Got Cryptocurrency? Get Ready For An IRS Audit

On May 12, the IRS issued a statement of work soliciting “consulting services to support a taxpayer examination involving virtual currency.” The SOW was sent to popular cryptocurrency tax software companies such as CyrptoTrader.Tax, among others, in an effort to provide the IRS with the industry expertise necessary to identify and pursue cases where taxpayers’ reporting (or lack thereof) of digital assets is inconsistent with their actual cryptocurrency transactions. In other words: the IRS is hiring outside contractors who are experts in cryptocurrency to help them identify cryptocurrency investors whose tax returns either omit or contain incorrect data regarding cryptocurrency transactions. There’s only one reason why the IRS would hire experts in cryptocurrency as outside contractors: because they plan to significantly increase the volume and scrutiny of cryptocurrency audits.

How Does the IRS Treat Cryptocurrency?

The IRS defines a virtual currency as “a digital representation of value” functioning “as a unit of account, a store of value, and a medium of exchange.” Any asset with these characteristics, “[r]egardless of the label applied, . . . will be treated as virtual currency for [f]ederal income tax purposes.” Some virtual currencies are convertible, which means that they have equivalent values in one or more traditional currencies (fiat) and may act as substitutes for them. The more well-known virtual currencies, such as Bitcoin, Ethereum, and Ripple, are termed cryptocurrencies because they use cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.

IRS Guidance on Treatment of Cryptocurrency

In Notice 2014-21, the IRS issued the first formal guidance on how cryptocurrency should be taxed. In a surprising move, the IRS applied general principles of tax law to conclude that virtual currency is property, rather than “currency,” for federal tax purposes. Consequently, an exchange of one virtual currency for another (e.g., Bitcoin for Ethereum) is a taxable transaction, resulting in gain or loss as well as a reporting obligation on the part of the taxpayer. This makes a lot of crypto transactions subject to the favorable capital gain and loss treatment instead of the more onerous ordinary income treatment. Mining and other receipt of units of cryptocurrency, such as being paid in cryptocurrency, create tax obligations and may need to be reported as ordinary income if they constitute income. Much like with the purchase of stock traded on a public exchange, simply buying or investing in cryptocurrency does not create a taxable event. Rather, it is the sale or exchange of virtual currency, or receipt of virtual currency in exchange for services performed or other property, that creates a taxable event.

The IRS provided further guidance in Revenue Ruling 2019-24, finding that a cryptocurrency “hard fork” (a single cryptocurrency splitting into two) in which no units of a new cryptocurrency are received does not result in gross income, but an “airdrop” (free distribution of units of cryptocurrency) does. In addition, the IRS has released and published on its website a set of frequently asked questions addressing the tax treatment of other virtual currency transactions, including those in which the virtual currency is held as a capital asset.

IRS Cryptocurrency Enforcement

In 2017, the IRS filed a lawsuit against Coinbase (one of the largest crypto exchanges) to obtain account holders’ names and account information. Why? Because during the years 2013 through 2015 Coinbase had almost six million customers, but only 800 - 900 taxpayers filed tax returns that reported gains from cryptocurrency. That’s a huge gap, and the court agreed that the IRS had a legitimate interest in investigating further. In 2018, Coinbase turned over 13,000 names to the IRS as a result of the litigation.

Not surprisingly, just over a year after the IRS received 13,000 names from Coinbase, the IRS sent roughly 10,000 “soft letters” to Cryptocurrency account holders. A so-called “soft letter” is not an IRS audit, but instead warns the recipient that they may want to consider taking certain action on their tax returns before an audit happens. Soft letters certainly doesn’t feel “soft” to the recipient, because anyone who gets one knows that the IRS knows something specific about them. If that isn’t on the tax return, that’s when trouble starts. Those soft letters didn’t necessarily mean that something was wrong on the recipients’ tax returns, but it may have been, and gave everyone a good faith opportunity to check the return and make sure all crypto was reported correctly.

Just about a year has gone by, and now the IRS is looking to hire crypto experts to assist with audits of taxpayers who have crypto. The statement of work looks for contractors who can “ingest all data provided by the IRS, as well as any attendant or related data the contractor collects through their systems.” Even though a cryptocurrency blockchain is anonymous, it remains susceptible to tracing as a public ledger. According to the statement of work, contractors should be able to analyze blockchain data and application programming interface keys obtained from virtual currency exchanges. Further, a contractor should “be available to consult with the IRS during meetings with taxpayers or their representatives,” including meetings with IRS Appeals Officers, “assist the IRS with trial preparation,” and, if needed, “to testify at trial as a summary witness explaining the calculations derived from the underlying data.” In other words, play time is over.

