New Kid on the Block: Criminal Tax and the Crypto Market

Internal Revenue Service and the Cash Issue

The Internal Revenue Service (IRS) has an extensive history in targeting certain industries or sectors.  Businesses that receive large payments in cash have been in the cross hairs of the IRS for the last forty years.  This focus is based on three reasons: 1) the inability to use classic banking information to track cash payments, 2) the ease of underreporting cash, and 3) the use of cash in illegal businesses.  Lawyers, restaurant owners, and hair dressers have all been the subject of IRS focus over the last few decades based on the IRS’s distrust of cash transactions.

To combat this problem, the IRS pushed Congress to pass the Financial Record Keeping and Reporting of Currency and Foreign Transactions Act in 1970.  This act is commonly referred to as the Bank Secrecy Act (BSA).  The main components of the BSA include requirements for banks to submit currency transaction and suspicious activity reports for large cash and/or foreign deposits.  The BSA requires banks to submit a currency transaction report (CTR) for all currency deposits at or over $10,000 in a calendar day.  These reports are submitted directly to the IRS, and include the name, date of birth, and social security number of the person who is conducting the transaction.

The suspicious activity report (SAR) requirement was embedded in the BSA to flag those individuals who may be involved in illegal activity.  If a bank sees a transaction that is unusual, suspicious, or otherwise does not fit a customer’s profile, they will file a SAR with the IRS.  These reports are confidential, and banks cannot notify the client when a SAR has been filed.  Many criminal tax investigations begin when a bank refers a SAR over to the federal government for review.  There are too many tax payors in the United States for the IRS to scan each person for compliance with the tax code.  The SAR focuses the IRS on the big fish with suspicious banking activity.

The federal government has a long history of working alongside banks to identify people who may be flaunting US tax laws.  The banks work to provide documentation to the federal government which will assist them in identifying potential tax violators.  Many IRS investigations will result in restitution to correct the tax error.  The egregious violations could end in criminal charges.  This interplay between US banks and the IRS is important, because it has meaningful implications in determining how the federal government will handle the new wave of crypto investment and tax compliance.

Bitcoin and the Emergence of the Crypto Market

Crypto currencies began with the introduction of Bitcoin in 2009.  Bitcoin is a form of currency crypto investors can hold in an online wallet to make payments for various items.  Bitcoin can be used to pay for goods online, pay other Bitcoin wallet holders or as a currency to initiate trades for other crypto assets.  All transactions are recorded on the Bitcoin block chain.  The accuracy of the transactions is confirmed by a computer process known as “mining.”

Crypto currencies were originally attractive for two reasons: 1) decentralization and 2) greater anonymity.  Decentralization refers to the process of cutting out a central entity to verify transactions.  Normally, a person makes deposits or withdrawals through their banking institution.  These centralized entities confirm the accuracy of various deposits and withdrawals, and further, report suspicious activity and large transfers to a governing body.  Crypto currencies cut out the centralized banks from monetary transactions.  The “mining” process confirms the accuracy of the transaction.  The transactions are thus verified online with no oversight.  The block chain technology is very accurate, making centralized banks unnecessary to store value or conduct business.

The second benefit to crypto currency is anonymity.  Unlike a bank account, Bitcoin holders’ wallets are not linked to any personal identifying information.  A wallet holder will have two important numbers to protect their assets: 1) public address and 2) private key.  A public address is a set of numbers that identifies the crypto wallet on the block chain.  This address is provided to third parties so they can send funds to your account.  You can view this as the bank account number for crypto assets.  The private key is a unique number which allows holders to view their funds and make transactions on the block chain.  The private key gives you access to your wallet.  This can be viewed as your driver’s license in the crypto market.  If another person stole the private key, they could easily access the wallet online and move Bitcoin to other addresses.  Neither the public address or private key is linked to any personal identifying information.

Though the most well-known and traded, Bitcoin’s technology is archaic. One example of this is the lack of total anonymity in Bitcoin transactions. If a person is linked to a public address, you can enter the blockchain ledger and retrieve a list of their transactions.  Newer crypto currencies, such as PIVX, implement technology which creates total transaction anonymity.   As the crypto industry grows, total anonymity is likely to be a staple of emerging crypto currencies.

