Cryptocurrency Stakeholders Should Prepare for Increased Tax Enforcement
November 16, 2021
Key Takeaways
• The Internal Revenue Service (“IRS”) is expanding its cryptocurrency tax enforcement efforts and will be aided in its efforts by several cryptocurrency-related amendments included in recently passed federal legislation.
• Within the past year, the IRS announced a new cryptocurrency tax enforcement initiative, requested a US$32 million budget increase to enhance its cryptocurrency enforcement efforts, and issued John Doe summonses to large cryptocurrency exchange operators to obtain certain taxpayer information.
• Recently passed legislation increases informational reporting requirements for cryptocurrency transactions. In turn, these new laws will make it easier for the IRS to identify and attribute such transactions to taxpayers.
• The focus on cryptocurrency taxation is likely to increase given the size and recent growth of the cryptocurrency market, and taxpayers should be aware of how their cryptocurrency transactions are taxed and how such transactions are reported to the IRS.
Introduction
As we recently noted in our OnPoint dated October 20, 2021, the rise in interest from retail and institutional investors in the cryptocurrency market has attracted increased regulatory and enforcement attention in the past year from agencies such as the Securities and Exchange Commission, the Commodity Futures Trading Commission and, most recently, the Department of Justice with the launch of its National Cryptocurrency Enforcement Team.1 Even Congress has entered the cryptocurrency fray by including several cryptocurrency-related amendments to the Internal Revenue Code (“IRC”) in its just-passed Infrastructure Investment and Jobs Act (the “Infrastructure Act”). Although the IRS has also been active in the cryptocurrency space for several years, its recent actions and pronouncements suggest an increase in enforcement efforts related to cryptocurrency tax reporting, which this OnPoint addresses in more detail.
Recent IRS Cryptocurrency Enforcement Activity
As background, the IRS treats virtual currencies as property under the IRC.2 This means a taxpayer may realize ordinary or capital gains or losses upon the sale or exchange of cryptocurrency. Over the past few years, the IRS noticed a large disparity between the number of cryptocurrency users and the number of taxpayers reporting income from cryptocurrency transactions.3 The underreporting of cryptocurrency income led the IRS to take several enforcement actions, including issuing a “John Doe” summons to Coinbase in 2016 to uncover taxpayer information in relation to cryptocurrency transactions and, in 2018, creating a cryptocurrency compliance campaign.4 However, in the past year alone, the IRS has announced a new enforcement initiative, requested a budget increase to expand cryptocurrency-related enforcement, and issued additional John Doe summonses. Such actions, discussed in more detail below, underscore the IRS’s increased focus on cryptocurrency tax enforcement.
“Operation Hidden Treasure.” At a tax conference held earlier this year, Damon Rowe, Director of the Fraud Enforcement Office of the IRS, announced a new IRS enforcement initiative called “Operation Hidden Treasure.”5 Operation Hidden Treasure is an initiative to uncover and attribute unreported income resulting from cryptocurrency transactions.6 At the same conference, Carolyn Schenck of the IRS shed additional light on the operation, stating that the IRS is working with third parties to identify different signs of cryptocurrency tax evasion in both the civil and criminal context, and is “analyzing blockchain and de-anonymizing [crypto] transactions” to aid in this enforcement effort.7
Request for Budget Increase. In addition to this new initiative, the IRS also requested a US$32 million budget increase for the 2022 fiscal year in order to enhance enforcement operations surrounding cryptocurrency taxation.8 The budget request explains that the additional amount will allow the IRS’s Criminal Investigation division to: (1) expand the use of “cyber/crypto experts,” which, among other services, are currently assisting the IRS in building an internal dashboard for cryptocurrency and blockchain analytics; (2) “establish a One-IRS approach to cryptocurrency non-compliance,” which “would supply proactive lead generation around tax compliance and illegal activities involving cryptocurrency”; and (3) “seek private sector expertise in applied analytics, cybercrime” and other related services.9 The IRS’s approach appears to heavily lean on third-parties, with US$23 million budgeted to “contractual services.”10
