Time to Hide your Bitcoin Wallet: How the IRS is Tracking your Virtual Currency

For the past several years, internet users have been able to remain mostly anonymous while purchasing goods and services by using bitcoins as a means of payment. The cryptocurrency operates outside of banks through a decentralized peer-to-peer transaction system that is impossible for the government to regulate directly. While transactional history is public, the digital addresses associated with particular transactions do not contain personally identifying information. Despite the ability to transfer bitcoins without revealing personal details, however, many users elect to provide their information to third party intermediaries. These third parties can facilitate the use of bitcoins by offering related services, such as currency exchange and wallet hosting. As a result, the government may be able to tie bitcoin transactions to specific persons through the examination of account records from any of the bank-like intermediaries.

One agency using this approach is the Internal Revenue Service. After an independent government investigation, the IRS is concerned U.S. taxpayers are evading taxes by not reporting income from virtual currency transactions. Aside from conscious misconduct, a significant cause of underreporting is lack of knowledge regarding how these transactions are taxed. Generally, bitcoins are treated as property rather than currency. For federal income tax purposes, this means the fair market value of the virtual currency as of the date of receipt is includible in gross income. Consequently, a federal district court in California has granted the IRS’ petition to serve Coinbase, Inc. with a “John Doe summons” for the account records of all U.S. customers who conducted virtual currency transactions between 2013 and 2015. While this subpoena has the potential to identify internet users who engaged in tax evasion, it does so at the cost of executing what some consider an unwarranted fishing expedition into millions of law-abiding transactions.

One way to maintain transactional privacy is for users to keep their digital wallets on a personal computer instead of requesting a third party to host them online. The resulting policy implication, however, is that only users who trusted a third party with their information are going to be penalized. This has the unfortunate outcome of targeting compliant taxpayers, or at least taxpayers acting in good faith, because a person knowingly breaking the law is less likely to be a member of the class that can be subpoenaed through any bank-like intermediaries. Regardless, U.S. case law holds that individuals have no reasonable expectation of privacy in information they voluntarily disclose to third parties. As a result, all of the bitcoin users taking advantage of third party services who thought they had nothing to hide, but still valued their privacy, are now the presumptive targets of future audits and criminal investigations.

It is painfully ironic that Bitcoin users in favor of transactional anonymity are going to have their privacy invaded by the government more than traditional banking clients and credit card consumers. In fact, they may find prophetic a 1988 crypto manifesto which predicted that state governments would try to halt or slow the progression of virtual currencies by fixating on their potential for tax evasion and other illicit activities. While it is still unclear whether the U.S. is actually impeding the use of virtual currencies by invoking its regulatory authority, regardless of any possible underlying intentions, there is no question that the IRS now intends to leverage the intermediaries of virtual currencies to acquire taxpayer information and enforce compliance. Contrary to the manifesto, however, virtual currency enthusiasts may take solace in the aggressive taxation of Bitcoin by viewing it as a natural progression of the currency’s widespread recognition. Government regulation of the cryptocurrency, enforced fairly alongside fiat currencies, will unavoidably broaden its appeal by legitimizing it as a medium of exchange.

Allison Kroeker
akroeker@rroyselaw.com
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