Crypto Market as a Tool for Investment

Since 2009, Bitcoin has been joined by numerous other crypto currencies and assets.  With the emergence of other crypto offerings came the flowering of a new purpose for the crypto market – investing.  Starting in 2014, new companies began to emerge to either offer alternative currencies with improvements over the Bitcoin block chain or to allow investment into projects that used block chain technology to solve real world problems.  These new arrivals caused a huge rush of capital into the crypto market.  In 2017 alone, Bitcoin saw its price increase by 20x.  Other currencies and assets saw huge gains as well, some reaching 1,000 times their starting prices.  To put that in perspective, an investment of $1,000 into a choice asset on January 1, 2017 would have been worth $1 million on December 31, 2017.  Some of these large gains happened in much smaller time frames during the year.

The gains in 2017 have caused an influx of capital into the crypto market.  The original investors are still there, but now we see the addition of capital firms taking notice of the huge gains.  The Chicago Board Options Exchange (CBOE) opened up Bitcoin options for investors, and there are numerous articles from top executives at JP Morgan and others who are taking notice of the crypto market as it legitimizes its place in stock portfolios.  As crypto assets continue to push into the mainstream, governments around the world are trying to figure out how to handle the sector.  Some governments have advocated banning their use, others are more open minded and accepting of the future.   This government interaction with the crypto market will be interesting to watch as it evolves over the next five years.

In the beginning of this article we discussed the issue of cash in determining tax liability.  Notably, how the IRS uses banks to red flag potential law violators through the use of CTR and SAR requirements.  In my opinion, crypto assets are the modern-day cash problem for the IRS.  The US government is aware people are investing in the crypto market.  They are also aware many of the gains realized in the crypto market will not hit our centralized banks.  This is a nightmare for an enforcement agency that relies heavily on bank transactions to determine tax loss.  Throw in the anonymity built into the block chain, and this issue is the cash problem on steroids.

For example, a person could invest $1,000 dollars in Bitcoin, realize a gain of $10,000, use it to buy another currency, and their bank account would show no activity.  This bank activity is at the heart of criminal tax fraud investigations.  This person would have $9,000 in capital gains for the taxable year, and no record would exist.  The IRS has to figure out a way to enforce their tax laws in this market.  And it is likely to start in the same place it did for cash under the BSA – the centralized banks.

To invest in the crypto market, United States dollars, or other fiat currency, must be transferred into the market.  Fiat currencies have to be placed on an exchange for conversion into Bitcoin, Etherium or another tradeable asset.  There are numerous exchanges available online, but most market entry transactions are done through a few entities, notably Coinbase and Gemini.  If the federal government wishes, and they likely will, they can easily gain access to all persons who have placed cash into the crypto market.  This can be done by working with banks, working with exchanges, or passing a law requiring disclosure of these transactions.  The banks are more than willing to aid the IRS in tax related concerns.

Once the IRS has a list of actors, the subpoena powers of the IRS will likely solve the issue of anonymity.  The IRS can subpoena records from the individual tax payer, or from the exchange, to locate private addresses connected to the person.  A tax payer will not be able to hide behind the anonymity of the block chain after they have been identified and documents have been subpoenaed.

This is just one way in which the IRS can penetrate the seemingly impenetrable shield of anonymity, but I assure you there are others.  And brainstorming is already taking place.

The IRS does not have the man power to look at the personal assets of every person or entity paying taxes in the United States.  However, historically they have bridged this gap by taking notice of industries or sectors that easily lend themselves to tax evasion.  The crypto market will be one of those sectors.  The boom of 2017, and the resulting influx of capital, ensures the IRS will find a way to monitor this space.  How this monitoring will happen is anyone’s guess, but a model that does not include the centralized banks is likely missing a key piece.  The crypto market will be interesting to watch in the next decade as the government figures out a way to control these assets and ensure crypto investors are paying their fair share.

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