The landscape is rapidly changing for those with ties to crypto. One just needs to peruse the daily tax press to read about the increasingly stiff penalties and potential criminal exposure for those operating in this industry. Despite crypto's useful and legitimate applications, tax authorities globally remain focused on the lookout for potentially abusive and criminal activities. Unfortunately, some institutions and individuals with the best intentions may get painted as nefarious with the broad brush. Therefore, it is imperative that institutions involved with crypto stay current with their tax obligations and abreast of the tax enforcement efforts. This article highlights three recent developments in this arena and offers suggestions for institutions and individuals to minimize their respective risks and exposure.
Honing and sharpening tools – the J5
The global fight against tax evasion and money laundering was boosted in 2018 by the creation of the "J5" – the Joint Chiefs of Global Tax Enforcement, which includes enforcement authorities from Australia, Canada, the Netherlands, the United Kingdom, and the United States. The goal of the J5 is to increase collaboration in the fight against international tax crime and transnational money laundering. We expect their efforts to root out these types of crimes to intensify as an increasing amount of data is shared among cooperating investigators. Recently, in November 2019, the J5 specifically announced that cybercrime and the threat that cryptocurrencies pose to the lawful administration of tax enforcement is one of the J5's main areas of focus. At that time the J5 organized the "crypto challenge" with some of its members sharing data seized during earlier investigations of cryptocurrency providers.
As a testament to J5's effectiveness, in February 2020 the Dutch Fiscal Intelligence and Investigation Service arrested two men in connection with criminal investigations on suspicion of money laundering using cryptocurrencies. Both men, unrelated to each other and in their transactions, were arrested by Dutch authorities for transacting significant sums in cryptocurrencies including crypto credit cards, with one of the individuals transacting over 2 million euros. By identifying their crypto addresses, the investigators identified the user's IP-addresses, which led them to the individuals themselves. Both men used the same crypto service provider. While it appears that the crypto service provider has been implicated in the concealing and laundering of income, no public charges or settlements as to the provider have been announced to date. It is likely that the sharing among J5 members of data obtained from independent investigations of cryptocurrency providers will probably lead to more international investigations by J5 countries.
The IRS's virtual currency compliance and enforcement campaign continues
As the use of virtual currencies expands, the collection of taxes related to these transactions has become a significant focus of the IRS. Back in 2014, the IRS issued Notice 2014-21 regarding the tax treatment of certain virtual currency transactions. These guidelines acknowledge that virtual currencies are customarily used as a medium of exchange and act as substitutes for physical currency. However, the Notice explained that generally transactions involving virtual currency are to be treated as property. In October 2019, the IRS issued Revenue Ruling 2019-24 and 43 FAQs. The revenue ruling and the FAQs provided additional information regarding the tax treatment of cryptocurrency transactions such as how to calculate gains or losses when selling virtual currency for real currency or property, and how to determine a cryptocurrency's fair market value. IRS Commissioner Chuck Rettig in a press release issued with the 2019 guidance stated the IRS was "committed to helping taxpayers understand their tax obligations in this emerging area." The release also states the IRS will also "take steps to ensure fair enforcement of the tax laws for those who don't follow the rules."
The warning – to the taxpayer
The IRS is well-aware that there is a significant compliance issue involving taxpayers reporting virtual currency transactions. For each year between 2013 and 2015, only about 900 taxpayers reported a gain or loss involving virtual currency yet more than 14,000 transactions occurred on at least one exchange during the same time period. Thus, it appears the IRS recently shifted its focus from guidance to the warnings as a precursor to its enforcement intentions.
In 2017, the IRS took a significant enforcement effort with the issuance of John Doe Summonses to one of the largest virtual currency exchanges. After some significant challenges from the exchange, in 2017, the IRS received financial information for 14,355 customers who engaged in crypto-transactions of US$20,000 or more. The IRS also revealed it collected information from other databases, some overseas, regarding individual transactions. In mid-2019, the IRS announced the mailing of "educational" letters to more than 10,000 taxpayers involved in virtual currency transactions. While it remains unclear how these taxpayers were identified, the IRS reported that the names were obtained through "various ongoing" IRS compliance efforts, thus suggesting that these letters may not be the last of to be sent.
