Bitcoin Users Beware: IRS John Doe Summons Finds Partial Support at Court

Virtual currencies like Bitcoin have been on the rise in recent years. 2017 saw the cryptocurrency market soar to $650 billion, with some investments more than doubling in value within the year. The skyrocketing value of these assets have caught the attention of the IRS, and an investigation into under-reported virtual income is already underway. Here's what bitcoin users need to know.

Why Cryptocurrencies Matter to the IRS

Many savvy investors have turned to cryptocurrencies, like bitcoin, in recent years, hoping to catch the next big wave. The industry is booming (though some believe it will eventually be a bubble that bursts). Forbes predicts 2018 will see investors double their investments in virtual currencies, so it is no surprise that thousands of investors are getting involved.

When assets boom in value, taxpayers can see substantial capital gains. For example, in 2012, one bitcoin was worth $15 USD. At the start of 2018, that number was $15,000 USD. Those capital gains are taxable income. But the IRS says that between 2013 and 2015, only 800 or 900 taxpayers reported bitcoin income. The IRS did the math and discovered that thousands of taxpayers may have had unreported income over those two years.

How Are Bitcoin Assets Taxed?

In Notice 2014-21, the IRS made clear that virtual currency is treated as property for tax purposes, and must be reported the same way. Taxpayers who receive virtual currency as payment for goods or services were instructed to report the fair market value of the currency on the date it was received as income. Changes in value while the bitcoins are in an investor's possession are taxable gains or losses that must be reported on the taxpayer's individual or corporate tax return for the year.

John Doe Summons Targets Bitcoin Users

In November 2016, the IRS issued a "John Doe Summons" to Coinbase, Inc., requesting extensive information on every one of the company's users, including:

• User profiles
• Taxpayer identification numbers and information
• Transaction records
• Account instructions
• Due diligence compliance forms
• Account statements
• Correspondence
• Security information

The request would have disclosed vast amounts of private customer data, so Coinbase asked the U.S. District Court for the Northern District of California to quash the subpoena. The IRS has often used these John Doe summonses to gather information, so Coinbase's attorney, Kevin F. Sweeney of Chamberlain, Hrdlicka, White, Williams & Aughtry admitted it was "an uphill battle going into it."

The summons was intended to identify U.S. taxpayers who hadn't properly reported their income from virtual currency, including both conversions between bitcoin and dollars, and transactions exchanging bitcoins out of their "wallets." Over the course of the next year, the IRS admitted the summons was overly broad, and voluntarily reduced its scope. But Coinbase said it wasn't enough.

District Court Supports, But Narrows John Doe Summons

Then, on November 29, 2017, the U.S. District Court weighed in, partially granting the Justice Department's enforcement of the John Doe summons. The court found that the IRS's investigation into the under-reporting of cryptocurrencies was a legitimate purpose, and not simply research. It also found that some, but not all, the information requested was relevant to that investigation. The court distilled the information requested in the John Doe Summons into three categories:

• Information relevant to determining if the account holder had unreported taxable gains
• Information relevant only if an account holder had a taxable gain
• Information that was never relevant

It held that the IRS could properly demand information in the first category at this time, but that the other two could only be sought for individual taxpayers where there was evidence of potential taxable gains. Based on that reasoning, the court ordered Coinbase to disclose information on approximately 14,000 customers - approximately 1 percent of its user base - including:

• Taxpayer identification numbers
• Names
• Birth dates
• Addresses
• Transactional records
• Account statements or invoices

If the IRS later determines that more information is needed for any particular taxpayer, the court instructed the Justice Department to issue a summons directly to the taxpayer or to Coinbase with notice to the named user.

Next Steps for Bitcoin Users

Coinbase is calling the decision a "partial victory", protecting more than 480,000 customers' records from disclosure. However, taxpayers with reportable transactions who have not disclosed their taxable gains from cryptocurrencies could face IRS enforcement in the months and years to come. Experts believe the IRS will focus on non-compliant taxpayers first, using a program similar to the offshore voluntary disclosure program. Bitcoin users who had hoped to avoid disclosure of those assets - or who did not realize bitcoins were considered income - are well advised to speak to their tax preparers and an experienced tax attorney. They may be able to amend their tax returns and voluntarily correct the unreported income, and avoid penalties later on.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years’ experience. If you have questions regarding reporting bitcoin income, contact Joe Viola to schedule a consultation.