The honeymoon period for bitcoin is over. Not waiting for Congress to figure out what to do about virtual currency and how to regulate it, the Internal Revenue Service has fired the first shot across the bow of Coinbase, one of the world's largest bitcoin trading exchanges, by serving Coinbase with a John Doe summons seeking customer information. Coinbase challenged the summons, but a federal court in San Francisco has ordered Coinbase to turn over information sought by the IRS regarding its bitcoin customers. See United States v. Coinbase, 2017 WL 5890053, Case No.17 cv 01431 (N.D. Calif. Nov. 29, 2017). The federal court order requires Coinbase to divulge details on all bitcoin customers who made a transaction worth $20,000 or more between 2013 and 2015. Coinbase has estimated that this request would total over 8.9 million transactions between 14,355 different account holders, according to the court order. To understand the significance of the IRS's action against Coinbase, we must turn back the clock to 2014.

In 2014 the IRS issued Notice 2014-21 (2014-16 I.R.B. 938), which describes how the IRS applies U.S. tax principles to transactions involving virtual currency. According to the IRS, virtual currencies that can be converted into traditional currency are considered “property” for tax purposes, and a taxpayer can have a gain or loss on the sale or exchange of a virtual currency, depending on the taxpayer's cost to purchase the virtual currency (i.e., tax basis). Thus, under general tax principles applicable to property transactions, virtual currency transactions are reportable to the IRS in the following situations:

• Wage, salary, or other income paid to an employee with virtual currency is reportable by the employee as ordinary income, subject to employment taxes.

• Virtual currency received by a self-employed individual in exchange for goods or services is ordinary income subject to self-employment tax.

• Virtual currency received in exchange for goods or services by a business is reportable as ordinary income.

• Gain on the sale of property held as a capital asset in exchange for virtual currency is reportable as a capital gain.

• Gain on the exchange of virtual currency for other property is generally reported as a capital gain if held as a capital asset and as ordinary income if it is property held for sale to customers in a trade or business.

• Payments made in virtual currency are subject to information reporting requirements to the same extent as payments made in real currency or instruments denominated in real currency.

According to the IRS, taxpayers who have engaged in any of these virtual currency transactions and have not properly reported the virtual currency transaction have failed to comply with internal revenue laws. In addition to the tax owed on these transactions, taxpayers may be subject to significant penalties for failure to comply with tax laws. For example, underpayments attributable to virtual currency transactions may be subject to accuracy-related penalties under IRC §6662, as well as information reporting penalties under IRC §§6721 and 6722. The Notice is clear that the IRS does not view virtual currency as private money that may remain untraceable and untaxed. This brings us to Coinbase.

Coinbase, a Delaware corporation, offers bitcoin currency trading in 33 countries. By the end of 2015, Coinbase was America's largest bitcoin trading platform, and the fourth largest globally. In 2013, Coinbase registered with FinCEN as a Money Transmitter. As a Money Transmitter, Coinbase is required by the Bank Secrecy Act and FinCEN regulations to develop, implement and maintain an effective anti-money laundering program that includes a process for verifying customer identifications. According to court filings, Coinbase had over 5.9 million customers, and 6 billion exchanged in bitcoin. However, the IRS did not believe that Coinbase customers were complying with Notice 2014-21 in reporting virtual currency transactions. To verify its suspicion, the IRS searched its vast computer database, containing over 375,000,000 tax returns filed electronically from 2013 to 2015, and found that only 807 taxpayers reported a bitcoin transaction in 2013, 893 taxpayers reported a bitcoin transaction in 2014 and 802 taxpayers reported a bitcoin transaction in 2015. Armed with this information, in November 2016, the IRS filed an ex parte petition in federal court seeking permission to serve a “John Doe” administrative summons upon Coinbase. A John Doe summons is a summons that does not identify the person with respect to whose liability the summons is issued. The Internal Revenue Code authorizes the Service to issue a John Doe summons pursuant to an investigation of a specific, unidentified person or ascertainable group or class of persons. See IRC §7609(c)(3) and §7609(f). The John Doe summons allows the IRS to get the names and requested information and documents concerning all taxpayers in a certain group. In the past, the IRS has employed the John Doe summons when trying to obtain the identity of investors involved in a tax shelter or account holders at a financial institution.

