DOJ, IRS to target virtual currency tax fraudsters

The following article was provided by Baker Hostetler and was written byJohn J. Carney, Andrew M. Serrao, Robert A. Musiala Jr., Jeffrey H. Paravano and Nicholas C. Mowbray

In the past several years, the use and prevalence of virtual currency have increased exponentially. The proliferation of digital assets has changed the way goods and services are exchanged and has allowed for faster and cheaper transactions. But with this new technology comes the increased risk of fraudulent activity – especially tax fraud. Recently, the Internal Revenue Service (IRS) has made it abundantly clear through guidance, amendments to tax forms, and even warning letters to Americans suspected of tax fraud, that it is getting very serious about virtual currency tax compliance.

The IRS and the Department of Justice (DOJ) appear to be poised to commence a flurry of enforcement actions against virtual currency tax fraud offenders. Likely to be entangled in these enforcement actions are virtual currency institutions and companies that regulators suspect facilitated their customers’ tax evasion. It is thus imperative for all entities in the virtual currency industry to ensure their compliance programs are equipped to detect and prevent the facilitation of virtual currency tax fraud.

I. The IRS focus on virtual currency

The IRS defines virtual currency as a “digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.”1 Cryptocurrency is “a type of virtual currency that utilizes cryptography to validate and secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.”2

Beginning in 2014, the IRS has demonstrated an increasing focus on virtual currency tax compliance. This focus has continued even through to October of this year, signaling that regulators may be preparing to commence enforcement actions in the near term.

A. The Beginning: Notice 2014-21, John Doe Summons and the J5

The IRS’s first major action on virtual currency came in 2014 with its Notice 2014-21 (the “2014 Notice”).3 According to the IRS, certain forms of virtual currency, known as convertible virtual currency, have an equivalent value in “real” currency like United States coin and paper money and can be used to pay for goods and services.4 Bitcoin is an example of a convertible virtual currency.5 The 2014 notice acknowledges that convertible virtual currency should be treated as property for tax purposes.6 The 2014 notice was the IRS’s first public pronouncement of tax consequences related to virtual currency.

In 2016, the IRS sought to gain information on potential tax violations involving virtual currencies by serving a “John Doe” summons on Coinbase, one of the largest cryptocurrency exchanges in the U.S. The IRS alleged that virtual currency gains had been widely underreported and sought to obtain various records related to persons and transactions conducted through the exchange during the period of 2013-2015. Coinbase refused to comply, resulting in litigation and a final judgment by the U.S. District Court for the Northern District of California. In its ruling, the court allowed the IRS to move forward with a narrowed summons that granted access to certain taxpayer records from Coinbase involving transactions valued at $20,000 or more during the 2013-2015 period.7

Another significant development came in 2018 with the creation of the Joint Chiefs of Global Tax Enforcement, also known as the J5.8 The alliance, formed among the United States, Australia, Canada, the Netherlands, and the United Kingdom, was a significant demonstration of the federal government’s commitment to combating tax fraud, both domestically and internationally. A year after its formation, the J5 was already involved in more than 50 investigations of international facilitators of tax fraud.9 Additionally, a few months later, the J5 quickly turned its attention to virtual currency tax enforcement. In its second annual “Challenge,” during which member nations focus their efforts to identify “the most egregious tax offenders in the world,”10 the United States hosted a J5 Challenge focused on cryptocurrency. Numerous experts from each member nation gathered in Los Angeles in November 2019 to generate leads and locate cryptocurrency tax offenders. In a statement after the cryptocurrency Challenge, the IRS stated that the “threat of cryptocurrencies to tax administration is one of the main focus areas of the J5.”11 According to Bloomberg, the IRS identified “dozens” of potential cryptocurrency tax evaders during the November 2019 meeting.12

B. 2019: A busy year for virtual currency

Last year, the IRS meaningfully increased its focus on virtual currency tax compliance.

In July 2019, the IRS sent letters to more than 10,000 American taxpayers who may have failed to report their virtual currency transactions and pay the associated income taxes.13 Each taxpayer received one of three letters, each varying in severity: Letter 6173,14 6174,15 or 6174-A.16 In Letter 6174, the least severe of the three letters, the IRS reminded taxpayers of their obligations to report virtual currency transactions. In Letter 6173, the IRS wrote to taxpayers who “may not have met {their} U.S. tax filing and reporting requirements for transactions involving virtual currency{.}” Letter 6173 went on to threaten an examination if recipients did not report their virtual currency transactions by filing a delinquent or amended return or submitting an affidavit stating they had properly reported their virtual currency transactions. Finally, in Letter 6174-A, perhaps the most serious of the three letters, the IRS threatened with enforcement activity those taxpayers who “may not have properly reported” their virtual currency transactions if they did not report these transactions with the filing of a delinquent or amended return.