The letters (Letter 6173, Letter 6174 and Letter 6174-A) inform the recipients that they either may have failed to report income and tax from a virtual currency transaction or may have not reported the transaction properly. The letters provide information regarding tax and filing obligations concerning virtual currency dealings and how to correct past errors. Only one of the letters, Letter 6173, requires a response by a particular date. It provides the following options: (1) filing of delinquent returns and reporting virtual currency transactions as soon as possible, (2) filing an amended return indicating any mistakes or incorrect calculations, or (3) returning a signed affidavit (under penalties of perjury) indicating that that the taxpayer has complied with all tax and reporting requirements relating to virtual currency accounts. It warns that failing to respond may cause a referral to exam. While Letters 6174 and 6174-A do not require a response, taxpayers receiving either should seek guidance. For example, Letter 6174-A states that failure to respond may result in the IRS sending further correspondence "about potential enforcement activity in the future." Regardless of which letter a taxpayer receives, the overlying message is the same – satisfy your tax obligations concerning your virtual currency transactions or face potential penalties.
This may be particularly challenging to those involved in these transactions as the IRS specifically foreclosed the idea of offering of a voluntary compliance initiative, similar to the Offshore Voluntary Disclosure Program that assisted numerous US taxpayers with bringing their previously undisclosed offshore assets into compliance. Thus, with the issuance of the letters and the foreclosing of the any compliance initiative, taxpayers with virtual currency transactions should act quickly to address any issues with their filings before the IRS's efforts intensify with audits or criminal investigations. In every case, taxpayers should consult experienced counsel before responding, as any response can be considered an admission and used in a criminal enforcement action.
The warning – to the virtual currency industry
Following the off-shore prosecution playbook, which resulted in settlements with over 80 Swiss banks and the prosecutions of numerous individuals, the virtual currency industry appears particularly vulnerable to the same approach. As noted above, now that the IRS has identified thousands of taxpayers who appear to have inadequately reported virtual currency transaction, agents will surely begin to meet with these individuals and gather information regarding these transactions. To potentially avoid or reduce their own exposure, individuals may be motivated to provide substantial assistance in the prosecution of others. Since there currently exist more than 10,000 potential criminal defendants, DOJ may have their choice of individuals willing to offer evidence against other individuals or institutions in exchange for leniency – a tool frequently employed successfully by US criminal prosecutors. These allegations by individuals regarding cryptocurrency institutions, including their officers, agents, and employees, may form law enforcement's initial perception of the institutions, including how the accounts were set up and marketed, as well as the anonymity element of the transactions. It will also include the names of the companies involved, as well as their employees, officers, and agents. Afterwards, DOJ and the IRS may pursue cases against those in the industry that they perceive as complicit in tax evasion and money laundering efforts, just as they did in the Swiss Bank Program. Thus, it is important to protect against this possibility and identify any issue before contact by DOJ.
Still holding financial institution responsible
In December 2019, the Department of Justice reminded financial institutions that it was not done holding them accountable for assisting US citizens in evading taxes. Specifically, a private bank headquartered in Geneva agreed to pay US$192.35 million in penalties as part of a deferred prosecution agreement for its role in assisting US taxpayers in avoiding paying taxes on undeclared assets. In conjunction with the agreement, Acting Deputy Assistant Attorney General Stuart M. Goldberg of the DOJ's Tax Division stated that "we will hold these institutions to account, right along with the taxpayers that use them to facilitate and disguise illegal activities." This is a strong indication that DOJ is continuing its highly successful off-shore bank program.
The time to act is now
If the penalties imposed in the Swiss Banks Program are indicative, then organizations that DOJ determines to be complicit in tax evasion can expect to turn over a significant portion of any proceeds from these transactions, pay significant fines, and involved individuals could face prison. Likewise, taxpayers who intentionally fail to report virtual currency transactions could face severe fines and criminal penalties, including years in prison.
There are measures that can be implemented now to avoid or reduce potential exposure. For institutions such measures include developing corporate compliance programs to ensure that an institution's services are not being used or promoted to facilitate tax evasion or money laundering. Measures also include policies and procedures, as well as internal controls, to prevent the individuals from intentionally circumventing US laws. When questionable activity is suspected or disclosed, the institutions should undergo a full range of measures including remediation and consider whether self-reporting is beneficial. For individuals utilizing virtual currency, they should seek counsel from attorneys to reduce potential liabilities.
The tax man is coming again, and the institutions and individuals associated with the crypto industry should evaluate their current position, and if necessary, take action now to minimize their potential exposure and risk of being swept up into the next enforcement wave. The risk of detection is high. Now is the time for those in the industry to carefully examine their interactions to assess any potential exposure as this enforcement effort will certainly move to the next level in the very near future. Finally, as DOJ has demonstrated repeatedly, its reach extends well beyond US borders.