Virtual currency transactions are now a prime focus of Internal Revenue Service (IRS) scrutiny.
The IRS has numerous information-gathering tools to enforce its taxing power, including summons, artificial intelligence, data analytics, whistleblowers and even a taxpayer’s social media.
The takeaway from the IRS focus on this area is that individuals should properly report and pay tax on virtual currency transactions or prepare to pay back taxes, interest and penalties. If the failure is willful in not complying with IRS reporting requirements, individuals may face potential criminal prosecution.
A High-Level Primer
What Is Virtual Currency?
Generally, virtual currency is a digital representation of value that functions in the same manner as a country’s traditional currency. There are more than 1,600 known virtual currencies. These currencies can be difficult to trace and have an inherently pseudo-anonymous aspect.
What Is Convertible Virtual Currency?
Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as “convertible” virtual currency (e.g., Bitcoin, Bitcoin Cash, Ethereum, Ripple).1 For example, Bitcoin, the most popular virtual currency with a market capitalization of approximately $132 billion (as of Dec. 2, 2019), can be digitally traded between users and purchased for, or exchanged into, U.S. dollars and other real or virtual currencies.
What Is Cryptocurrency?
The IRS defines cryptocurrency as “a type of virtual currency that utilizes cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.” Cryptocurrency units are generally referred to as coins or tokens. Cryptocurrencies use decentralized control through distributed ledger technology (e.g., a blockchain).
Is Virtual Currency Treated as a Real Currency?
No. Virtual currency is a digital representation of value that functions as a unit of account, a store of value and/or a medium of exchange. In some environments, virtual currency operates in a manner similar to real currency, such as the coin and paper money of the United States or of any other country.
How Can Virtual Currency Be Used?
Virtual currency can be held for investment or used to pay for goods or services.
How Is Virtual Currency Treated Under U.S. Tax Law?
Virtual currency is treated as property for U.S. tax purposes. General tax principles that apply to property transactions will apply to transactions using virtual currency. Thus, the sale or exchange of virtual currency, or the use of virtual currency to pay for goods or services, has U.S. tax consequences that may result in a tax liability, as well as information reporting consequences.
What are Some Examples of Property-Like Transactions Involving Virtual Currency?
- Transactions encompass 1) creating, investing in and trading in virtual currency or 2) using virtual currency as a medium of exchange for goods or services.
- Relevant issues relate to:
- the identification of units in, the fair market value of, cost basis and gain or loss of virtual currency transactions
- whether a virtual currency transaction is a taxable or nontaxable event
- if a taxable event, whether such event produces capital gain or loss or ordinary income or loss, and
- information reporting requirements
- In illustration:
- The acquisition and disposition of virtual currency, generally results in gain or loss that would be required to be reported on a U.S. federal income tax return and/or returns of states and municipalities. The character of gain or loss to the taxpayer from the sale or exchange of virtual currency would depend on whether the virtual currency is a capital asset or ordinary income transaction.
- Wages paid to employees or independent contractors using virtual currency are taxable to the employee or independent contractor and implicate information reporting and wage withholding, depending on the status of the recipient.
- According to the IRS, a “hard fork” does not generate taxable income provided that no new cryptocurrency is received; whereas, a hard fork with an “airdrop” creates taxable income.
Timeline of IRS Interest in Virtual Currency
- April 14, 2014: The IRS issued Notice 2014-21 defining a virtual currency as property.
- Nov. 30, 2016: The IRS issued a “John Doe” summons3 to Coinbase Inc., a San Francisco-based virtual currency exchange, seeking information relating to an investigation of the identity and federal income tax liabilities of Coinbase’s U.S. customers for the 2013 through 2015 tax years.
- Nov. 28, 2017: A federal court ordered Coinbase to produce documents for accounts with at least $20,000 in any one type of transaction (buy, sell, send or receive) in any year from 2013 through 2015 relating to: taxpayer identification numbers, names, birthdates, addresses and certain transaction records.
- Feb. 23, 2018: Following the government’s victory in federal district court, Coinbase notified approximately 13,000 of its customers that it would be turning over information pursuant to the court’s Nov. 28, 2017, order.
- March 23, 2018: The IRS issued a news release reminding U.S. taxpayers that virtual currency transactions were reportable on U.S. income tax returns and failure to properly report such transactions could result in additional tax, interest, penalties and, in more extreme situations, criminal prosecution.
- July 2, 2018: The IRS announced a new Virtual Currency Compliance audit campaign to address taxpayer virtual currency noncompliance. In its announcement, the IRS stated that it was not contemplating a voluntary disclosure program to address virtual currency tax noncompliance.
