IRS vs Coinbase: Massive Implications for Bitcoin, Digital Currencies

The recent Internal Revenue Service request to Coinbase, seeking records of customers who purchased virtual currency from 2013 to 2015, has led to a flurry of media attention both in the U.S. and worldwide. This action affecting America’s largest Bitcoin exchange — arguably the most comprehensive sweep of virtual currency for the purpose of identifying lawbreakers — has massive implications for the future of financial privacy and taxation.  

Documents filed by the IRS signal the agency’s intent to pursue both egregious tax evaders, as well as small, everyday users who use bitcoin and other forms of digital currency as a potential dodge for paying taxes. In the John Doe Summons, the IRS alleges that they have uncovered three instances where people have used bitcoin to evade taxes — two involving Coinbase customers. Based on these findings, the IRS. now surmises that many more people are utilizing digital currency for similar aims.  

This unprecedented action follows a Treasury Department Inspector General report, which casts blame on the IRS for failing to establish guidelines and take aggressive action to address what it believes to be unlawful activities on the part of digital currency users.

The request would require Coinbase to hand over the identity and full transaction records of millions of customers. The company immediately responded with a Protecting Customer Privacy notice on their website:

“Our customers may be aware that the U.S. government filed a civil petition yesterday in federal court seeking disclosure of all Coinbase U.S. customers’ records over a three year period. The government has not alleged any wrongdoing on the part of Coinbase and its petition is predicated on sweeping statements that taxpayers may use virtual currency to evade taxes.

“Although Coinbase’s general practice is to cooperate with properly targeted law enforcement inquiries, we are extremely concerned with the indiscriminate breadth of the government’s request. Our customers’ privacy rights are important to us and our legal team is in the process of examining the government’s petition. In its current form, we will oppose the government’s petition in court. We will continue to keep our customers informed on developments in this matter.”

By law, Coinbase and other companies that purchase and sell bitcoins are required by regulators to capture identifying information on users who initiate purchase and sell orders on their platforms. Because bitcoin transactions generally do not share the identities of the people involved, tracking the flow of funds has arisen as a concern for the IRS.

While guidelines for bitcoin users were established by the IRS in 2014, the tax agency has long alleged that is not receiving information from exchanges like Coinbase in order to ensure that proper tax payments are being captured.

This escalating development between the IRS and Coinbase could be a watershed moment for the future landscape of tax regulators, both in the U.S. and globally. Bitcoin evangelist and investor, Roger Ver, said to Bitcoin Magazine: “It seems very obvious that they (the IRS) are overstepping their already overly broad reach. It also makes me feel extra happy to not be American any longer, and to be a citizen of a country with a much more sane tax policy.”

As the regulatory parameters of bitcoin taxation are being examined, questions abound as to whether digital currencies are emerging as a preferred method for tax evaders, given the worldwide crackdown taking place on offshore banks and other tax havens. Tax authorities could eventually end up in a challenging scenario from a monitoring and enforcement standpoint, given the rapid proliferation of digital currencies like Monero and zCashthat feature increasing levels of privacy, complexity and security. By some estimates, the number of online market trades is well over 700 and growing by the day. Online sites CoinMarketCap and CoinCap offer an overview of the expansive nature of the digital currency landscape.

Legal professional, Adella Toulon-Foerster, who spearheads the crypto/alternative currency practice at Cogent Law Group in Washington, D.C., told Bitcoin Magazine she believes the IRS’s absurdly broad request is an obvious fishing expedition that in any sort of free society would never have passed the straight face test.  She also thinks that we are in the dark in terms of what will happen at the hands of a fickle judiciary that has often shown little regard for due process, and even less reluctance about unreasonable search and seizure.

But, she says, at least we know about this particular summons. “In an era of secret programs of mass surveillance, sneak and peek warrants, and secret courts that make 1984 look like a bedtime story, one can only imagine how little financial privacy bitcoin users really have, regardless of what is being made known to the public.”

That said, she offers the reminder that, by definition, the blockchain is a publicly viewable ledger. “Every transaction provides another thread of information that can lead to the identity of a bitcoin account holder. Ultimately, the Bitcoin blockchain is like a giant game of Sudoku that federal law enforcement has the manpower and computing resources to win.”

Perry Woodin, a computer engineer and CEO of the blockchain governance company, Node40, offered a couple of pragmatic solutions for simplifying this tax environment. First, he says, the IRS needs to clarify and update their tax guidelines so that they are more digestible for the consumer.

“Right now the IRS is looking to reduce noncompliance among all these people who have these cryptocurrencies or digital assets. Problem is, I don’t think most people quite know how they’re supposed to report in order to comply. The guidance is currently not very clear, particularly in terms of how to calculate gains and losses.”

This confusion ties to his second recommendation, which proposes the development of a software system or computer protocol that follows or establishes what the IRS uses for compliance guidelines, so that any user of, or investor in, digital currency can compile a report at the end of the fiscal year.

“It would allow the person to show unrealized gains and losses from their entire virtual currency portfolio, and hand it to their accountant in a format that is easily understood, consistent and accurate. This national standard would provide this information in a manner consistent with the customized Portfolio Insight Reports that Node40 provides to its DASH clients.”

Wooden believes that because the vast majority of all digital currency holdings are held in bitcoin, this was a logical place for the IRS to expand their U.S. enforcement efforts. “They wanted to go after bitcoin because that’s the big fish in terms of figuring out how to work with all of these compliance issues. Once they figure bitcoin out, they are just going to apply their findings to all of the other digital currencies.”

This is where things get a little tricky, according to Wooden. “All of this of course is tied to whether a particular cryptocurrency uses a transparent blockchain. zCash and Monero use an opaque blockchain and that means the only people who can verify a transaction on the blockchain are the parties to the transaction itself. So those people brazen enough to want to skirt this type of regulation would not only have to make use of a opaque blockchain, but would be subjected to having to live a full life of cryptocurrency without being able to ever cash out for fiat dollars. Because to do so the person would run the risk of being flagged.”

Given the IRS crackdown, Wooden advises that those involved with holding or trading digital currencies, or using them for day-to-day transactions, should begin carefully documenting their transactions. Eventually, tax compliance is going to require the collection of more information, and the more organized users are in terms of their assets, the easier things will be when that day comes. “If you’re just shifting assets all over the place, it’s going to be a major headache and a real nightmare to comply with the tax reporting agencies.”

Bitcoin Magazine reached out to Coinbase with request for comment on this story; however, we did not receive a response.

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