Fresh “John Doe” Summonses. Further emphasizing its enforcement commitment, the IRS took direct action this year to obtain information on taxpayers using cryptocurrency. Following its 2016 service of a John Doe summons on Coinbase, in 2021, the IRS served two more John Doe summonses on large cryptocurrency exchange operators.11 A John Doe summons permits the IRS to request information on unidentified taxpayers from third parties as long as the IRS satisfies certain requirements under the IRC.12 In May and April of this year, two federal courts authorized the issuance of such summonses on cryptocurrency exchange operators Circle and Kraken.13 Both summons seek “information about U.S. taxpayers who conducted at least the equivalent of US$20,000 in transactions in cryptocurrency during the years 2016 to 2020.”14 Chuck Rettig, IRS Commissioner, stated with respect to the Kraken summons that the “summons is part of [the IRS’s] effort to uncover those who are trying to skirt reporting and avoid paying their fair share.” Commissioner Rettig further noted with respect to the Circle summons that the IRS action is a “clear message to U.S. taxpayers that the IRS is working to ensure that they are fully compliant in their use of virtual currency.”15
New Cryptocurrency Tax Reporting Requirements
Congressional Action. The IRS is not alone in its tax enforcement efforts. Congress recently passed and President Biden subsequently signed into law the Infrastructure Act, which contains several cryptocurrency-related amendments to the IRC that will make it easier for the IRS to identify and attribute cryptocurrency transactions to taxpayers.16
The first of these amendments expands the definition of a broker for purposes of required information reporting under the IRC to include persons “regularly providing any service effectuating transfers of digital assets on behalf of another person,” and further expands the securities covered by this section to include digital assets.17 This means that persons who fall within the new definition of broker under this section must make informational returns in connection with cryptocurrency transactions that contain, among other things, “the name and address of each customer” along with information on “the customer’s adjusted basis in such security and whether any gain or loss with respect to such security is long-term or short-term.”18
The second cryptocurrency-related amendment amends a section of the IRC that requires persons engaged in a trade or business to report to the IRS receipts of more than US$10,000 in cash in connection with such trade or business.19 Such a report must contain, among other items, the identity of the other party, the amount received, and the nature of the transaction.20 The amendment expands the definition of cash under this section to include “any digital asset.”21
Both amendments will make it easier for the IRS to identify taxpayers who sell and/or exchange cryptocurrency. These cryptocurrency reporting requirements will become effective after December 31, 2023.22
Potential Future Congressional Action. These amendments will likely not be the end of cryptocurrency tax legislation. Earlier this year, Senator Rob Portman noted that he is developing a bill that “would define cryptocurrency for tax purposes and try to provide appropriate reporting rules.”23 Although there have not been any recent developments regarding such a bill, Senator Portman has remained active in the cryptocurrency area, drafting and defending a portion of the cryptocurrency tax amendments included in the Infrastructure Act.24
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Taxpayers and others involved in cryptocurrency transactions need to be aware of the uptick in IRS enforcement activity as well as changing cryptocurrency informational reporting requirements. It is important for taxpayers to understand how their cryptocurrency transactions are taxed and how such transactions are reported to the IRS so they can accurately report cryptocurrency income and/or take action to correct past filings. This focus on cryptocurrency tax compliance is likely to only intensify given the growth of the cryptocurrency market and the number of taxpayers transacting in cryptocurrency.
Footnotes
1) The Cryptocurrency Market – Prepare for an Uptick in Enforcement Activity, DECHERT LLP (Oct. 20, 2021).
2) IRS Notice 2014-21.
3) Tim Cotter and Casey Daderko, IRS Continues Focus on Cryptoassets, THE TAX ADVISER (Oct. 1, 2021).
4) Id.
5) Guinevere Moore, Operation Hidden Treasure is Here. If You Have Unreported Crypto, Get Legal Advice, FORBES (Mar. 6, 2021).
6) Id.
7) Id.
8) Congressional Budget Justification & Annual Performance Report and Plan, IRS Publ’n 4450 (Rev. 5-2021) at 117.
9) Id.
10) Id.
11) Press Release 16-1404, Dep’t of Just. (Nov. 30, 2016); Press Release 21-298, Dep’t of Just. (Apr. 1, 2021); Press Release 21-410, Dep’t of Just. (May 5, 2021).
12) IRC § 7609.
13) Press Release 21-298, Dep’t of Just. (Apr. 1, 2021); Press Release 21-410, Dep’t of Just. (May 5, 2021).
14) Id.
15) Id.
16) Infrastructure Investment and Jobs Act, H.R. 3684, 117th Congress (2021) at § 80603 [hereinafter Infrastructure Act]; Bill Signed: H.R. 3684, THE WHITE HOUSE (Nov. 15, 2021), https://www.whitehouse.gov/briefing-room/statements-releases/2021/11/15/bill-signed-h-r-3684/.
17) Infrastructure Act, supra note 16; IRC § 6045.
18) Id.
19) Infrastructure Act, supra note 16; IRC § 6050I.
20) IRC § 6050I.
21) Id.
22) Infrastructure Act, supra note 16.
23) At Senate Finance Hearing, Portman Discusses Concerns Regarding IRS’ Processing Backlog of Tax Filings, Modernization, Press Release, April 13, 2021.
24) Sebastian Sinclair, Senator Rob Portman Defends Crypto Provision in US Infrastructure Bill, NASDAQ (Aug. 3, 2021).
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