IRS Entitled to Examine Cryptocurrency Exchange's Client Records

(Parker Tax Publishing December 2017)

A district court partially granted a petition to enforce a summons the IRS served on Coinbase, Inc., a virtual currency exchange, seeking information on transactions by Coinbase customers during 2013 through 2015. The court said that the records, which Coinbase claimed applied to 8.9 million transactions and 14,355 users, served a legitimate purpose of investigating whether gains on bitcoin transactions had been properly reported. U.S. v. Coinbase, Inc., 2017 PTC 536 (N.D. Cal. 2017).

Background

In Notice 2014-21, the IRS determined that virtual currencies that can be converted into traditional currency are considered property. Thus, a taxpayer can have a gain or a loss on the sale or exchange of bitcoin and other virtual currencies.

In 2016, the IRS served an initial summons on Coinbase, Inc., a virtual currency exchange, seeking records regarding almost all of Coinbase's customers for 2013 through 2015. The summons requested a broad range of documents including complete user profiles, know-your-customer (KYC) due diligence, documents regarding third party access, transaction logs, records of payments, and other documents. A district court granted permission for the IRS to serve the initial summons on Coinbase, but Coinbase refused to comply.

The IRS filed a petition to enforce the initial summons. The petition included a declaration from David Utzke, a senior agent in the IRS's offshore compliance program specializing in virtual currency, stating that the IRS was trying to determine the identity and tax liability of U.S. persons who conducted virtual currency transactions during 2013 through 2015. According to Utzke, the IRS believed that virtual currency gains are underreported. He said the IRS had found that only 800 to 900 taxpayers reported a virtual currency transaction on Form 8949, Sales and Other Dispositions of Capital Assets, for the relevant years. Utzke cited information from Coinbase's website that it operates in 33 countries, has 5.9 million customers and has exchanged $6 billion in bitcoin. By the end of 2015, Coinbase was the largest bitcoin exchange in the U.S. and the fourth largest globally, according to Utzke.

Eight months after the initial summons, the IRS requested permission to serve a narrowed summons on Coinbase. The narrowed summons requested information on accounts with at least $20,000 in any one transaction type (buy, sell, send or receive) in any one year and excluded users who only bought and held bitcoin as well as users for whom Coinbase filed Forms 1099-K. The IRS said that the narrowed summons was the result of discussions between it and Coinbase regarding the scope of records Coinbase would be willing to provide. Coinbase claimed that the narrowed summons applied to 8.9 million transactions and 14,355 users.

The narrowed summons requested registration records for each account, records of KYC customer due diligence, third-party access agreements, account activity records, correspondence between Coinbase and users or third parties regarding account opening, closing, or transaction activity, and all account invoices. Coinbase refused to comply with the narrowed summons and the IRS petitioned the district court for an order to enforce it.

Code Sec. 7602 authorizes the IRS to issue a summons to ascertain the correctness of any return, make a return where none has been made, and determine and collect the tax liability of any person. Under U.S. v. Powell, 379 U.S. 48 (1964), the IRS can obtain a court order enforcing a summons if it establishes that (1) the summons is issued for a legitimate purpose, (2) the summons seeks information relevant to that purpose, (3) the information sought by the summons is not already in the IRS's possession, and (4) the IRS satisfies all required administrative steps. If the IRS meets these requirements, the burden shifts to the taxpayer to show an abuse of process or lack of good faith by the IRS.

The parties did not dispute that the IRS satisfied the third and fourth elements of the Powell test. Coinbase argued that the summons lacked a legitimate purpose and sought irrelevant information. Coinbase argued that the term "likely related to bitcoin" in the summons was vague. It asserted that taxpayers who bought bitcoin at high prices in 2013 and sold in 2014 and 2015 probably had losses due to a fall in the price of bitcoin. Coinbase argued that the narrowing of the subpoena was arbitrary. Finally, Coinbase contended that the IRS was not permitted to use its summons power to conduct a general research.

The IRS argued that the records it sought would allow it to determine if users filed tax returns correctly reflecting any bitcoin gain or loss during the summoned period. The IRS also said that it requested broad swaths of records so that it would not need to return to court later to ask for them if and when needed.

Analysis

The district court partially granted and partially denied the IRS's petition to enforce the summons. In looking at the question as to whether the summons served a legitimate purpose and sought relevant information, the court concluded that the answer to the first question was yes and the answer to the second question was yes in part.

The court found that the summons served the legitimate purpose of investigating the reporting gap between the number of Coinbase's users and those reporting bitcoin gains and losses to the IRS. The court noted that the summons was supported by Utzke's declaration and that Utzke had sufficient personal knowledge to support his declaration. The court found it was reasonable for the IRS to premise an investigation on the assumption that taxpayers were reporting bitcoin transactions on Form 8949, and said that Coinbase offered nothing to suggest otherwise. The court rejected Coinbase's suggestion that its customers would be more likely to file paper returns, noting that 83 to 84 percent of taxpayers file electronically. The IRS was not required to define "likely related to bitcoin," the court found, but only to make a minimal showing that there were more Coinbase users transacting in bitcoin than filing electronic tax returns. Coinbase's argument that bitcoin prices fell in 2014 and 2015 was unpersuasive to the court because the narrowed summons sought information on accounts with transactions occurring within any one of the relevant years. Finally, the narrowing of the summons was not arbitrary, according to the court, because it was based on information the IRS learned after discussions with Coinbase in an attempt to reach an agreement regarding the records Coinbase would produce.

Coinbase's argument that the IRS was not permitted to use its summons power for general research was also rejected. The court found that the purpose of the investigation was related to tax compliance, not research, and that the IRS had provided a declaration describing how the disparity between the number of Coinbase users and the number of electronic returns created an inference that many users were not reporting their gains.

Next, the court considered the relevance of the requested records to the IRS's investigation. It found that the relevant identity documents were the taxpayer ID numbers, names, dates of birth, and addresses of account holders. Identity records that the court found were not relevant included account opening records, copies of passports or driver's licenses, wallet addresses, and public keys. The court held that transaction history records were relevant and ordered Coinbase to produce transaction logs, post transaction balances, and the names of counterparties. However, the court found that requests or instructions to send or receive bitcoin, and information identifying the users of such accounts where counterparties transact through their own Coinbase accounts and their contact information, were not relevant. The court also denied the request for Coinbase's records of KYC diligence, agreements granting third party access, and correspondence between Coinbase and users or third parties regarding account opening, closing or transaction activity.

Finally, the court found that the IRS did not commit an abuse of process in seeking to enforce the summons. It found that the IRS had met its burden of showing that the narrowed summons served the legitimate investigative purpose of enforcing tax laws against those who profit from trading in virtual currency and that the information the court ordered Coinbase to produce was relevant and no more than necessary to serve that purpose.

For a discussion of the IRS's summons authority, see Parker Tax ¶263,120. For a discussion of the treatment of gains and losses on virtual currency transactions, see Parker Tax ¶110,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com