Can the IRS Do That?

You might be thinking, wait, I thought IRS data is private and they can’t provide my tax return information outside of the IRS agency, right? Yes, in general that’s the rule: the IRS has to keep tax return information private. But there are exceptions to that rule, and the IRS has used outside contractors before. The IRS has long relied on such advice for valuation purposes—most frequently for valuing non-cash charitable contributions, gifts, and estates. Conservation easements and artwork are especially contentious valuation items, often pitting the IRS’ experts against the taxpayer’s. Indeed, for artwork, the IRS has institutionalized reliance on outside expert advice in the form of the Commissioner’s Art Advisory Panel, comprised of academics and industry representatives from the private, public, and non-profit sectors, and the Art Appraisal Services (AAS) unit in the IRS Appeals Office. The panel provides advice and makes recommendations to AAS regarding the acceptability of appraisals that taxpayers submit supporting the fair market value claimed on the wide range of works of art featured in income, estate, and gift tax returns. In addition, anytime a tax return selected for audit includes an appraisal of a single work of art valued at or more than $50,000, the examining agent or appeals officer is required to consult AAS for possible referral to the panel, which meets in closed session to review all referred appraisals.

Procedures adopted by the AAS ensure strict compliance with the confidentiality requirements. These procedures ensure that information provided to panel members does not include the taxpayer’s name, the type of tax, the tax consequences of any adjustments to the appraised value, or details regarding the appraiser. To minimize the possibility that panelists recognize a taxpayer’s entire collection, the works of art are usually discussed in alphabetical order by artist or, in the case of decorative art, by object type. If there is a conflict of interest with a panelist and a work of art under review, the panelist does not participate in the discussion and is excused from that portion of the meeting.

In sharp contrast with how it has routinely used outside expert advice on artwork appraisal audits, the IRS pushed the envelope when in 2014, it engaged the California-based litigation powerhouse Quinn Emanuel Urquhart & Sullivan to assist with Microsoft’s transfer pricing audit, spanning the company’s 2004 to 2006 tax years. The $2.2 million contract with Quinn Emanuel was authorized by a Temporary Treasury Regulation issued in June 2014, issued two weeks after the contract was awarded. The regulation was issued under the IRS’ authority for summoning “books, papers, records, or other data” for examination and summoning individuals for taking their testimony under oath. Those regulations have now been finalized, and provides that a contractors may “receive and review” the summoned materials and “participate fully” in taking the testimony of the summoned person “in the presence and under the guidance of an IRS officer or employee.”

News of the Quinn Emanuel contract provoked sharp criticism from practitioners and on Capitol Hill, with many questioning the propriety of the IRS’ delegating a core governmental function—a tax audit—to private litigators. In a summons enforcement action, Microsoft challenged the validity of the regulation on those grounds. But a taxpayer challenging summons enforcement is in for an uphill battle. Although the district court expressed concern at “Quinn Emanuel’s level of involvement in this audit” and was troubled by “[t]he idea that the IRS can ‘farm out’ legal assistance to a private law firm,” the court ordered enforcement of the summons. The case is United States v. Microsoft Corp., 154 F. Supp. 3d 1134, 1143-44 (W.D. Wash. 2015).

Although the Court upheld the summons, a warning that “this case may lead to further scrutiny by Congress” proved prophetic when, in 2019, Congress passed the Taxpayer First Act, which added a new Section of the Internal Revenue Code that expressly prohibits the type of Quinn Emanuel arrangement permitted in Microsoft. That new subsection precludes an outside consultant from examining summoned “books, papers, records, or other data,” except for “the sole purpose of providing expert evaluation and assistance to the Internal Revenue Service.” It also prohibits any person, “other than an officer or employee of the Internal Revenue Service,” from “question[ing] a [summoned] witness under oath.” It is a question of when and how the IRS’s use of outside experts in cryptocurrency cases will be challenged in court - not if.

The Bottom Line

The Coinbase reporting gap puts this problem in perspective: in just one exchange there were over six million customers and less than one thousand taxpayers who reported cryptocurrency transactions. The IRS is justifiably wondering who the rest of the account holders are, why they haven’t reported any cryptocurrency transactions on their tax returns, and will be looking soon to make some strong examples out of cryptocurrency account holders who fail to fulfill their income tax obligations.

Thank you to Tax Notes reporter William Hoffman for bringing this issue to my attention.