The Internal Revenue Service (IRS) and the U.S. Department of Justice (DOJ) recently showed their hands in their ongoing fight against tax noncompliance relating to cryptocurrency. The IRS is authorized by statute to issue John Doe administrative tax summonses to obtain information from third-parties regarding taxpayers whose identities are unknown. However, before the IRS may serve a John Doe summons, it must first obtain authorization from a federal district court. This authorization is sought by the DOJ, at the IRS’s request.
The DOJ recently filed two petitions for leave for the IRS to issue John Doe summonses to third-parties related to certain U.S. taxpayers who conducted at least the equivalent of $20,000 in cryptocurrency transactions with that third-party during the years 2016 to 2020. The first petition, made public on March 30, 2021, was directed against Payward Ventures Inc. d/b/a Kraken (Kraken). Kraken is a California-based cryptocurrency exchange and bank. Although the court has directed the IRS to narrow the John Doe summons to be issued to Kraken, as discussed below, it is reasonable to expect that the IRS will, as it has done with prior John Doe summonses, narrow the request to obtain court authorization to issue the John Doe summons to Kraken. Assuming that the court narrows and authorizes the issuance of the John Doe summons, and assuming further that the IRS issues it, it is reasonable to expect that Kraken will comply with the resulting summons.
The second petition, made public on April 1, 2021, was directed against Circle Internet Financial Inc. or its predecessors, subsidiaries, divisions, and affiliates, including Poloniex LLC (collectively, Circle). Circle is a Massachusetts-based peer-to-peer payments technology company that has, prior to the 2016 tax year, also operated as a consumer bitcoin exchange. The court authorized the IRS to serve a John Doe summons on Circle. Circle has announced that it expects “to work collaboratively with the IRS” in complying with the John Doe summons.
The pursuit of John Doe summonses to enforce the tax laws relating to cryptocurrency is not a new or unexpected development. In late 2016, on behalf of the IRS, the DOJ requested judicial permission to serve a John Doe summons on Coinbase, Inc. (Coinbase). Coinbase is a California-based exchange dealing in cryptocurrency that operates a bitcoin wallet and exchange business. The Coinbase summons sought information regarding U.S. persons who, at any time during 2013 to 2015 bought, sold, sent or received at least $20,000 of cryptocurrency in a year. The court granted the IRS’s request to issue the John Doe summons and Coinbase complied, providing information to the IRS about some 13,000 customers.
And, as we explained in January 2021 (here), using information obtained from Coinbase, the IRS examination divisions have been conducting civil audits and the IRS Criminal Investigation division and the DOJ are pursuing criminal investigations. Indeed, the IRS is mining this information and using data analytics to identify persons and transactions of interest. The expected issuance of John Does summonses on Kraken and Circle, and the related compliance, will give the IRS and the DOJ additional and more current information about a broader class of taxpayers that can be used to pursue more audits, investigations, and prosecutions of individuals and entities who have not complied with the internal revenue laws relating to cryptocurrency.
While the anticipated John Doe summons to be issued to Kraken and Circle only recently became public, it is interesting to note the divergent positions courts have taken with respect to the government’s requests. The U.S. District Court for the District of Massachusetts authorized the John Doe summons against Circle, which is seeking information about U.S. persons who directly or indirectly had authority over any combination of accounts held with Circle with at least the equivalent of $20,000 in transactions in cryptocurrency in any one year during the years 2016 to 2020. The response will provide information to the IRS about Americans who engaged in business with or through Circle. IRS Commissioner Chuck Rettig stated, “[t]he John Doe summons is a step to enable the IRS to uncover those who are failing to properly report their virtual currency transactions. We will enforce the law where we find systemic noncompliance or fraud.” In issuing the order authorizing the service of the John Doe summons against Circle, Judge Richard G. Stearns found that “there is a reasonable basis for believing that [cryptocurrency users] may have failed to comply with [provisions of the] internal revenue laws.”
