IRS Investigations into the Crypto Market | Criminal Tax Blog

IRS Investigations into the Crypto Market

IRS Investigations into the Crypto Market

Brian T. Hobson

The Internal Revenue Service fears the cryptocurrency market has given birth to large scale tax fraud in the United States.  As previously discussed, the anonymity, decentralized nature of crypto currency trading, and large gains in the last five years, make crypto investments an obvious focus for the IRS.

The question circling the crypto investment community is how the IRS will pierce the vail of anonymity that is built into all crypto assets.  The IRS made moves in 2017 which give an important insight into how criminal tax investigations are likely to start in 2018 and beyond.

New Investigative Tactics

Most criminal tax investigations begin with suspicious activity reported by a bank.  Once notified, the IRS can investigate a tax payers financials and previous tax returns.  It is during this process where mistakes or fraudulent activity is uncovered.  For example, an owner of a company may purchase a million-dollar yacht in 2017.  This purchase is flagged as suspicious activity by the tax payer’s bank.  The IRS will begin digging into the tax payer’s financials and tax filing history.  During this investigation, they may uncover multiple flags of fraud: reporting $30,000 of income in 2017, multiple wire transfers to offshore accounts, large cash deposits into bank accounts not owned by the tax payer, or many other activities that are consistent with hiding money from taxation.  Most IRS investigations begin with suspicious activity within the tax return itself or within a tax payer’s financial history.

The IRS is taking a different stance on crypto investments.  They are not waiting for any specific activity on the back end.  The IRS is taking a proactive approach to track down all crypto investors for potential audit.  This is likely due to the anonymization issues embedded in crypto assets and the resulting opportunities for tax fraud within the crypto sector.

“John Doe” Subpoena Litigation

In November of 2016, the IRS issued “John Doe” (JD) subpoenas to Coinbase.  Coinbase is a crypto exchange incorporated in San Francisco, California.  Coinbase brought in over 1 billion dollars in revenue over the course of 2017 by charging a transaction fee for purchasing Bitcoin and other crypto currencies through their application.

The JD subpoenas asked Coinbase to produce the identities of all United States’ customers from 2013-2015.  Per the government memorandum, the issuance of the summons was warranted because 1) the summons related to an ascertainable group or class of persons, 2) there was a reasonable basis to believe these persons failed to comply with the Internal Revenue Code, and 3) information to ascertain these identities was not readily available from other sources.

Some select Coinbase users, John Doe 1-4, filed a motion to quash the IRS subpoenas in federal court in 2017.  There reasoning was based on the overbreadth of the subpoena in requesting the identity of every person who used Coinbase over a three-year period.  The federal courts ruled the John Doe’s had standing to challenge the subpoena and agreed to hear the case in late 2017.

As litigation approached in 2017, the IRS narrowed the scope of the JD subpoenas to focus on a smaller, more suspect class.  The JD subpoenas no longer requested information on all Coinbase users within the United States, but rather, only those who bought, sold or exchanged virtual currencies in an amount over $20,000.  This move was made in hopes of weakening the John Does’ overbreadth argument.

The court hearing on the motion to quash was held in the federal district court for the Northern District of California in November of 2017.   The district court judge ruled the new subpoena request was not overbroad as it “served the IRS’s legitimate purpose of investigating Coinbase account holders who may not have paid federal taxes on their virtual currency profits.” The entire ruling can be viewed here. 

The Court’s ruling allowed the IRS to subpoena the name, tax payer ID number, transaction log, and all invoice reports for United States customers who bought, sold, or exchanged Bitcoin in excess of $20,000 over the three-year period.

The Implications of the Coinbase Experience

The IRS has flexed its muscle for the first time in the crypto investment sector.  Their attack is aimed at one of the largest exchanges for crypto investment in the United States.  Coinbase is the low hanging fruit which allows the IRS to identify many big investors without the need to expend considerable resources.

Those Coinbase users who bought and sold Bitcoin on the application will be easily identified under the subpoena.  Further, the taxes owed on those transactions will be easily ascertained if Coinbase is the only platform they used to trade crypto assets.  If you are a United States resident that fits this model, the IRS will likely audit your 2013-2015 tax returns to ensure the correct amount was paid on any capital gains.  It is unclear whether investigations which start under the JD subpoenas will be turned over to the IRS – Criminal Investigation Division.  However, the general rule is the more tax loss the IRS can show the greater likelihood criminal tax sanctions will be imposed.

The JD subpoenas involving Coinbase are just the tip of the iceberg.  Coinbase allows investors to buy and sell four separate crypto currencies – Bitcoin, Ethereum, Bitcoin Cash, and Litecoin.  Bitcoin was the only currency at issue in the JD subpoenas.  If the IRS decides to add the other three crypto assets, the scope of the investigation will increase substantially.

The JD subpoena brings into focus one of the tools the IRS will use in attacking tax fraud in the crypto market.  But it does not answer what the IRS plans to do with the substantial capital traded outside of large centralized exchanges.  The Coinbase supported currencies make up a large part of the crypto market, but many investors have moved past the big currencies to begin trading in “token” projects.  These projects are small start-up companies.  These start-ups sell “tokens”, or shares, in their company and use the cash raised to fund the production of a block chain based product.

Investments in these token projects follow a similar MO throughout the crypto space – a Coinbase (or other large exchange) user buys Bitcoin or Ethereum, moves the asset to their personal wallet, and exchanges the asset for tokens on a smaller exchange.  These tokens are then held in a private wallet.  The investor can sell these tokens later for profit.  These smaller token transactions are done on two types of exchanges: 1) centralized and 2) decentralized.  A centralized exchange requires the identifying information of the user prior to making a transaction.  These exchanges include Binance, Bittrex, and many others.  Bittrex is based out of the United States.

A decentralized exchange, however, does not obtain any identifying information from the user before processing trades.  It is these exchanges that create the next hurdle for the IRS in their mission to recoup tax dollars within the crypto market.  The JD subpoena model works for all exchanges within the United States who hold the users’ identifying information.  It fails when tackling foreign or decentralized exchanges.

With the JD subpoenas, the IRS has targeted one section of the crypto market.  It will be interesting to see how the IRS navigates the anonymity of the decentralized exchanges moving forward.  One thought is the IRS may only need to expound on the JD subpoenas to bridge the anonymity gap.  Almost all users in the United States bring money into the crypto market through Coinbase, or other similar centralized exchange, prior to investing in any crypto asset.  This is true for the big four currencies and token shares.  If the IRS continues to subpoena major exchanges for user information, they are likely to have a thorough list of persons who are active in trading tokens on lesser known exchanges.  The IRS could then issue personal subpoenas to unlock the anonymity issue.

The resources necessary to conduct that type of investigation would be enormously expensive.  I am not sure the IRS has the man power to subpoena personal information from every Coinbase user in hopes of tracking down profits made in token investing.  But it is the area of crypto trading that has not been addressed by the IRS in the JD subpoenas nor in their current investigations.  It will be interesting to follow their investigative techniques moving forward as they continue to navigate the crypto landscape.