TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

Why is it that tax compliance involving this emerging asset continues to be problematic?  Aside from any individualized taxpayer’s confusion or potential motivations, one additional answer may be the direct result of the lack of third-party reporting requirements.  While digital currency exchanges, under Title 31 and the Bank Secrecy Act, are generally regulated as money transmitters and required to maintain certain records,[1]  for many cryptocurrency exchanges, the reporting requirements under Title 26 are somewhat limited.  For example, there is no requirement for the issuance of a Form 1099-B to their users and 1099-K is only required if the user exceeds $20,000 in transactions and the aggregate number of such transactions exceed 200 in one year.[2]  Unfortunately, as experience has shown, third-party reporting is often one of the great human regulators when it comes to tax compliance.  In other words, this lack of third-party reporting obligations often means “out of sight, out of mind” for taxpayers.  This in turn can lead to what the IRS considers to be a rampant amount of intentional “forgetfulness” on the part of taxpayers, who may otherwise have independent obligations to report cryptocurrency transactions on their tax returns.    

The IRS has not been shy in recent years in expressing its position that obtaining information about a U.S. taxpayer’s cryptocurrency transactions is necessary to tax administration.  Obtaining such information, however, can be a bit like looking for a needle in a haystack.  That said, in instances where the IRS can establish that a group of unidentified taxpayers are engaged in conduct that may violate U.S. tax laws, Congress has provided an investigation tool for the IRS to use to make its search a bit easier.  That tool is known as a John Doe summons.

A John Doe summons, unlike an individualized summons used in an investigation of a single taxpayer and which the IRS can issue without judicial approval,[3] permits the Government to obtain information about a larger group of unidentified taxpayers where the Government can demonstrate a reasonable belief that the “unidentified” taxpayers are engaged in conduct that may violate U.S. tax laws.  In the context of obtaining information related to unidentified taxpayers’ use of cryptocurrency transactions, the Government’s first attempt to use a John Doe summons was in 2017 and was directed at Coinbase, the largest cryptocurrency exchange in the world.  That case was heard by the United States District Court for the Northern District of California, which initially determined the scope of the Government’s request for information to be overbroad.[4]  While the Court narrowed the reach of the summons, ultimately, Coinbase, was required to respond and turned over 14,355 users’ information to the IRS.

Since the decision in Coinbase, the law involving the issuance of John Doe summons has been narrowed by the Taxpayer First Act of 2019 (“TFA”).  The three prong test must still be met by the Government for a Federal Court to grant the right for the IRS to issue a John Doe summons, namely the following:[5]

1. The John Doe summons relates to the investigation of a particular person or ascertainable group or class of persons;
2. There is a reasonable basis for believing that such person or group or class of persons may fail or may have failed to comply with any provision of any internal revenue law, and
3. The information sought to be obtained from the examination of the records or testimony (and identity of the person(s) with respect to whose liability the summons is issued) is not readily available from other sources.

However, now the Government must also meet the narrowly tailored requirement in the flush language of the statute added as part of the (TFA).[6]  That language requires that the information sought to be obtained in the summons should be narrowly tailored to information that pertains to the failure or potential failure of the group or class of persons that have failed to comply with one or more provisions of the internal revenue laws which have been identified.  So, in light of the TFA and the decision in Coinbase, both of which involve a narrowing of the reach of the IRS under a John Doe summons, what can taxpayers expect in future IRS’s requests for authorizations to issue John Doe summonses?  The answer may already be before us, based upon the filing of two recent John Doe summons cases discussed herein.

The Circle John Doe Summons Case

On March 30, 2021, the Government filed a petition for approval to issue a John Doe summons to Circle Internet Financial, Inc. and its affiliate Poloniex LLC cryptocurrency exchange (“Circle”).[7]  Poloniex is the 18th-largest cryptocurrency exchange by trading volume and is known for supporting a variety of digital currencies.[8]  The case was filed in the United States District Court for the District of Massachusetts.   The Government cited to the TFA and Coinbase case and spelled out why it believes that virtual currency transactions are not being properly reported and the role that the lack of third-party reporting plays in this deficiency.   In the words of the Government, this “information gap” increases tax noncompliance and makes the “likelihood of underreporting significant.”[9]  The Government also noted that the limitations imposed in Coinbase were not in the summons for Circle because the terminology of Circle’s exchanges differ.[10]  The Government also argued that the summons meet not only all three of the numbered criteria in § 7609(f), but also the new “narrowly tailored” requirement.[11]  On April 1, 2021, the Court issued an order allowing the Government to serve the requested John Doe summons against Circle.[12]   

