Coinbase IRS Battle: Legal Experts Weigh In

A hurricane of bitcoin news hit the press this week. Nobel Prize-winning economist Joseph Stiglitz, a former chief economist of the World Bank, declared bitcoin should be outlawed because it is supposedly only good for circumvention. Yet Google Trends appear to show more people are searching for queries related to bitcoin than the Kardashians these days. On Thursday, White House press secretary Sarah Huckabee Sanders said the White House and homeland security team are monitoring cryptocurrencies. Perhaps the week's most impactful news isn't price dips or pop star Katy Perry's sudden interest in bitcoin. Instead, it might be a tax audit in California.

A California court just told the Internal Revenue Service they can’t demand the cryptocurrency exchange Coinbase hand over the private records of more than 480,000 customers, including public keys, account activity and correspondence. Coinbase is one of the United States’ most popular bitcoin platforms, with around 11.9 million users and a valuation of more than $1.6 billion. The whole cryptocurrency community was holding their breath for this case, because it could set a precedent for how the government keeps tabs on blockchain industry platforms.

“The IRS gets to go now to all the other exchanges, around the U.S. and maybe even globally, and say: hey, you claim you have this many users who are American but we know there are less than a 1,000 Americans every year who file their taxes reporting cryptocurrency,” former R3 director of market research Tim Swanson told International Business Times. “When you use third parties, then you’re eventually going to run into all the legal stuff.”

Law enforcement agencies have found a few specific cases of money laundering with bitcoin. On the other hand, Swanson noted private blockchain networks would be a terrible way to do money laundering. Criminals who use bitcoin are offering law enforcement agencies crystal clear evidence on a blockchain-shaped platter. Those transactions are public, albeit complex. "Law enforcement needs to rely more heavily on subpoenas, undercover work, and analytics to identify participants," Swanson said. If the issue at hand is tax evasion, not money laundering, the plot thickens.

A 2017 survey of 564 American bitcoin users by the online loan marketplace LendEDU, revealed more than 35 percent didn’t plan to report bitcoin-related gains or losses on their tax returns. The IRS isn’t currently looking at the flood of new bitcoin users. This audit is focused on bitcoin veterans who started using Coinbase in 2013.

Peter Van Valkenburgh, director of research at Coin Center, told IBT he is concerned the IRS didn’t adequately justify the sweeping collection of this data because the legal precedent says subpoenas shouldn’t be used for general research or “phishing.” Basically, the IRS needs a specific reason to justify getting information on individual accounts. The reasons the IRS provided were a little too vague for Valkenburgh’s taste.

“In this case, the only justification given was all of these transactions are in bitcoin,” he said. “If all you did is buy it [bitcoin], there’s no taxation then. I would have liked to see more evidence of tax evasion from the IRS to justify what is still a broad and sweeping collection of personal information.”

Many Coinbase customers are simply storing their cryptocurrency on the platform, which in itself is not a taxable event. Selling cryptocurrency means the seller needs to report capital gains tax. But that’s not what the IRS is limiting their request to. All 14,355 users who bought, sent, sold or received $20,000 worth of cryptocurrency on the platform in a single year between 2013 and 2015 are included. Someone could theoretically send or receive cryptocurrency from their Coinbase account via their personal wallet. That’s not a sale; It’s also not taxable.

At the time, there was scant guidance for anyone who actually wanted to report hit or her bitcoin earnings. Valkenburgh said a 1099B form could have been helpful. However, the IRS has not required or suggested exchange platforms offer this type of guidance to users.

“The IRS has been silent, since 2014 when they issued the first bit of guidance, about whether exchanges can or should offer those 1099B forms,” he said. “I think more guidance should be non-controversial. It would mean that you have more voluntary compliance. It’s easier to figure out what everybody owes.” If the IRS provided more guidance, they wouldn’t need to have legal battles about bulk data collections.

Bitcoin users aren’t the only ones who think the IRS needs to offer more guidance. The Treasury Inspector General’s office and the Government Accountability Office both criticized the IRS for not offering enough guidance. If the laws are unclear, who can blame bitcoin users for failing to follow them?

“There isn’t any information reporting, at least right now, for cryptocurrency exchanges,” Lisa Zarlenga, co-chair of the tax group at Steptoe & Johnson LLP law firm, told IBT. “They are claiming transactions from 2013, from before the guidance came out. A failure to report before the law was more clear could be excusable, at least from penalties.”

The guidance available now is still widely considered inadequate for the increasingly complex cryptocurrency market. How will bitcoin users report airdropped or forked network tokens? (Cue crickets.)There was no guidance at all for many of the people involved in this audit. Zarlenga hypothesized the IRS could claim money as unpaid taxes, even if they don’t pursue penalties. “There’s still a lot of open questions the government needs to consider,” she said. “And I think the industry is starting to engage with the government to approach these questions.”

The pending Cryptocurrency Tax Fairness Act of 2017, which was offered as an amendment to the H.R.1 Tax Cuts and Jobs Act, would get the ball rolling for more legal clarity. But tax reform is a slow and controversial process. In the meantime, Coinbase officially declared the ruling a victory on their blog, saying: “Thanks to Coinbase’s efforts, more than 480,000 customers’ records were preserved from disclosure. This is a 97% reduction in the number of customers impacted by this summons.”

The numbers may be less important than the data collected about those individuals. At first, the IRS wanted all kinds of personal information about these accounts. The California court limited the order to a fraction of the original request. “The court said the IRS doesn’t need all the information it requested. So they significantly narrowed the amount of information that they could get in the summons,” Zarlenga said. “I think legally, it seems like a sound decision.”