Operation Hidden Treasure - Tightening the Vise on Crypto Investors

Operation Hidden Treasure – Tightening the Vise on Crypto Investors

Criminal Tax Attorneys

It is well known the federal government is losing out on millions of dollars in tax revenue generated from crypto currency gains.  The violent bull cycles seen in the crypto market are producing huge returns for many American citizens.  The United States Tax Code requires those gains to be reported on the investors’ tax returns.  Due to a misunderstanding of the requirements, or a belief their gains cannot be tracked, many in the crypto space are failing to report their earnings.  This reality leaves the federal government without a key sector of tax revenue and the taxpayer at risk for civil penalties and/or criminal charges.

In previous blogs, we discussed IRS guidance on crypto transactions.  These blogs outline how the IRS classifies various crypto transactions including sales proceeds, staking rewards, mining rewards, air drops, and hard fork token creation.  The IRS guidance released to date does not cover every crypto transaction class, and there are still gray areas within the law.  However, a few things should be clear in 2022: 1) the sale or swap of a crypto token triggers a taxable event, 2) a taxable event occurs when a taxpayer receives free tokens by air drop or a hard fork, and 3) any tokens received through mining are taxable income in the year received.  Staking rewards have not been addressed specifically by the IRS, but it seems logical the rewards from staking would follow the guidance issued for Bitcoin mining operations.

With these well-understood rules in place, the IRS has turned their focus to enforcement of these principles.  Their enforcement steps are fine tuned yearly.  The result is an ever-increasing bureaucracy to handle these transactions and a wider net of individuals coming under the IRS’ microscope.  This blog will review the steps taken by the IRS as they attempt to recoup their losses in the crypto market.

The First Step – Identifying the Enforcement Class

In 2016, the government issued “John Doe” subpoenas to multiple crypto exchanges.  The subpoena that received the most attention went to Coinbase, the largest crypto exchange in the United States.  The subpoena requested the names of all users that exceeded $20,000 in transactions on the platform.  In 2017, Coinbase released identifying information for those users that fit the subpoenaed criteria.

This initial step was aimed at identifying the class subject to enforcement.  The government realized the anonymity inherent in a blockchain created substantial obstacles to enforcement.  People were holding millions of dollars in blockchain wallets.  These wallets were not tied to an individual’s name, but rather a public key consisting of lengthy alpha-numeric characters.  The government had to find a way to identify citizens that were holding and transacting in crypto.  The John Doe subpoenas were meant to isolate crypto traders from the millions of Americans who were inactive in the space.

The John Doe subpoenas were an intelligent first step in that process.  There are numerous ways to transact in the crypto market.  However, the majority of investors fit in two classes.  The first class consists of investors who buy major tokens available on large exchanges like Coinbase, Kraken, or Gemini.  These investors purchase a virtual currency within the platform and store the currency within their exchange wallet.  Their behavior is isolated to the big exchange.  The second class is more advanced as they purchase smaller project tokens from smaller or decentralized exchanges.  These smaller exchanges often do not allow trades from fiat currency.  The investor must buy Bitcoin, Ethereum, or a stable coin first, then execute the transaction.

Though the two classes have different trading habits, they both need a larger exchange, like Coinbase, to convert their fiat currency into virtual currencies.  The former as their investment and the latter to obtain tradeable assets.  Most crypto investors interact with a large exchange at some point during their transaction history.

If the government’s goal was to identify persons involved in crypto, the John Doe subpoenas were an efficient tool. The subpoenas will miss some advanced traders who “on-ramp” currency through smaller exchanges.  They will miss persons that trade Bitcoin using peer-to-peer options.  But by and large, they will identify the vast majority of investors in the space.

Second Step – Following the Trail

The John Doe subpoenas provided all trading history for users who conduct their trades within Coinbase, Gemini, or another subpoenaed exchange.   However, they also provided the IRS with a starting point for tracking more advanced trading histories.  The government could now trace transaction histories to uncover additional private wallets and other exchanges used by a given taxpayer.

An example will likely help to clarify the paper trial.  Let’s say a user buys 2 Bitcoin for $50,000 using Coinbase.  The user then transfers the Bitcoin to a smaller exchange like Kucoin.  On Kucoin, the user swaps their Bitcoin for a smaller project like Verasity (VRA).  The user transfers the remaining Bitcoin to his private Bitcoin wallet and the recently bought VRA to his private Ethereum wallet.

If the IRS has the public key address for the user’s Coinbase account, they can track each one of those steps quite easily.  Bitcoin, and most crypto solutions, use public chains where the data is easily accessible through a block explorer.  An investigator can plug a person’s public key into the explorer and see the details of every transaction, including the recipient address for any transfers.  In the above example, an IRS agent can track the Bitcoin off Coinbase and into the smaller exchange, see Bitcoin was involved in a swap of a smaller project token, and determine the private wallet address where the Bitcoin was later stored.  Now, the investigator possesses the user’s Coinbase public key, a smaller exchange public key, and the public address for the user’s private accounts.

By following the trail on multiple transactions, an investigator can identify taxable events (Bitcoin swap for VRA above) and develop a crypto holding profile for the taxpayer.  This process is very useful to determine the transaction habits and the potential holdings of any user.