The John Doe summons issued to Coinbase broadly requested information regarding all U.S. persons who, at any time during the period Jan. 1, 2013, through Dec. 31, 2015, conducted transactions in a convertible virtual currency as defined in Notice 2014-21. The purpose was to obtain the identity and transaction activity of Coinbase users who are U.S. persons. The IRS asserted that the information was relevant to the IRS's investigation into the identity and correct federal income tax liability of U.S. persons who conducted virtual currency transactions. The IRS requested specific Coinbase documents including Know-Your-Customer due diligence documents, all accounts records, all correspondence between Coinbase and the user or third parties with access to the user's account, all records of payments to or from the user, and all exception reports produced by Coinbase's AML system. On Nov. 30, 2016, the court gave the IRS permission to serve the John Doe summons upon Coinbase after concluding that the summons to Coinbase related to the “investigation of an ascertainable group or class of persons, that there is a reasonable basis for believing that such a group or class of persons has failed or may have failed to comply with any provision of any internal revenue laws, and that the information sought to be obtained from the examination of the records or testimony are not readily available from other sources.” On Dec. 6, 2017, the IRS issued the summons and directed Coinbase to produce the information by Jan. 9, 2017.

Not surprisingly, Coinbase resisted which precipitated a motion by the United States in March 2017 to enforce the summons pursuant to 26 USC §§7402(b) and 7604(a). Coinbase moved to quash the summons. The federal district court permitted a Doe to intervene, and heard oral argument on Nov. 9, 2017. While the motion to enforce the summons was pending, the IRS agreed to narrow the summons. As modified, the IRS sought information regarding accounts “with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013-2015 period.” The narrowed summons excluded users who only bought and held bitcoin during the 2013-2015 period; or for which Coinbase filed Forms 1099 during the 2013-2015 period. According to Coinbase, the narrowed summons requested information regarding 8.9 million transactions and 14,355 account holders.

Enforcement of a summons requires the IRS to satisfy the Powell test. United States v. Powell, 379 U.S. 48, 57-58 (1964). Under Powell, the government's burden is “slight,” and may be satisfied by a simple declaration from the investigating agent that the Powell requirements have been met. The government must establish “good faith” by showing that the summons: (1) is issued for a legitimate purpose; (2) seeks information relevant to that purpose; (3) seeks information that is not already in the IRS's possession; and (4) satisfies all of the administrative steps set forth in the Internal Revenue Code. Applying Powell, the court concluded that the first, third and fourth Powell factors were satisfied. As to the relevancy factor, the court agreed with the government's request for Coinbase account holder's identity and transaction records, but refused the government's broader request for Know-Your Customer diligence, correspondence between Coinbase and account holders, and third-party agreements or instructions. Accordingly, the district court ordered that Coinbase produce the following information to the IRS related to customers with at least the equivalent of $20,000 in any one bitcoin transaction (buy, sell, sell, or receive) in any one year during 2013 to 2105:

• The taxpayer ID number

• Name

• Birth date

• Address

• Records of account activity

• All periodic statements of account invoices (or the equivalent)

The lesson to be learned from Coinbase is that the IRS is committed to determining whether taxpayers are using virtual currency to commit tax avoidance. If a U.S. person has sold, purchased, sent or received bitcoin or other virtual currency since 2013, the taxpayer should determine whether they have unreported taxable virtual currency transactions and take swift action to ensure total compliance with tax reporting requirements. Given the increased focus, once the IRS receives Coinbase's customer records, U.S. persons who maintained a Coinbase account may undergo an IRS audit, or even an IRS criminal investigation. Thus, taxpayers must consider whether they need to amend any prior tax filings that failed to disclose virtual currency transactions, and consider any available disclosure options.

