According to Law360, Law360 (January 3, 2021, 12:02 AM EST) -- A high-stakes game of chicken moves to the next level in 2021. Over the past several years, the Internal Revenue Service has repeatedly warned that taxpayers who violate the law while using virtual currency, including cryptocurrency, will be pursued for civil and, potentially, criminal penalties.
To some, the warnings seem to be all smoke and mirrors: Other than a few high-profile prosecutions and forfeiture actions for especially egregious alleged violations of the tax and money laundering laws, the IRS has yet to announce many mainstream tax evasion or money-laundering cases involving virtual currency.
Rather, the IRS appears to be focusing its resources on educating taxpayers about relatively novel tax-related virtual currency issues. Their is a long-standing policy of the U.S. Department of Justice that it not criminally investigate or prosecute a case in which the law is unsettled or uncertain, or novel issues of law or fact are presented.
The IRS has devoted substantial resources to educating taxpayers about the tax consequences of transacting in virtual currency. For example, the IRS issued Notice 2014-21, Revenue Ruling 2019-24 and frequently asked questions, advising taxpayers and practitioners of the tax consequences of investing in, trading or creating virtual currency.
In the summer of 2019, the IRS issued more than 10,000 educational letters to taxpayers who the IRS knows or believes had virtual currency transactions. The IRS also added a question to page 1 of Form 1040, U.S. Individual Income Tax Return, asking whether the taxpayer transacted in virtual currency.
Finally, the IRS updated Form 14457, Voluntary Disclosure Practice Preclearance Request and Application, to allow taxpayers to make a voluntary disclosure with respect to unreported income from virtual currency.
With taxpayers and advisers on notice that transacting in virtual currency may have tax implications, the IRS is now in line with government policies to investigate and, as appropriate, prosecute taxpayers who willfully avoid tax obligations related to virtual currency transactions.
In early 2018, in response to a John Doe summons, San Francisco-based Coinbase Inc. provided information to the IRS about 13,000 customers who bought, sold, sent or received at least $20,000 of cryptocurrency between 2013 and 2015.
Using information obtained from Coinbase, the IRS examination divisions are conducting civil audits and the IRS Criminal Investigation Division and the DOJ are pursuing criminal investigations. The IRS continues to mine this information, using data analytics to identify persons and transactions of interest.
In July 2018, the IRS announced an audit campaign focused on addressing "noncompliance related to the use of virtual currency through multiple treatment streams including outreach and examinations." The first leg of the campaign — outreach — was achieved with the administrative guidance and educational letters issued from 2014 through 2020.
The second leg of the campaign — enforcement — is in full swing and primed to increase in 2021. The IRS is auditing taxpayers and has sought to obtain information about at least one taxpayer from other virtual currency exchanges, like the Luxembourg-based Bitstamp Ltd.
This article first examines the impact of unreported virtual currency transactions on the U.S. tax gap to explain the government's interest in seeing that taxpayers report virtual currency transactions for tax purposes. Next we explore the current enforcement environment, including important changes under the Bank Secrecy Act. Finally, we survey various methods for correcting historical noncompliance, including the qualified amended return and voluntary disclosure.
There is currently a gap in information reporting with respect to virtual currency. Since at least Oct. 8, 2019, the IRS has included in its priority guidance plan the issuance of guidance regarding information reporting on virtual currency under Internal Revenue Code Section 6045.
Once the requirements of third-party information reporting concerning virtual currency are clearer, and complied with by virtual currency exchanges and other third-parties, it will be easier for the IRS to narrow the tax gap by identifying unreported income from virtual currency transactions.
Using virtual currency to facilitate an economic crime is just the latest technology that poses a challenge for the government and financial investigators. At the end of day, fiat currency has to be converted into virtual currency (this conversion is commonly referred to as an onramp).
Once armed with relevant and valuable information, the IRS will leverage data analytics to identify taxpayers and transactions of interest. Data analytics is a generic term that refers to various electronic tools through which IRS agents can easily pick up and track a taxpayer's digital trail by leveraging billions of records at their disposal, Bank Secrecy Act and Foreign Account Tax Compliance Act filings, public records, and information from thousands of whistleblowers, informants, and cooperators every year.
