Originally published on Forbes.com.
The United States District Court for the Northern District of California has approved a summons by the IRS to Coinbase Inc “seeking the records of Americans who in engaged in business with or through Coinbase, a virtual currency exchanger”. There has been enough coverage of this matter starting with the Justice Department press release and including posts by Kelly Erb and Bob Wood on this platform that I was inclined to let it pass, but I keep being nagged by the question of what I would do if I got a call from somebody who had been fooling with virtual currency. That sent me down the virtual currency rabbit hole, a topic that traces back to my earliest blogging days.
What Is Virtual Currency And Why I Don’t Mess With It
At this time, the most popular, but not the only, virtual currency is the bitcoin, so I’ll restrict my discussion to bitcoins. You can read a lot about the nuances of bitcoins starting with the wikipedia entry. When you get to the part about Iceland being a good place to set up your bitcoin mining operation because of the geothermal energy and the arctic air, you may have gone far enough. The thing I’m going to focus on is the blockchain. The blockchain is like a really thorough version of the website “Where’s George” which allows people to enter the serial numbers of dollar bills and note where they got them, so you can watch how a dollar bill moved from one place to the other.
Every transaction with every bitcoin ever is recorded in the blockchain, which is public. The accounts are called “wallets”. In order to spend your bitcoins you send a message to transfer bitcoins from your wallet to somebody else’s wallet. You have to provide your “private key” to do this. This is all done by software of course. As best I can understand it, the private key is mathematically associated with the public key.
The system works because some mathematical things are easy to do one way, but very hard to do another way. For example, multiplying is pretty easy, but factoring can be hard. If you have an old fashioned calculator multiply 101 by 137. It will take you less than a minute. Now, no cheating here, try to systematically factor 13,837. To do that you divide 13,837 by each prime number until you get one that comes out even or you go past the square root of 13,837. It took me three minutes. However as the numbers get bigger, the difference in the time it takes increases exponentially.
The mathematical conversion for a private bitcoin key to a public bitcoin key is more complicated than multiplying. I’ll let you read about it and you can explain it to me, but I’m not going to look into it further until I understand semiotics, presuppositionalism and Foucault. The principle is the same. The private key could be derived from the public key in principle, but not in any practical sense. Of course that’s what the Germans thought about their Enigma – just saying.
So a big reason I don’t fool with bitcoins is that if you lose your private key or somebody else gets a hold of it, you are out of luck. When was the last time you had to give up the name of your first pet or whatever so they would reset your password to something or other? If it is less than a year ago, then bitcoins are probably not for you. Apparently lost bitcoins are a real thing according to this article by Lauren Orsini
55% of bitcoins that have been issued to date were active in the third quarter of 2013; 10% of bitcoins haven’t been active since 2012. And a substantial 35% haven’t been spent since 2011. It’s this third number that is most likely to consist of lost coins, though they could just be being hoarded.
Then there is the price fluctuation. Bitcoins shot up in value in late 2013 to over $1,000. They were below $400 early in 2016 and are over $700 as I write this. So if I did bother with bitcoins it would be more as a speculative investment not as a medium of exchange. But there is the anonymity. Right?
About That Anonymity
In the memorandum supporting its petition for a “John Doe” summons on Coinbase, the US attorneys lay out causes for concern. Essentially they suspect that people are avoiding reporting requirements by transacting business in bitcoins. And then there are all the capital gains. In Notice 2014-21, the IRS let us know that since bitcoins are property, meaning you have to recognize gain when you exchange them for something else (they kind of hedge on whether you recognize loss). So people who have been trying to live in the bitcoin economy have a lot of reporting to do even if they were not trying to get away with anything.
Using the anonymity to avoid reporting income at all seems to be the main concern of the IRS fishing expedition:
Senior Revenue Agent Utzke identified and interviewed three taxpayers who had used virtual currencies as a means of evading taxes. Two of these taxpayers were corporate entities with annual revenues of several million dollars that bought and sold bitcoins. Both entities had wallet accounts at Coinbase and attempted to conceal bitcoin transactions as technology expenses on their tax returns. Id. The third taxpayer diverted his income to an offshore tax haven and used virtual currency to repatriate his assets without government detection.
The more I think about it, the dumber it seems. Once the IRS can identify a bitcoin account as belonging to you, they can extract every single transaction from the blockchain. In some cases they will have identified the other side of the transaction. If the IRS has its data processing act together, a big if granted, this could be like shooting fish in a barrel. The criminal mastermind who has been doing nefarious transactions with a bitcoin wallet, just has to have one counter-party rat him out and the IRS now has every transaction that ran through that wallet identified to him.
Computer savvy whistleblowers will have a great time. Bitcoin miners can take up tax informing as a sideline.
What To Do
So how should you react to this interest by the IRS in bitcoin transactions, if you have been receiving income in bitcoins and have kind of sort of forgotten to report it? Here is some good news. Scot Michel and Mark Matthews observe that the filing of a John Doe summons is not the equivalent of the opening of an investigation into the tax misdeeds of any particular John or Jane.
U.S. taxpayers who are not in tax compliance arising from virtual currency transactions involving Coinbase have an extremely short window to avoid serious tax problems. The IRS has a longstanding voluntary disclosure policy, which allows taxpayers – without any public disclosure – to correct prior tax non-compliance, avoid criminal prosecution and usually receive more lenient treatment than one would see in a criminal or civil tax proceeding. The IRS policy is clear that the issuance of a John Doe summons does not disqualify a taxpayer from making a voluntary disclosure, but once Coinbase complies and gives the IRS its customers’ names, any disclosure is likely too late. Anyone who has a Coinbase account and who has tax exposure should contact a tax professional immediately.
If you have been doing your bitcoin dodging on a grand scale, it is best to start with a lawyer rather than an accountant. If amended returns are in order the lawyer will hire the accountant. This is important because, in general, communications with an accountant are not privileged.
If, on the other hand, you have just neglected to report some gains from the sale of bitcoins, just do amended returns if you are the nervous type or run for luck if you are on the wild and crazy side.
On the third hand, if your involvement with bitcoins has been entirely innocent, but of a high volume, it would be prudent to assemble all supporting data that demonstrates that all your bitcoin receipts were either reported on your return or items that were not required to be reported. Revenue agents are trained as accountants, they respond better to ticked and tied schedules than to elaborate stories.
An Accounting Nerd Observation
You will often see the blockchain referred to as a ledger. As I read the descriptions, though, I think that it is actually more of a journal. Back in the day we would have various journals that item by item recorded things like purchases, sales, receipts and disbursements. The totals from the journals would be “posted” to the ledger. At year end, the income accounts would be closed. To analyze an account was to show the exact transactions that went into that account. A critical component of the process was to cut things off. Beginning in the eighties, we entered a kind of brave new world thanks to databases. Some of the systems designed to use them were focused on issues like inventory management with the accounting functions thrown in. It sometimes seemed that it was like never being able to step into the same river twice.
The blockchain really intrigues me because all the transactions are preserved in all their granularity forever and the blockchain discipline assures that they all remain in order. You can’t do any backdating with the blockchain. It is like everybody’s books are closed every ten minutes or so. And you can create the cash receipts and cash disbursements journal for every wallet for any period you want from here to eternity. The books close every ten minutes, but in a sense remain open forever.
There is a lot more coming out of the blockchain concept than bitcoins. I got a glimpse of it on the etherum website. It is going to be interesting, but that is far beyond the tax reservation.