If the U.S. person opened a foreign account or has signatory authority over a foreign account to hold the bitcoin, the U.S. person, in addition to reporting any income from the bitcoin account, is required to disclose the foreign account and file an annual FBAR (Report of Foreign Bank and Financial Accounts) and other federal tax forms if the account or accounts exceed more than $10,000 in value. A U.S. person for tax purposes includes a U.S. citizen, legal permanent resident-Green Card holder or foreign national subject to U.S. tax under the substantial presence test. A U.S. person also includes an entity created or organized in the United States or under the laws of the United States. The term “entity” includes but is not limited to, a corporation, partnership, and limited liability company. Failure to file an FBAR can result in substantial civil penalties, criminal penalties, or both. The IRS may seek to penalize a taxpayer upwards of $10,000 per unreported account per year for a six-year period if the account holder is deemed non-willful. If the account holder is determined to be willful, the civil penalties can reach 100 percent value of the foreign accounts, as well as a possible criminal investigation. To eliminate the potential of criminal punishment and to reduce the civil penalties, U.S. persons may qualify for the IRS's offshore disclosure or domestic disclosure programs. If a U.S. person only has undisclosed domestic income as a result of a bitcoin account, the taxpayer may consider entering the IRS's domestic voluntary disclosure program. If the U.S. person has offshore related issues, then the account holder may consider entering into one of the IRS's offshore voluntary disclosure programs.

Under the IRS's offshore voluntary disclosure program (OVDP), the applicant must submit to the IRS amended tax returns and FBARs for the past eight years. OVDP enables noncompliant taxpayers to resolve their tax liabilities and minimize their chance of criminal prosecution. Only taxpayers who have legal source funds invested in undisclosed foreign accounts are eligible to apply under OVDP. Under OVDP, the taxpayer is required to pay the outstanding tax liability for the eight years within the disclosure period, as well as pay interest and a penalty on the nonpayment of tax. In addition, the FBAR penalty is 27.5 percent of the highest account balance in the foreign account (this penalty is 50 percent if held at certain financial institutions publicly identified as being under investigation or cooperating with a government investigation).

The fact that the IRS served a John Doe summons does not make every member of the John Doe group ineligible to participate in OVDP. However, once the IRS obtains information that provides evidence of a specific taxpayer's noncompliance with the tax law reporting requirements, the taxpayer will become ineligible for OVDP. For this reason, a taxpayer who is part of a John Doe group should consider filing a voluntary disclosure as soon as possible.

Although restrictions apply, if the U.S. person can demonstrate that that their actions were not “willful” the taxpayer may qualify under the IRS's Streamlined Filing Compliance Procedures program. Unlike OVDP, under which the FBAR penalty is either 27.5 percent or 50 percent of the highest aggregate balance in the foreign accounts over the eight-year reporting period, the FBAR penalty under the streamlined procedures is either zero for nonresident taxpayers or 5 percent of the highest balance over the three-year reporting period for resident taxpayers. Taxpayers must certify that they understand that their conduct was “non-willful” and are required to provide a narrative that explains their failure to report the foreign financial account, including specific reasons for the failure to report all income. The IRS will scrutinize the taxpayer's sworn explanation of non-willfulness.

Conclusion

The IRS's action to enforce the summons against Coinbase was triggered by the IRS's belief that bitcoin investors may not have been properly reporting bitcoin transactions. If the Government's past investigation of Swiss accounts and Swiss banks is any indication of the IRS's interest in virtual currency, the summons served on Coinbase marks the beginning of the IRS's war on virtual currency. Given the increasing focus by the IRS, time is ripe for bitcoin investors to determine if they need to report any virtual currency transactions and consider available disclosure options.

Richard A. Nessler is of counsel to Winston & Strawn in New York.