By comparison, the U.S. District Court for the Northern District of California, which is hearing the government’s request related to Kraken, issued an Order to Show Cause why the petition should not be denied for failure to meet the requirement of 26 U.S.C. § 7609(f) that a John Doe summons be “narrowly tailored” to information pertaining to persons who have violated the internal revenue laws. A similar concern was raised in response to the IRS’s 2016 request concerning Coinbase, and in response, the Government narrowed its request. The Kraken court expressed concern over the potential breadth of the government’s request for, among other similarly expansive requests, “complete user preferences, any other records of Know-Your-Customer due diligence, and all correspondence between Kraken and the User or any third party with access to the account pertaining to the account.”
Regardless of how the Kraken matter is resolved, it is reasonable to assume that Circle and Kraken are not the only two requests to issue a John Doe summons being pursued by the government with respect to cryptocurrency firms. We expect these additional investigative efforts will be made public in due course. And, as the Coinbase, Circle, and Kraken requests demonstrate, the IRS and DOJ are ramping-up efforts to shine the light on U.S. taxpayers who may not have been compliant with their tax obligations.
Correcting Historical Noncompliance
The IRS has well-established paths for taxpayers to use to rectify tax noncompliance relating to virtual currency. For taxpayers who engaged in virtual currency transactions, but did not report the transactions for tax purposes, a qualified amended return or a voluntary disclosure may offer a path to compliance that limits the likelihood of civil or criminal penalties. The availability (and advisability) of the qualified amended return or the voluntary disclosure depends heavily upon whether the taxpayer willfully failed to report her virtual currency transactions (i.e., whether the taxpayer intentionally violated a known legal duty).
One avenue for taxpayers to voluntarily come into tax compliance regarding previously unreported virtual currency transactions, filing a qualified amended return, has the benefit that a taxpayer can avoid accuracy-related penalties that might otherwise apply. Generally, for a document to be treated as a qualified amended return, pursuant to Treasury Regulations section 1.6664-2(c)(3)(i), the document must be filed before the IRS issues a John Doe summons covering the taxpayer seeking to amend their return.
As noted, the IRS served a John Doe summons on Coinbase in late 2016 and is expected to issue John Doe summonses on Circle and Kraken in short order (if the John Doe summons on Circle has not already been served). Absent some exemption from the IRS, which has not yet occurred (and does not appear likely to occur), the Coinbase summons makes individuals who “bought, sold, sent or received at least $20,000” worth of virtual currency through Coinbase between 2013 and 2015 ineligible for the qualified amended return procedures. Additionally, the Circle and Kraken summonses, when issued, will make individuals within the scope of those summonses ineligible for the qualified amended return procedures.
Even if the qualified amended return procedure is available, its attractiveness as an option must still be evaluated in the light of its drawbacks. If the IRS determines the underpayment of tax regarding the original return is fraudulent, the taxpayer is potentially liable for criminal prosecution and a civil fraud penalty equal to 75% of the underpayment of tax. Moreover, qualified amended returns do not protect taxpayers from other civil penalties, such as those attributable to failing to file international information returns (including Form 8938).
For taxpayers who were willfully noncompliant, the IRS offers its voluntary disclosure practice, which is designed for taxpayers who have true exposure to a criminal investigation and prosecution. The IRS has updated Form 14457, Voluntary Disclosure Practice, Preclearance Request and Application, to allow taxpayers to make a voluntary disclosure with respect to unreported income from virtual currency.
Taxpayers who may not be in compliance with the tax laws relating to cryptocurrency must continue to carefully weigh their limited options going forward. Once a taxpayer’s name is disclosed to the government, or if the taxpayer is a member of the class to whom a John Doe summons is issued, the taxpayer’s options to voluntarily come into compliance with the internal revenue laws are significantly limited. Stated more bluntly, if a taxpayer’s name is disclosed to the government as part of a response to a John Doe summons, as it stands now, neither the qualified amended return procedures nor the voluntary disclosure practice is an option.
Taxpayers should consult a lawyer with respect to whether their behavior may be classified as willful, whether the qualified amended return or voluntary disclosure is available in their individual situation, and what other measures can be taken in light of the Coinbase, Circle, and Kraken John Doe summonses.
 See Treas. Reg. § 1.6664-2(c)(2)