United States: Digital Currency Exchange Customers Targeted In IRS Information-Gathering Sweep

Last Updated: November 24 2016
Article by Carol R. Van Cleef, Jeffrey H. Paravano and Jay R. Nanavati

Coinbase, one of the largest digital currency exchange companies in the world, will likely be asked to provide the Internal Revenue Service (IRS) with transactional data and other information on all U.S. customers who used its services over a three-year period. Using what is known as a "John Doe" summons, the IRS has formally requested permission from a federal court to seek extensive information on all "United States persons who, at any time during the period January 1, 2013, through December 31, 2015, conducted transactions in a convertible virtual currency" through Coinbase.

If the summons is served as approved by a federal court this week, Coinbase will face the substantial burden of producing a long list of customer-related and other records. However, this data production will only be the first step in a process that may ultimately impact accountholders whose information is turned over to the IRS. The accountholders (corporate and individual) may become subject to IRS audits and potentially fines if there are any unpaid taxes related to their virtual currency transactions.

While the action states that it is civil in nature, the IRS is clearly seeking customer information to open separate investigations of potential tax avoidance, which could become criminal cases in certain circumstances. The information that is collected in this investigation may also be used in other investigations undertaken by IRS itself or any other part of the U.S. Department of the Treasury, including the Office of Foreign Assets Control (OFAC) and the Financial Crimes Enforcement Network (FinCEN). Other digital currency exchangers and their customers could also become targets in similar actions, either directly or potentially as a result of information collected from this summons, or in follow-on investigations. Even noncustomer receivers of virtual currency could become the subjects of investigation.  

Background. On Nov. 17, 2016, the U.S. Department of Justice Tax Division, on behalf of the IRS, petitioned the U.S. District Court for the Northern District of California for permission to serve a 15-page John Doe summons on Coinbase. Accompanying the summons was a 16-page memorandum prepared by the U.S. Department of Justice in support of the summons. Also submitted to the court was a 16-page declaration of the IRS agent who has been working on the matter, setting forth how he believes virtual currencies are being used by companies to evade paying taxes.

Press reports indicate that Coinbase had expressed concern about the "indiscriminate breadth" of information requested by the summons.

The Summons. The John Doe summons requires Coinbase to provide the IRS with extensive information about Coinbase customers – both those who may have fully complied with federal tax laws and those who may have failed in one or more ways to comply with them. Obviously, this action may touch a substantial number of bitcoin holders; according to the government's petition, as of December 2015, Coinbase was "the fourth largest exchanger globally of bitcoin into U.S. dollars and the largest exchanger in the United States of bitcoin into U.S. dollars."

The information sought by the John Doe summons leaves little to the imagination. It requests:

  • All records on every account wallet or vault owned or controlled by a user, including, but not limited to, complete user profile, history of changes to user profile from account inception, complete user preferences, complete user security settings and history (including confirmed devices and account activity), complete user payment methods, and any other information related to the funding sources for the account/wallet/vault, regardless of date.
  • Any other records of customer due diligence (Know Your Customer) performed with respect to the user.
  • Information about any third-party access to, control of or transactional approval authority over an account, wallet or vault.
  • Records of all activity, including transaction logs or other records identifying the date, amount and type of transaction (purchase/sale/exchange), the post-transaction balance, the names or other identifiers of counterparties to the transaction; requests or instructions to send or receive bitcoin; and, where counterparties transact through their own Coinbase accounts/wallets/vaults, all available information identifying the users of such accounts and their contact information.
  • For each merchant to which Coinbase has provided payment services, records of all payments processed, including records identifying the user of the wallet charged, if a Coinbase user, or the address of the wallet charged, if not; the date and amount of the transaction; and any other information that will enable the merchant to identify the transaction.
  • All correspondence between Coinbase and the user or any third party with access to the account, wallet or vault, including but not limited to letters, memoranda, telegrams, telexes, facsimiles, email, letters of instruction and memoranda of telephone or oral instructions received.
  • All periodic statements of account or invoices (or the equivalent).
  • All records of payments to or from the user by checks, wire or other electronic transfer; ACH transaction; PayPal transfer; credit or debit card transaction; money order; transfer to or from other digital currency wallet address; or any other method, including records reflecting the form, manner, nature and purpose of such payment including, but not limited to, ABA routing number and other routing information; payment instructions; and any and all invoices, billing statements, receipts, or other documents memorializing and describing such transaction.
  • All exception reports produced by the Coinbase AML system, and all records of investigation of such exceptions.

In the past decade, the IRS has greatly increased its use of the John Doe summons as it has sought information on taxpayers it may not be able to readily identify as having not paid taxes. The traditional summons used routinely by the IRS in tax investigations to develop evidence must identify the taxpayer whose conduct is at issue. As a result, traditional summonses are of limited use in identifying unknown taxpayers. Thus, the John Doe summons is perfectly tailored to the IRS's effort to identify account holders in cases such as offshore bank accounts or virtual currencies where there is "anonymity and a lack of third-party reporting," as it allows the IRS to seek information on an entire class of taxpayers whose identities are unknown. In exchange for not having to name specific taxpayers at the beginning of this type of investigation, the law requires that a federal district judge authorize the issuance of the summons.

Typically the recipient of the John Doe summons has attempted to limit the scope of the information requests by either petitioning the court or engaging in discussions with the IRS.

Taxpayer Implications. The IRS clarified in March 2014 that virtual currency is to be treated as property and not as currency for federal income tax purposes. This determination requires taxpayers to include in income any virtual currency received in exchange for goods or services.

Coinbase does not provide tax advice to its customers, but has provided customers with a comprehensive first-in-first-out cost basis report to assist them with their tax-reporting obligations. Those reports typically show customers their digital currency acquisition dates and sale dates, and a brief description of any purchases made using digital currency.

Holders of virtual currency who may have been unaware of IRS rules relating to the tax treatment of digital currency transactions may be contacted by the IRS with tax audit inquiries to which they will need to respond.

Taxpayers responding to such IRS audit inquiries will need to be careful that their responses do not cause the IRS to refer what otherwise may be a simple civil tax inquiry into a proceeding that results in the imposition of penalties or, worse, into a criminal investigation or proceeding.

Implications for Other Exchangers and Virtual Currency Users. If the IRS decides to issue the same or a similar John Doe summons to other digital or virtual currency exchangers, the recipient should consult with counsel before responding.

Based on what has been requested in this John Doe summons, the exchangers should also be prepared to provide more than just customer identifying information and data related to customer transactions. Even if an exchanger has already been examined by the IRS for compliance with applicable Bank Secrecy Act requirements (Title 31 Examination), the John Doe summons could expose weaknesses in the company's anti-money laundering (AML) compliance program that could have other consequences. Thus, exchangers may want take the opportunity now to review their customer identification and verification, due diligence, and suspicious activity monitoring processes.

Virtual currency users that received virtual currency in transactions with the customers of any exchange that receives such a summons could also eventually find their transactional activity and tax returns being scrutinized.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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