- July 26, 2019: The IRS announced it had commenced sending letters to U.S. taxpayers that may have failed to report, or failed to report properly, virtual currency transactions (Virtual Currency Letter).4 More than 10,000 U.S. taxpayers received a Virtual Currency Letter providing information on their tax and filing obligations and how to correct past noncompliance. The IRS also disclosed that it had learned the names of the thousands of U.S. taxpayers “through various ongoing IRS compliance efforts” and that “[v]irtual currency is an ongoing focus area for IRS Criminal Investigation.” The IRS Criminal Investigation Chief announced that details on new criminal tax cases involving cryptocurrency would be publicized.
- Oct. 9, 2019: The IRS issued its second detailed guidance on the U.S. federal tax considerations relating to virtual currency transactions by way of frequently asked questions (FAQs) and Rev. Rul. 2019-24. The FAQs and Rev. Rul. 2019-24 expand and supplement the IRS’ 2014 notice by providing taxpayers with examples and explanations of how longstanding tax principles apply to transactions involving virtual currency and new guidance on how certain transactions (e.g., hard forks, airdrops) are treated for federal income tax purposes.
- Oct. 11, 2019: The IRS released a draft 2019 Form 1040 Schedule 1 asking taxpayers to respond to a question similar to that relating to foreign financial accounts. The new question is: “[a]t any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
- Oct. 22, 2019: The IRS Office of Chief Counsel alerted its attorneys to procedures for working and coordinating cases involving virtual currency and other digital asset-related issues. The IRS Office of Chief Counsel noted that virtual currency-related cases may involve information received from third-party sources (e.g., information returns, “John Doe” summons) and requests for advice from the IRS concerning federal tax or Bank Secrecy Act audits or cases in litigation.
- Nov. 8, 2019: The IRS Criminal Investigation Division announced that it has identified “dozens of leads” and several new investigations of potential cryptocurrency tax evaders at the conclusion of recent collaborative investigations initiated by the J5 (Joint Chiefs of Global Tax Enforcement), composed of Australia, Canada, Netherlands, the United Kingdom and United States.5 The investigations targeted crimes committed both by large organized networks and individuals.
- Nov. 13, 2019: An IRS attorney at the American Institute of CPAs (AICPA) conference in Washington, D.C., announced that it is the IRS’ position that like-kind exchange principles under Section 10316 were never applicable to cryptocurrency, even for transactions made before 2018.7 However, on Nov. 15, 2019, a different IRS attorney at the same AICPA conference stated that the IRS does not have a blanket policy to deny taxpayers the ability to treat cryptocurrency trades as like-kind exchanges and will instead make a determination based on a taxpayer’s specific facts and circumstances.
- Nov. 15, 2019: The Financial Crimes Enforcement Network (FinCEN)9 announced that it has received more than 10,000 suspicious activity reports (SARs) related to convertible virtual currency since it issued its virtual currency guidance in May 2019. Two-thirds of the SARs are from convertible virtual currency entities such as kiosks, exchanges and peer-to-peer exchangers, many of whom had never filed a SAR prior to the May advisory.
- Nov. 19, 2019: An IRS official stated that the IRS cannot currently provide a definitive answer as to whether a taxpayer must report offshore cryptocurrency holdings on IRS Form 8938, Statement of Specified Foreign Financial Assets (Form 8938). To avoid potential information return reporting penalties, the IRS official stated that taxpayers may want to report offshore cryptocurrency holdings on Form 8938.
The Emphasis on Enhanced Information Reporting
One way the IRS can monitor compliance is to obtain information reports on virtual currency transactions. The current IRS guidance already requires information reporting in a number of virtual currency transactions, such as the payment of wages using virtual currency (as well as federal wage withholding, employment and unemployment tax) and payments of $600 or more by a person in a trade or business to an independent contractor.
The tax press has recently reported that the IRS’ next big virtual currency guidance project will focus on developing rules for gross proceeds (gross proceeds reporting by brokers under Section 6045 to enhance taxpayer compliance). As the IRS Chief Counsel said in connection with this enhanced compliance initiative: “it’s no mystery that when you have any kind of information reporting, your level of compliance increases dramatically.” Interestingly, in this regard, the Chief Counsel indicated that an estimated 8 percent of American adults hold some form of cryptocurrency and, based on 150 million tax returns filed per year, that would mean about 12 million taxpayers should have been reporting some type of cryptocurrency transactions15 but the IRS has not received 12 million returns reporting cryptocurrency transactions.
The IRS likely will issue further guidance on international information reporting. Currently, a foreign cryptocurrency account is not reportable under Foreign Bank Account Reports (FBAR) provisions. However, FinCEN, “in consultation with the IRS, continues to evaluate the value of incorporating virtual currency held offshore into the FBAR regulatory reporting requirements.” Accordingly, it is possible that accounts or wallets held with foreign virtual currency exchanges would become reportable under the FBAR provisions in the near future.
Finally, taxpayers engaging in virtual currency transactions should well to maintain precise records to establish positions taken on tax returns. These records should document receipts, sales, exchanges or other dispositions of virtual currency and the cost basis and fair market value of the virtual currency.
