Should we be happy as it gives credibility to the world of cybercurrency or should we be sad as the regulation is coming?

We all must be realistic when dealing with something as disruptive as cybercurrency. People who just 9 months ago believed that Bitcoin was a Ponzi scheme and a fad, now are looking at ways to monetize it.

Why are we surprised when the federal government tries to do the same thing?

Slowly but surely people are beginning to understand that the world of cybercurrency is here to stay.

A NEW HIGH-PROFILE CASE ENTITLED UNITED STATES VS COINBASE INC SUDDENLY IS PLACING BITCOIN AND TAXATION IN THE SAME SENTENCE

The IRS is actively seeking information from at least one major Bitcoin exchange to determine the actual tax liability of the exchange’s account holders for gains achieved from cryptocurrency. In United States v. Coinbase, Inc, Case No. 17-cv-01431-JSC, the IRS (“Government”) sought enforcement of a summons seeking information from Coinbase, Inc (“Coinbase”) about Coinbase’s customers and their transactions. The Government apparently frustrated at the lack of reporting of gains resulting from Bitcoin transactions is now actively attempting to seek the information necessary to pursue individuals who have realized gains from Bitcoin but have not reported said gains. This signals the Government’s newly focused attention on Bitcoin gains and the attendant tax liabilities.

Taxing Bitcoin will be a big revenue source for the US government, especially in light of the fact that the Court looked to Coinbase’s claim that it has at least 5.9 million customers, who performed 6 billion transactions, while only 800 to 900 taxpayers a year have filed tax returns claiming gains from Bitcoin.

In an effort to determine the actual amount of gains being realized by Coinbase account holders, the Government served an administrative summons (“Summons”) on Coinbase seeking records regarding nearly all of Coinbase’s customers for a several year period. The Summons sought information regarding “United States persons who at any time during the period January 1, 2013 through December 31, 2015 conducted transactions in a convertible virtual currency as defined in IRS Notice 2014-21.”

The Government was casting a wide net to get as much information on Bitcoin users as possible!

The Summons requested nine categories of information, including: complete user profiles, know-your-customer due diligence, documents regarding third-party access, transaction logs, records of payments processed, correspondence between Coinbase and Coinbase users, account or invoice statements, records of payments, and exception records produced by Coinbase’s AML system. Coinbase refused to comply with the Summons and the Government in turn sought to enforce the Summons.

The Government acknowledged that it wants to take its share of Bitcoin users gains!

In support of its attempt to enforce the Summons, the Government submitted a declaration from an IRS Official which stated that the Government “is conducting an investigation to determine the identity and correct federal income tax liability of United States persons who conducted transactions in a convertible virtual currency … for the years ended December 31, 2013, 2014, and 2015.” The Government believes that virtual currency gains are underreported. In particular, approximately 83 to 84 percent of taxpayers file returns electronically which are maintained in various databases including the Modernized Tax Return Data Base (“MTRDB”). Capital gain or loss for property transactions, including those from virtual currency, is reported on IRS Form 8949, which is attached to Schedule D of a Form 1040. Form 8949 includes a space where the taxpayer is asked to report the type of property sold. Based upon an IRS search, only 800 to 900 persons electronically filed a Form 8949 that included a property description that is “likely related to bitcoin” in each of the years 2013 through 2015.

Coinbase was chosen as the first target because of its size.

Coinbase has a strong position in the Bitcoin exchange business and is a prime target for Government examination. By October 2012, the company launched the ability to sell and buy bitcoin through bank transfers. Coinbase offers buy/sell trading functionality in 33 countries, with (according to its website) 5.9 million customers served and $6 billion exchanged in Bitcoin. By the end of 2015, Coinbase was America’s largest platform for exchanging Bitcoin into U.S. dollars, and the fourth largest globally.

The Government narrowed its request but still wants a lot of information.

Sometime after the service of the initial Summons, the Government narrowed the scope of the Summons (“Narrowed Summons”). The Government now sought information regarding accounts “with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013-2015 period.” The Narrowed Summons “do[es] not include users: (a) who only bought and held bitcoin during the 2013-15 period; or (b) for which Coinbase filed Forms 1099-K during the 2013-15 period.”

According to Coinbase, the Narrowed Summons requested information regarding 8.9 million transactions and 14,355 account holders. For the qualifying accounts, the Government sought the following records:

  • Request 1: Account/wallet/vault registration records for each account/wallet/vault owned or controlled by the user during the period stated above limited to name, address, tax identification number, date of birth, account opening records, copies of passport or driver’s license, all wallet addresses, and all public keys for all accounts/wallets/vaults.
  • Request 2: Records of Know-Your-Customer diligence.
  • Request 3: Agreements or instructions granting a third-party access, control, or transaction approval authority.
  • Request 4: All records of account/wallet/vault activity including transaction logs or other records identifying the date, amount, and type of transaction   purchase/sale/exchange), the post transaction balance, the names or other   identifiers of counterparties to the transaction; requests or instructions to send or   receive bitcoin; and, where counterparties transact through their own Coinbase   accounts/wallets/vaults, all available information identifying the users of such   accounts and their contact information.
  • Request 5: Correspondence between Coinbase and the user or any third party with access to the account/wallet/vault pertaining to the account/wallet/vault opening, closing, or transaction activity.
  • Request 6: All periodic statements of account or invoices (or the equivalent).

Once again, Coinbase refused to comply.

The Court reviewed the request.

The Court explained the law regarding enforcement of summons. To obtain a court order enforcing a summons, the IRS must first establish “good faith” by showing that the summons: (1) is issued for a legitimate purpose; (2) seeks information relevant to that purpose; (3) seeks information that is not already in the IRS’s possession; and (4) satisfies all of the administrative steps set forth in the Internal Revenue Code. United States v. Powell, 379 U.S. 48, 57-58, 85 S. Ct. 248, 13 L. Ed. 2d 112 (1964). The court then analyzed the Governments Narrowed Summons for compliance with the above-referenced test.

The Court first determined that the Narrowed Summons served a legitimate purpose because the purpose of the Government’s investigation was to determine the reporting gap between the number of virtual currency users which Coinbase claimed to have during the period of the Narrowed Summons and the number of tax payers who filed tax returns that reported Bitcoin gains. The Court looked to Coinbase’s claim that it has at least 5.9 million customers, who performed 6 billion transactions, while only 800 to 900 taxpayers a year have filed tax returns claiming gains from Bitcoin.

The Court limited the information that the Government could get but the Government is still getting enough information to pursue certain Bitcoin Users!

The Court next determined that some of the information requested was relevant to the legitimate government purpose of determining tax liability. After a thorough analysis, the Court determined that the following categories of documents were not relevant to the Governments purpose at the beginning stages of the Government’s investigation:

  • Request 2: Records of Know-Your-Customer diligence,
  • Request 3: Agreements or instructions granting a third-party access, control, or transaction approval authority, and
  • Request 5: Correspondence between Coinbase and the user or any third party with access to the account/wallet/vault pertaining to the account/wallet/vault opening, closing, or transaction activity.

The Court did not limit the Government’s ability to get some of the contested information in the future.

The Court found that although these records may become necessary at some point in the Government’s investigation, the records may never be relevant for some, or perhaps even, most of Coinbase’s account holders. Therefore, the Court struck these requests from the Narrowed Summons. However, the Court did not preclude the possibility that these records could be sought in the future for specific account holders.

Requests 1, 4 and 6 have survived the Court’s scrutiny and absent an appeal by Coinbase, must be complied with by Coinbase. This case demonstrates that the Government is now actively seeking information from exchanges like Coinbase to determine the tax liability of their account holders.

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