The IRS reportedly sent a second round of these letters the following month, in August 2019. According to Bloomberg, the second round of letters addressed tax returns that did not match information received from cryptocurrency exchanges and “acknowledge{d} that trading exchanges, not the taxpayers, may have made the errors.”17 According to reports, the IRS letters may be based on information obtained by the IRS from its 2016 John Doe summons on Coinbase.18 In comments made on July 30, 2019, IRS Commissioner Charles Rettig reportedly said of the letters, “We didn’t send a letter to every seventh address. One might assume we had information, and we’re encouraging people to get there first.” An allegedly leaked IRS presentation from the same time period also indicates an increased focus on cryptocurrency tax enforcement.19

In October 2019, the IRS issued its most significant guidance on virtual currency since the 2014 Notice.20 The guidance, which came in two parts, was part of the IRS’s “wider effort … to enforce the tax laws in a rapidly changing area” and “ensure fair enforcement of the tax laws for those who don’t follow the rules.”21 The first part, Revenue Ruling 2019-24, provides guidance on certain virtual currency transactions known as hard forks and airdrops.22 In the second part, the IRS issued a list of frequently asked questions that address transactions for taxpayers who hold virtual currency as a capital asset, such as calculating gains and losses.23

Finally, in 2019, the IRS made two important updates to tax forms that signaled a growing interest in virtual currency. In early 2019, the IRS released a new Form 14457, “Voluntary Disclosure Practice Preclearance Request and Application,” that includes a question on disclosing special features. One category listed under this question is virtual currencies. The form is used to make a preclearance request and determine the eligibility of a taxpayer to utilize the IRS’s voluntary disclosure program.24 In December 2019, the IRS published the 2019 Schedule 1 to Form 1040.25 Form 1040 is used to report taxpayers’ gross and taxable income, and taxpayers use Schedule 1 to report additional income such as prize or award money. On the 2019 Schedule 1 to Form 1040, the IRS explicitly asked, “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”26

C. 2020: The IRS continues to get serious

This year, the IRS has continued its focus on virtual currency tax compliance.

In February, the J5 announced that Dutch authorities had arrested two men in connection with two criminal investigations on suspicion of money laundering using cryptocurrencies.27 Also in February, the U.S. Government Accountability Office (GAO) published a study finding that additional information reporting and clarified guidance could improve cryptocurrency tax compliance. Among other things, the GAO report found that steps to increase third-party information reporting on virtual currency transactions could help the IRS provide taxpayers with useful information for completing tax returns and give the agency an additional tool to address noncompliance.28 In March, the IRS reportedly invited cryptocurrency companies and advocates to a March 3 summit to discuss how the agency can “balance taxpayer service with regulatory enforcement.”29

In May, the IRS made a public request for assistance from third-party contractors on auditing tax returns for virtual currency issues.30 In its Statement of Work, the IRS stated that it needed “consulting services to support a taxpayer examination involving virtual currency” and assistance to “calculate taxpayers’ gains or losses as a result of their transactions involving virtual currency.”31 The Statement of Work even says that consultants “may need to testify at trial” to explain their calculations.32

In July, news outlets reported that the IRS had contracted with a major U.S. cryptocurrency exchange to use its proprietary blockchain analytics software33 and had separately negotiated a contract with another blockchain analytics firm based in the U.K.34 Also in July, the IRS, together with the Department of Treasury, reportedly commented during a webcast that in-progress guidance will address third-party tax reporting requirements for cryptocurrency transactions.35 Specifically, the IRS is reportedly planning to issue guidance for information reporting on cryptocurrencies under Section 6045 of the tax code, which generally requires securities brokers to report basis and gross proceeds upon the sale of securities on Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions.”36

In August, the IRS perhaps had its busiest month yet on virtual currency. On August 14, the IRS reportedly sent out a new set of warning letters to taxpayers similar to the 2019 letters.37 A few days later, the IRS published a proposed Form 1040 for the 2020 tax year that again asked Americans about their virtual currency transactions.38 This year, however, the IRS plans to raise the stakes by making the virtual currency question the very first question on Form 1040 instead of burying the question on Schedule 1. On August 28, the IRS released a memorandum concerning tax implications when receiving convertible virtual currency for services performed through a crowdsourcing or similar platform.39 There are digital platforms that allow requestors to “crowdsource” jobs to others, such as completing an online quiz or survey. Sometimes compensation for completing a job is provided in the form of convertible virtual currency, which, as discussed above, is treated as property for tax purposes under the 2014 Notice. In its August 28 memorandum, the IRS makes clear that compensation in the form of convertible virtual currency must be reported on the recipient’s tax return.

