Background
Before 2014, the treatment of virtual currency for tax purposes was somewhat of an open question. That is, would it be treated like a currency? Maybe a foreign currency? Or would it be treated like property? Or maybe a commodity or a derivative? The IRS took initial steps to answering that question in Notice 2014-21, where the IRS asserted that virtual currency would be treated like property.
A lot of practitioners thought that this was probably the right answer, as did many significant investors, but for ordinary folks who have been using bitcoin or other virtual currency to buy goods and services, it may have been a bit surprising. Essentially, the IRS characterization means that if you go to Starbucks and use bitcoin to buy your coffee, while it may seem to you the same as using dollars, for tax purposes, it’s more like using gold. And if your gold has appreciated in value since you acquired it, you may owe tax on the gain. Same thing with virtual currency. The problem arises because using virtual currencies to buy things seems much more like using cash than like using gold, so many virtual currency users may not have even considered that there could be potential tax consequences. But the IRS’s reasoning was that it cannot be a foreign currency because it’s not a fiat currency—that is, it’s not recognized by any government.
Beyond the treatment of virtual currency as property, the guidance is pretty thin. The IRS assumes that once it is characterized as property, normal tax consequences flow from that. Thus, for example, the Notice explains that if an employer pays an employee in virtual currency, the employee must include the value of the virtual currency in income as compensation, and the employer must report the value of the compensation on a Form W-2. However, there are many more questions that the Notice doesn’t answer, such as how to calculate the gain upon disposition, nor does it even try to. It contemplated that there would be more guidance in the future and the Notice requests comments on what the guidance would look like. Unfortunately, so far, the IRS has not issued anything further. In fact, last fall, the Treasury Inspector General for Tax Administration (TIGTA) issued a report taking the IRS to task for not providing more guidance.
TIGTA Report
The title says it all: “As the use of virtual currencies and taxpayer transactions becomes more common, additional actions are needed to ensure taxpayer compliance.” The report has the three main points:
First is that the IRS needs to develop a coordinated virtual currency strategy. TIGTA found little coordination between IRS functions to see the big picture for virtual currency. Individual parts of the IRS may be looking at virtual currency, but there is no master plan for how to deal with virtual currency within the IRS.
The second is that taxpayers need more education about virtual currency tax compliance. The treatment as property under Notice 2014-21 creates compliance issues for taxpayers and the IRS really needs to issue more guidance.
Finally, the report indicates that there should be some modifications to third-party information reporting to help identify virtual currency transactions. There is a range of third-party reporting that has implications for virtual currency, only some of which is addressed by the Notice. For example, the Notice states that payers must file Forms W-2 or Forms 1099-MISC in appropriate circumstances, but those forms do not break out receipts of virtual currency. Having a little more information could be very helpful for the IRS to understand better how virtual currency is being used.
Enforcement Actions
Perplexingly and frustratingly for taxpayers, instead of providing more guidance and educating taxpayers of their tax obligations relating to virtual currency, the IRS instead is pursuing enforcement actions. The first such action was issuing a “John Doe summons” to the Coinbase virtual currency exchange. Generally speaking, if the IRS doesn’t know the identity of person about whom it seeks information, it can issue a John Doe summons to obtain information about an ascertainable group of people. The Coinbase summons seeks all customer records for a period from 2013 to 2015. This includes basically everything– all records of account/wallet vault activity including transaction logs and other records. The summons also asks for any correspondence between Coinbase and the users. After some pushback from Coinbase and its customers, the IRS has narrowed the scope of the summons to cover customers engaging in transactions of $20,000 or more.
This summons may be a sign of things to come. It seems like the IRS feels like there’s not a lot of transparency into what’s going on with these virtual currencies. In a recent interview, the new Chief of IRS Criminal Investigation (CI) division hinted the IRS is going to step up a campaign into the virtual currency space, noting that virtual currency is increasingly becoming a tax evasion issue and the IRS must train its agents to understand and address these issues. Accordingly, we may see more enforcement actions, such as additional summons to other virtual currency exchanges and wallets, possibly extending investigations into other virtual currencies.
On the other hand, rather than pursue this enforcement route, there may be an opportunity to issue guidance which would be helpful for taxpayers. Steptoe has been working with an industry coalition to engage proactively with the IRS to develop guidance that provides clear rules for taxpayers to follow and the IRS to administer. More information to allow taxpayers to comply without the expense and time (on both sides) of enforcement action would certainly be better for taxpayers as well as for the IRS.