The IRS goes after Bitcoin users

Fresh off its resounding success in finding taxpayers who were evading taxes though the use of foreign bank accounts, the IRS has a new group of tax evaders in its crosshairs: virtual currency users.

In a virtual currency system, a user creates a “wallet.” A wallet is a digital computer file that contains information used in sending and receiving units of virtual currency.  A wallet holds any number of public keys with their associated private keys (similar to a user ID and a digital signature, respectively).  A virtual currency user electronically sends his public key (user ID) to anyone with whom s/he wishes to transact.  If the transaction is signed by both parties, the transaction is complete and is added to the blockchain.  All transactions in a virtual currency blockchain can be viewed by the public on any computer connected to the Internet.  The blockchain, however, does not identify the wallet owners.

The most commonly known virtual currency is bitcoin. Its value has risen from nothing to almost $5,000 per bitcoin in the past four years.  Between 200,000 and 400,000 Bitcoin transactions take place every day.  By comparison, the next most popular virtual currency is Ethereum, which accounts for approximately 50,000 daily transactions.  The remaining virtual currencies account for less than 10,000 transactions combined.  It is estimated that between 3 and 10 million individual worldwide hold bitcoins.  It is further estimated that approximately 17% of those users (or between 500,000 and 1.7 million) are located in North America.  Based on the IRS’ review of filed tax returns, less than 900 individuals in the United States reported a transaction involving bitcoins.  This disparity, not surprisingly, drew the attention of the IRS, which is actively investigating the identity and correct federal tax liability of taxpayers who conducted transactions in virtual currency.

As part of that investigation, the IRS summoned the records of Coinbase, Inc., which operates a bitcoin wallet and exchange business. Coinbase is the largest exchanger in the United States of bitcoin and the fourth largest exchanger globally.  It alone accounts for 6 million customers worldwide.  The IRS was looking for records for every transaction of Coinbase users from January 1, 2013 through December 31, 2015.  After some back and forth involving pressure from Congress, the IRS reduced its demand to users with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year.  Coinbase still refused to comply with the summons, but the federal court sided with the IRS recently.  Coinbase estimates that at issue is the identity of only 14,355 individuals; that number, of course, has not been independently verified.  Based on the author’s experience enforcing summons for the Tax Division of the U.S. Department of Justice, it is difficult to imagine that other courts will reach a different decision and block the IRS from getting the information it seeks from Coinbase.

The summons battle with Coinbase is reminiscent of the earlier battle the IRS waged with foreign banks over the identity of their customers who were evading the payment of income taxes in the United States. That battle eventually led to the disclosure by 146 foreign banks of the identity of the customers.  The effort also led to the IRS collecting over $10 billion with 100,000 taxpayers coming back into compliance.

Since it seems inevitable that the IRS will ultimately get the information it seeks from Coinbase (and other exchanges), the remainder of this article focuses on virtual currency user’s tax obligations.

For federal tax purposes, virtual currency is treated as property and, therefore, general tax principles applicable to property transactions apply to transactions using virtual currency. This means that virtual currency is not treated as currency and, thus, cannot generate foreign currency gain or loss.  This has several implications.

First, a taxpayer who receives virtual currency as payment for goods and services must include as gross income the fair market value of the virtual currency, in U.S. dollars, on the date the currency was received. The same methodology is used to establish the basis in virtual currency.

Second, if a taxpayer exchanges virtual currency for other property, s/he may have a gain or a loss. The character of the gain or loss depends on whether the virtual currency is a capital asset (e.g., investment property) or not (e.g., inventory or other property held mainly for sale to customers in a trade or business).

Third, a taxpayer who “mines” virtual currency (e.g., uses computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger) must include in his/her gross income the fair market value of the currency as of the date of the receipt. This income will be subject either to self-employment tax or to payroll taxes (depending on whether the taxpayer is an employee).

Fourth, payments using virtual currency are subject to the same reporting requirements and the same backup withholding as any other payment.

It remains to be seen whether the IRS has the same level of success with tax compliance by virtual currency users as it did with holders of foreign bank accounts.