In September, the IRS published a solicitation seeking to procure tools for tracing and attribution of privacy-focused cryptocurrencies like Monero. According to reports, proposals accepted by the IRS will receive an initial payment of $500,000 and will be eligible for a further grant of $125,000.40 Finally, in October, the Tax Division of the DOJ unsealed an indictment against John McAfee, a computer programmer and businessman, alleging that McAfee “evaded his tax liability by directing his income to be paid into bank accounts and cryptocurrency exchange accounts in the names of nominees.”41

II. The need for an effective compliance program

The federal authorities will likely soon begin enforcement actions against taxpayers who have failed to properly report their virtual currency transactions. But institutions and entities in the virtual currency industry are also at risk if the IRS believes they facilitated tax fraud. For example, the IRS may assert that an employee of a virtual currency vendor improperly told a customer that taxpayers need not report virtual currency transactions on their returns.

One need only look to the DOJ Swiss Bank Program for insight on how regulators may proceed. After discovering U.S. assets hidden in Swiss banks, the DOJ created the program in 2013 to encourage banks to cooperate with investigations into the use of their accounts to commit tax evasion.42 Cooperating banks were given non-prosecution agreements.43 In December 2016, the DOJ reached its 80th and final resolution under the program, collecting more than $1.36 billion in penalties.44 Just over a year later, Chief of the IRS Criminal Division, Don Fort, noted the Swiss Bank Program’s parallel with virtual currency tax fraud when he stated that it is “possible to use Bitcoin and other cryptocurrencies in the same fashion as foreign bank accounts to facilitate tax evasion.”45 Additionally, last year, Treasury Secretary Steven Mnuchin made a similar comment about the parallel between virtual currency and “Swiss-numbered bank accounts.”46

Virtual currency institutions and entities must protect themselves now from unnecessary scrutiny and investigation with a robust and effective compliance program. Companies should look to the DOJ’s guidance published in June (the Guidance) for the best practices on implementing compliance measures to reduce fraud risks.47 Aimed at determining whether a company’s compliance program seeks to meaningfully engage with risks and prevent fraud, the Guidance asks three “fundamental questions”: (1) Is the compliance program well designed? (2) Is the compliance program adequately resourced to function effectively? (3) Does the compliance program work in practice?48

A compliance program for a company in the virtual currency industry must ensure that customers and employees are not using the company’s services to facilitate tax evasion. Companies should keep the following concepts in mind when evaluating and updating their policies:

  1. Design a program specific for the virtual currency industry

As a general principle, the Guidance makes clear that all companies are different and context matters. It lists specific factors that the DOJ will use to make individualized determinations of a program’s effectiveness, including “the company’s size, industry, geographic footprint, {and} regulatory landscape{.}”49

Companies in the virtual currency industry should thus be mindful that their compliance programs must address issues specific to the industry, including the heightened risk for tax compliance issues.

2. Tracking and using data

In connection with whether the compliance program is adequately resourced (fundamental question 2), the Guidance highlights the importance of tracking and using data. Specifically, the Guidance asks whether compliance personnel have access to relevant sources of data to “allow for timely and effective monitoring and/or testing of policies, controls, and transactions{.}”50

By its very nature, the virtual currency industry is data-driven. Companies should thus be particularly mindful of the data they are collecting and whether they are using the data to root out tax compliance issues.

3. Evolution of a compliance program

In connection with whether a compliance program is well designed (fundamental question 1) and whether the program works in practice (fundamental question 3), the Guidance emphasizes that a compliance program must change and evolve over time. The Guidance encourages companies to conduct periodic review of their compliance programs that lead to updates to the company’s policies, procedures, and controls.51 Prosecutors will also consider whether a company adapts its program based on “lessons learned from its own misconduct and/or that of other companies facing similar risks{.}”52

The virtual currency industry is rapidly changing. Companies should thus be constantly mindful of developing compliance issues. For example, if regulators commence an enforcement action that reveals that virtual currency technology was used to commit a crime, companies should assess their own compliance programs to ensure their programs are equipped to address that risk.

III. Conclusion

Regulators are poised to commence a flurry of enforcement actions related to virtual currency tax fraud. Institutions and entities in the industry should prepare their compliance programs now to guard against fraudulent activity and unnecessary federal scrutiny and investigation.

Authorship Credit: John J. Carney, Andrew M. Serrao, Robert A. Musiala Jr., Jeffrey H. Paravano and Nicholas C. Mowbray

Alert with footnotes can be found here: https://www.bakerlaw.com/alerts/doj-and-irs-may-soon-begin-enforcement-actions-against-virtual-currency-tax-fraudsters#46