Once an IRS agent catches a taxpayer's digital scent, the scales tilt in the government's favor. Although a taxpayer can attempt to keep their virtual currency holdings outside of the view of others by spending the ill-gotten gains in other cryptocurrency-denominated transactions, most individuals will convert the virtual currency back into fiat currency (this conversion is commonly referred to as an offramps), thereby coming back on the grid.
Also on the international stage, the IRS Criminal Investigation Division has teamed up with four other countries to form the Joint Chiefs of Global Tax Enforcement, or J5. One of the areas of emphasis for the J5 is on crimes involving virtual currency, including sharing information about tax evasion using virtual currency.
Other agencies are following suit. On Dec. 31, 2020, FinCEN issued a notice clarifying that FinCEN Form 114, Report of Foreign Bank and Financial Accounts, was not historically required with respect to a foreign account holding virtual currency. That same notice states that FinCEN intends to proposed to amend BSA regulations to require FBAR reporting with respect to virtual currency. It is reasonable to expect these regulations will expand the definition of "account" to cover certain virtual wallets held outside of the U.S. or certain types of virtual currency traded through foreign exchanges or stored on non-U.S. servers.
In a possible sign that the enforcement environment is heating-up, in November the U.S. District Court for the Western District of Washington, in U.S. v. Kvashuk, sentenced an ex-Microsoft engineer for an elaborate cyber theft that included the movement of approximately $2.6 million of bitcoin through bank and investment accounts using a bitcoin mixer and filing false tax returns. The IRS touted this as the first Bitcoin case charged as a tax crime.
In October 2020, John McAfee, founder of the McAfee computer security software company, was indicted on federal tax charges. According to the indictment, McAfee allegedly evaded his tax liability by directing his income to be paid into bank and cryptocurrency exchange accounts in the names of nominees.
The IRS has well-established paths to rectify tax noncompliance relating to virtual currency. For taxpayers who engaged in virtual currency transactions, but did not report the transactions for tax purposes, a qualified amended return or voluntary disclosure may offer a path to compliance that limits the likelihood of civil or criminal penalties.
The availability — and advisability — of the qualified amended return or the voluntary disclosure depends heavily upon whether the taxpayer willfully failed to report their virtual currency transactions — i.e., whether the taxpayer intentionally violated a known legal duty.
One avenue for taxpayers to voluntarily come into tax compliance regarding previously unreported virtual currency transactions is the qualified amended return. The benefit of filing a qualified amended return is that a taxpayer can avoid accuracy-related penalties that might otherwise apply.
For a document to generally be treated as a qualified amended return, pursuant to Treasury Regulations Section 1.6664-2(c)(3)(i), the document must be filed before the IRS issues a John Doe summons covering the taxpayer seeking to amend the return.
As noted, the IRS served a John Doe summons on Coinbase in late 2016. Absent some exemption from the IRS, which has not yet occurred (and does not appear likely to occur), the Coinbase summons makes individuals who "bought, sold, sent or received at least $20,000" worth of virtual currency through Coinbase between 2013 and 2015 ineligible for the qualified amended return procedures.
Even if the qualified amended return is available, its attractiveness as an option must still be evaluated in the light of its drawbacks. If the IRS determines the underpayment of tax regarding the original return is fraudulent, the taxpayer is potentially liable for criminal prosecution and a civil fraud penalty equal to 75% of the underpayment of tax.
Moreover, qualified amended returns do not protect taxpayers from other civil penalties, such as those attributable to failing to file international information returns (including a Report of Foreign Bank and Financial Accounts or Form 8938), or from criminal prosecution.
For taxpayers who engaged in willful noncompliance, the IRS offers the voluntary disclosure practice, which is designed for taxpayers who have true exposure to a criminal investigation and prosecution. The IRS updated Form 14457 to allow taxpayers to make a voluntary disclosure with respect to unreported income from virtual currency.
Taxpayers should consider the existence of willful behavior and the availability of the qualified amended return or voluntary disclosure for a particular fact pattern.
The government's threats to pursue civil and criminal tax noncompliance relating to virtual currency will likely start to bear fruit in 2021. Noncompliant, eligible taxpayers should consider NOW the option to use a qualified amended return or a voluntary disclosure to come into compliance with the tax laws to mitigate civil penalties and/or criminal investigations and prosecutions.