The Kraken and Coinbase John Doe Summons Cases

The same day, March 30, 2021, that it filed the Circle case, the Government filed another John Doe summons case, seeking authorization to summons records from the cryptocurrency exchange Payward Ventures Inc. d/b/a Kraken (“Kraken”).[13] Kraken is one of the largest digital currency exchanges with over 4 million clients and over $140 billion in trading activity since 2011.[14]  It has been reported that, as of the end of 2017, Kraken was registering up to 50,000 new users a day.[15]     

The John Doe summons case against Kraken was filed in the United States District Court for the Northern District of California, the same Court which heard the Coinbase matter.  Perhaps, as might have been expected, the filing of the Kraken case was met with judicial resistance from the Court.  Citing to the  limitations set forth in  the Coinbase case, the Court in Kraken issued an order requiring that the Government show cause why the petition to grant the John Doe summons should not be denied.[16] Specifically, the Court, relying on the analysis in the Coinbase decision, questioned whether the broad category of information sought in the John Doe summons was irrelevant and premature, such that the IRS should first review the basic user information and transaction histories (e.g., derived from a more limited summons to Kraken) should happen before determining whether further summonses – to either the cryptocurrency exchange or to individual users – are necessary or appropriate under the law.[17]

The Government, in response to the Court’s order, agreed, as it had done in Coinbase, to  narrow the scope of the information requested in the Kraken John Doe summons.[18]  Thus, the  revised summons request for Kraken excluded, from the original summons request, “all correspondence between Kraken and the User or any third party with access to the account pertaining to the account, including but not limited to e-mails, chat support logs, telephone logs or recordings, letters, or other memoranda of communication.”[19] 

Conclusion

The adverse impact on tax administration by the lack of third-party reporting by cryptocurrency exchanges that may result in taxpayer non-disclosure and non-compliance is clearly something the IRS recognizes as a problem.  It is also information that the IRS, by the filing of simultaneous, coast-to-coast John Doe summons requests, has very publicly signaled it has every intention of affirmatively going after “one haystack at a time”.

Sandra R. Brown is a Principal at Hochman Salkin Toscher Perez P.C., and former Acting United States Attorney, First Assistant United States Attorney, and the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal). Ms. Brown specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court. 

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C.

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[1] See FinCEN Guidance No. FIN-2013-G001: Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies (Mar. 18, 2013), available at https://www.fincen.gov/sites/default/files/shared/FIN-2013-G001.pdf [https://perma.cc/E9C8-YH3C]; FinCEN Guidance No. FIN-2019-G001: Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies (May 9, 2019), available at https://www.fincen.gov/sites/default/files/2019-05/FinCEN%20Guidance%20CVC%20FINAL%20508.pdf [https://perma.cc/6BVK-AJVP]. 

[2] IRC §6050W(e).

[3] 26 U.S.C. §7602(a).

[4] United States v. Coinbase, Inc., No. 17-cv-01431-JSC, 2017 WL 5890052, at *6-7 (N.D. Cal. Nov. 28, 2017).

[5] 26 U.S.C. §7609(f).

[6] Pub. L. No. 116-25, §1204(a), 133 Stat. 988 (2019).

[7] In the Matter of the Tax Liabilities of John Does, No. 21mc91201 RGS, Docket No. 3, (D.Mass. March 30, 2021).

[8] Evelyn Cheng, Circle Acquisition of Poloniex is Just The Beginning of Likely Consolidation in Crypto, CNBC, (Feb. 26, 2018), available at https://www.cnbc.com/2018/02/26/circle-acquisition-of-poloniex-is-just-the-beginning-of-likely-consolidation-in-crypto.html.

[9] In the Matter of the Tax Liabilities of John Does, No. 21mc91201 RGS, Docket No. 3, page 8, (D.Mass. April 1, 2021).

[10] Id. at 9.

[11] Id. at 15.

[12] In the Matter of the Tax Liabilities of John Does, No. 21mc91201 RGS, Docket No. 5, (D.Mass. April 1, 2021).

[13] In re Tax Liability of John Does, Case No. 21-cv-02201-JCS, Docket No. 2, (N.D. Cal. March 30, 2021).

[14] Lara AbdulMalak, Kraken Crypto Exchange Opening up Shop in UAE, Unlock, available at https://www.unlock-bc.com/news/2019-05-14/kraken-crypto-exchange-opening-up-shop-in-uae.

[15] Frank Chaparro, Bitcoin exchange Coinbase reportedly made more than $1.25 billion in revenues last year, Business Insider, (Jan 23, 2018), available at https://www.businessinsider.com.au/coinbase-reportedly-made-more-than-1-billion-in-revenues-last-year-2018-1.

[16] In re Tax Liability of John Does, Case No. 21-cv-02201-JCS, Docket No. 6, (N.D. Cal. March 31, 2021).

[17] Id. at 3.

[18] In re Tax Liability of John Does, Case No. 21-cv-02201-JCS, Docket No. 8, page 8, (N.D. Cal. March 31, 2021).

[19] Id. at 15.