Taxpayers should take prompt action to assess their situation, yet move carefully before making representations or filings to the IRS.
Over the past month, the Internal Revenue Service (IRS) has sent letters to over ten thousand taxpayers that it believes may have failed to report virtual currency transactions (primarily Bitcoin-related) or may have omitted income derived from virtual currency transactions. These letters continue to receive significant press coverage from major financial outlets and may be just the beginning of the government’s notification, collection and enforcement efforts. For example, the IRS has also recently sent notices to certain virtual currency investors informing them that the investors’ reporting does not match other records in the IRS’s possession.
Taxpayers who receive an IRS letter, receive an investor notice, or have questions about reporting their past virtual currency transactions (e.g., sales of tokens or exchanges of one token for another) should consider the following advice:
- Do Not Panic. These letters do not mean you are being audited by the IRS. Remember, this is relatively new territory for the government and taxpayers. While the investor notices, for example, have been used in the past by the IRS, their application to virtual currency appears new. The appropriate response will vary depending upon multiple factors, including the ability to document virtual currency transactions that may have occurred many years ago.
- Do Not Delay. There may be compelling reasons to quickly amend any federal income tax returns that you believe may have inadvertently omitted reportable transactions (like every exchange from Bitcoin to Ethereum in a particular year, for example). Quick action may help avoid additional penalties and minimize the pain of audit, if any. But speed cannot come at the expense of accuracy, and thus taxpayers will want to be careful and perhaps seek further clarification before responding or amending. An experienced accountant or attorney can help taxpayers understand the broader risks and options, including how to best avoid drawn-out disputes with the government.
- Do Not Deceive. Everything that you say in writing or otherwise to the IRS matters, and an inaccurate or misleading response, even if unintentional, can quickly create problems. This is especially true for those who are already identified by the government through the IRS letters or those who are informed through the investor notices of a records mismatch. Your understanding of the facts may be different than what can be proved with hard evidence, and the IRS may later ask taxpayers pointed questions directly (in writing or orally, under penalty of perjury), including whether the taxpayers used “tumblers” or other tools that the government finds suspicious. Thus, written records are not the only considerations as taxpayers determine their approach. Communications with legal counsel are privileged, so seek advice from counsel first if you have any concerns about the accuracy of your planned response.
IRS Reporting Virtual Currency Letters from July and August 2019
Beginning last month, the IRS sent three different “Reporting Virtual Currency Transactions” letters to taxpayers that they have reason to believe may have failed to report income from digital currency transactions (Letters 6174, 6174-A and 6173). While these letters are similar, there are important distinctions. Letter 6173 asks the recipient to complete and return a signed statement (under penalty of perjury/felony) that the recipient’s tax returns complied with federal tax law. This version is more than a simple “nudge” by the government to encourage compliance. Letters 6174 and 6174-A do not request such a statement but do request that taxpayers amend their prior returns if they did not accurately report their virtual currency transactions.
The IRS has obtained court authorization to obtain information from a well-known virtual currency exchange about (primarily Bitcoin-related) transactions in which a particular transaction type exceeded $20,000 in a single year, in aggregate. The IRS is almost assuredly relying upon these transaction records to identify taxpayers who may not have reported virtual currency transactions. It is also possible that the IRS has used other methods and sources of information about virtual currency trades, and one of the more significant factors in determining how to respond to these letters may be that the taxpayer does not know what information the IRS already has in its possession.
Along with these letters, certain investors are also receiving so-called CP2000 notices, which the IRS has previously used to inform taxpayers that a tax return does not match income information that the IRS has about the taxpayer.
Do Not Panic, But Do Not Delay Taking Some Action — History As a Guide
Sending letters to virtual currency traders is new territory for the IRS, but it is not the first time that the government has reached out to specific groups of taxpayers to encourage reporting. This type of notice serves multiple purposes, including being a low-cost way for the IRS to increase payment/recovery of taxes due without needing to conduct costly audits or investigations. The letters also assist the government by laying the foundation for future enforcement actions. Put another way, it is much harder for a taxpayer to claim ignorance after the IRS has sent it a letter, and it is likewise much easier for the IRS to pursue enforcement actions after the world has been put on notice of the government’s position that virtual currency transactions are often not being properly reported. The government has expressed concerns that virtual currency can be used to facilitate illegal transactions that threaten national security, for example, and thus the stakes remain high.
The IRS also has used similar techniques in the past when going after taxpayers who were suspected of having unreported offshore bank accounts. In that example, the IRS subpoenaed information from foreign banks and mail services that delivered correspondence from U.S. residents to foreign banks. It is noteworthy that in the offshore bank account scenario, taxpayers who voluntarily reported and amended their returns early in the program often paid lower penalties than taxpayers who waited until the end. On the flip side, certain taxpayers who did not voluntarily report faced drawn-out legal battles and charges of civil and criminal fraud. Failing to take action after being put on notice may also increase the risk that the IRS will pursue additional penalties based upon a claim that the taxpayer acted knowingly or willfully. Taxpayers found to have committed a voluntary, intentional violation of their tax reporting legal responsibilities may face criminal fraud penalties, and recent case law has suggested that “willful blindness” and “recklessness” may be enough to maintain civil fraud charges.
At a bare minimum, taxpayers who fail to report income on their federal tax returns may be exposed to additional tax and interest. The potentially bigger question is whether a taxpayer can be subject to civil and criminal penalties on top of that. In the past, the IRS has considered the speed, accuracy and completeness of voluntary remedies by the taxpayer in making that determination.
While the IRS said in 2018 that it is not contemplating a formal voluntary disclosure program for noncompliance involving virtual currency—whereas such a program was implemented for offshore bank accounts—the underlying principles favoring early voluntary disclosure of virtual currency transactions may still apply. Therefore, taxpayers should consider that despite the lack of an official voluntary disclosure program, there may be significant advantages to preemptively filing amended returns to accurately disclose virtual currency transactions before an IRS audit.
 Coinbase generally organizes transactions as buy, sell, send or receive transactions. The court authorized the IRS to request accounts that engaged in transactions in the sale, send, or receive category that cumulatively represented at least $20,000 in value during a single year. However, this excludes individuals whose transactions were reportable on Form 1099-K in that year. United States v. Coinbase, Inc., 2017 WL 5890052, 120 A.F.T.R.2d 2017-6671 (N.D. Cal. Nov. 28, 2017).
 See Dashiell C. Shapiro, Cryptocurrency and the Shifting IRS Enforcement Model (June 23, 2018), https://stanford-jblp.pubpub.org/pub/crypto-irs-enforcement (describing the new IRS enforcement model). That was followed this week by Dashiell Shapiro, Reading Between the Lines of the IRS Cryptocurrency Warning Letters (Aug. 6, 2019), https://medium.com/@dashiellshapiro/reading-between-the-lines-of-the-irs-cryptocurrency-warning-letters-d35286ca2d3.