
The IRS is also increasing its use of data analytics to identify taxpayers who have potentially failed to properly report virtual currency transactions. Between this and the use of “John Doe” summons, the IRS can gather information on virtual currency transactions from all over the world. Moreover, while the blockchain for cryptocurrency is inherently anonymous, as a public ledger, it is also inherently traceable. Cryptocurrency owners may find it difficult to remain anonymous from the IRS, particularly when they eventually convert their cryptocurrency to cash, which tends to require personal identification at the exchange. “No one should assume we don’t know you hold virtual currency,” Darren Guillot, director (field collection), IRS Small Business/Self-Employed Division, reported to Tax Notes in January 2019.
U.S. taxpayers who have held any virtual currency should be mindful of the increased IRS scrutiny in this area. With limited IRS guidance on virtual currency available, taxpayers should establish a clear reporting plan as soon as possible.
Disclosing virtual currency transactions early—ideally prior to government contact—is important for avoiding or reducing civil and criminal penalties. So long as noncompliance was not deliberate or fraudulent, a taxpayer can generally avoid civil penalties by filing a qualified amended return. If noncompliance was deliberate or fraudulent, then a taxpayer may want to consider disclosing its noncompliance voluntarily—before government contact—to avoid criminal prosecution. Although these options may not be available to taxpayers who have already been contacted by the IRS regarding their virtual currency transactions, it is important to have a lawyer, well-versed in the issues, who can negotiate the best resolution on the taxpayer’s behalf.
If you have questions about this IRS press release, the tax treatment of virtual currency generally, or whether/how to make a disclosure to the IRS, please contact any member of the Baker Botts Virtual Currency IRS Task Force listed below.
ABOUT BAKER BOTTS L.L.P.
Baker Botts is an international law firm of approximately 725 lawyers practicing throughout a network of 13 offices around the globe. Based on our experience and knowledge of our clients' industries, we are recognized as a leading firm in the energy and technology sectors. Since 1840, we have provided creative and effective legal solutions for our clients while demonstrating an unrelenting commitment to excellence. For more information, please visit bakerbotts.com.