Third Step – Push for Voluntary Compliance

In 2017-2019, the IRS was able to take a cross section of crypto investors focusing on those users with the most transactions and/or the largest holdings.  From this list, the IRS began issuing letters to individual taxpayers.  These letters informed the taxpayer of their failure to report crypto transactions and requested voluntary compliance with the current tax code provisions.  The IRS was providing an opportunity for delinquent filers to amend their returns and report their crypto gains and losses.

This push led to many users quickly contacting CPAs to amend their returns.

IRS Criminal Investigations

Fourth Step – Adding the Virtual Currency Question to the 1040

In 2019-2020, the IRS added a virtual currency question to the 1040.  Before filing a tax return, a taxpayer must now answer the following question – “at any time during X year, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?”  The taxpayer must check yes or no next to this question.

This question is exceptionally broad.  If a taxpayer transacted with any cryptocurrency during the tax year, they must answer yes to this question.  This question serves three purposes for the IRS.  One, it serves to identify a taxpayer who may be underreporting crypto gains (similar to the John Doe subpoenas).  Two, it makes the taxpayer deliver a statement under penalty of perjury.  A false statement to this question opens the door to various enforcement routes not otherwise available to the IRS, including increased penalties, increased statute of limitations, and potential criminal charges.  Three, it ensures CPAs are incorporating a cryptocurrency questionnaire into their clients’ files.  If a CPA was not concerned with crypto reporting prior to the virtual currency question, they were certainly focused on this issue in the 2020 and 2021 tax years.

Fifth Step – Operation Hidden Treasure

From 2016-2020, the IRS focused on clarifying baseline rules for crypto transactions, issuing letters to promote voluntary compliance, and otherwise alerting taxpayers and tax professionals of their focus on the market.  In 2021, the IRS started their pursuit of enforcement through official civil and criminal litigation.  The Office of Fraud Enforcement teamed up with agents within the IRS’ criminal investigation division (CID) to conduct Operation Hidden Treasure.  As the name suggests, this operation’s goal was/is to recoup the lost revenue in this space.

Operation Hidden Treasure is a full-scale push by the IRS to ferret out uncollected tax liabilities.  The operation has already resulted in numerous IRS notices and full-scale audits.  The most egregious offenders will fall under review by CID.  The government has employed a team of agents/professionals that understand the crypto landscape to efficiently lead the charge.

Our firm has been contacted by multiple crypto investors who are at various stages of contact with task force agents – including under notice, audit, and criminal investigation.  We saw very few crypto specific inquiries from CID prior to 2021.  The IRS is now putting manpower and finances behind ensuring crypto compliance.  For most taxpayers, it is time to amend old returns and ensure full transparency moving forward.

The Veil Has Been Lifted

For a decade, many crypto investors failed to report their gains or other crypto based income.  Their reasoning usually fits neatly in a few categories: 1) the IRS guidance is too unclear (thus, nullifying a duty to report), 2) the anonymity of the blockchain ensures the government cannot track transactions, or 3) no taxable transactions take place until crypto assets are converted into fiat currency.

Today, these reasons fail to account for the reality within the IRS.  The guidance is clear on the key areas of crypto income – proceeds from sales, mining, and airdrops. For most investors, their transactions can be tracked by use of John Doe subpoenas.  Nothing the government does is perfect; some investors will slip through the cracks.  However, the reality for most investors is the IRS will confirm they take part in the market and contact will follow.

There is no longer a logical reason to withhold crypto income from the IRS.  The IRS has laser focus on this investment sector.  It is a good idea for taxpayers to recognize these realities and move forward with transparency.  It will save taxpayers the headache of dealing with a civil or criminal investigation and the large attorney’s fees that come with that venture.

As the rules become clearer, the risk of criminal investigation increases.  In 2017, there was a very low risk of criminal investigation into a crypto investor.  The rules were still being clarified on many crypto topics.  The government knows they must prove the taxpayer knowingly violated a clear legal duty to prove tax fraud or tax evasion.  This acknowledgement resulted in the voluntary tax compliance efforts we saw in 2017-2018.  Having said that, the landscape is quickly changing.  Most taxpayers and accounting professionals are aware of the rules regarding crypto gains and passive income.  As these rules become common knowledge (which may already exist), CID will begin taking a larger role in enforcement.  Criminal tax cases are serious as they combine the harsh penalties of the civil process with the prospect of time in a federal prison.

Our firm has seen an uptick in criminal investigations into crypto investors over the last year.  This observation coincides with the movements we are seeing within the IRS.  It has taken some time for the IRS to catch up to the market, but we are approaching a time where crypto investigations will mimic those seen in other financial sectors.

The federal government’s recent funding legislation should result in more robust spending and more encompassing enforcement.  We do not expect Operation Hidden Treasure to slowly stall leaving some on the outside.  Operation Hidden Treasure is merely the first ideation for ensuring tax compliance in this space.  As the rules clarify, and the market gains more widespread acceptance, crypto taxation will become part of the normal process.  This is the beginning of a long journey towards clear rules and harsh enforcement.