A U.S. taxpayer who failed to properly report or pay tax on virtual currency transactions may have one or more options to become U.S. tax and reporting compliant. Taxpayers who received a Virtual Currency Letter would be well advised to remediate their possible noncompliance in a timely manner and may have more than one way to become tax compliant. To navigate compliance options, consultation with a tax advisor familiar with virtual currency and tax remediation procedures would be advisable.
Filing Delinquent or Amended Tax Returns
The likely compliance option for most U.S. taxpayers who did not commit tax or tax-related crimes and who did not willfully violate the law to report or pay tax on virtual currency transactions is to file delinquent or amended tax returns.
In general, a U.S. taxpayer should submit delinquent or amended tax returns for the taxpayer’s most recent three tax years. A taxpayer should also submit delinquent or amended tax returns in any one of the most recent six tax years in which the taxpayer omitted at least 25 percent of gross income.
A taxpayer’s filing of a delinquent or amended tax return may be subject to certain automatic penalties. For example, the IRS may automatically assess up to 47.5 percent in combined failure-to-file and failure-to-pay penalties. In addition, the IRS could also select a taxpayer’s tax returns for examination and assess additional penalties.
Taxpayers who willfully violated the law should consider submitting a disclosure under the IRS Criminal Investigation Division’s updated voluntary disclosure practice. While a voluntary disclosure does not guarantee immunity from criminal prosecution, a voluntary disclosure may result in prosecution not being recommended.
IRS Criminal Investigation Division will accept a voluntary disclosure if it is timely, accurate and complete. A taxpayer’s voluntary disclosure is timely only if the IRS Criminal Investigation Division receives it before the IRS has:
- commenced a civil examination or criminal investigation
- received information from a third party (e.g., “John Doe” summons, whistleblower, other government agency, etc.) regarding the taxpayer’s noncompliance, and
- acquired information directly related to the taxpayer’s noncompliance from a criminal enforcement action (e.g., grand jury subpoena, search warrant, etc.)
If the IRS Criminal Investigation Division determines that a taxpayer is eligible to submit a voluntary disclosure, the disclosure will be forwarded to an IRS civil examiner for examination. In general, the disclosure period is the taxpayer’s most recent six tax years of noncompliance and requires the taxpayer to submit all of the required returns and reports. In addition to ordinarily applicable taxes, penalties (including FBAR penalties) and interest under existing law and procedures, a taxpayer will generally have to pay a 75 percent civil fraud penalty based on the tax year with the highest tax liability.
The taxpayer must then promptly and fully cooperate during a civil examination and is generally expected to fully pay all taxes, penalties and interest for the disclosure period. Failure to cooperate during civil examination may result in the IRS Criminal Investigation Division revoking the taxpayer’s preliminary acceptance and extend the civil fraud penalty beyond the ordinarily applicable six-year disclosure period.
Certain Non-Willful Taxpayers: Streamlined Filing Compliance Procedures
Although designed to address offshore-related noncompliance, the IRS’ Streamlined Filing Compliance Procedures (Procedures) may be a viable option for certain non-willful taxpayers with virtual currency reporting issues, especially in view of the uncertainty over a U.S. taxpayer’s cryptocurrency-related international reporting requirements. The requirements of the Procedures differ depending on whether the taxpayer resides in the U.S. or outside the U.S.
In general, the Procedures are for taxpayers who failed to report foreign financial assets and pay tax due in respect of such assets because of non-willful conduct. A taxpayer must generally file up to three years of delinquent or amended tax returns (including information returns), as well as up to six years of FBARs. A taxpayer must submit a statement of facts (favorable and unfavorable) and certify under penalties of perjury that the taxpayer’s noncompliance was a result of non-willful conduct. A taxpayer must pay the full amount of tax and interest thereon and, if residing in the U.S., a miscellaneous offshore penalty equal to 5 percent of the highest aggregate balance/value of the taxpayer’s foreign assets subject to the offshore penalty.
A taxpayer’s eligibility to make a submission in accordance with the Procedures requires a thorough analysis of the taxpayer’s specific facts and circumstances. Nonetheless, the Procedures are more likely than not an atypical compliance option for most taxpayers who failed to report virtual currency transactions.
The IRS has made virtual currency a top priority. Noncompliant U.S. taxpayers, whether non-willful or willful, should take timely action to come into U.S. tax and reporting compliance before it’s too late.
The IRS Commissioner has stated in this regard:
“The IRS is committed to helping taxpayers understand their tax obligations in this emerging area. The new guidance will help taxpayers and tax professionals better understand how longstanding tax principles apply in this rapidly changing environment. We want to help taxpayers understand the reporting requirements as well as take steps to ensure fair enforcement of the tax laws for those who don’t follow the rules.”
Taxpayers have been forewarned.
Compliments of Holland & Knight LLP, a Member of the EACCNY