IRS continues targeting virtual currency

The Internal Revenue Service (IRS) continues to expand its compliance efforts related to virtual currency. A Massachusetts federal judge recently authorized a John Doe summons enabling the IRS to subpoena virtual currency records directly from certain exchanges. In addition, the IRS launched program Operation Hidden Treasure to identify and combat serious noncompliance through virtual currency transactions.

Key takeaways

• To increase taxpayer compliance in reporting and paying tax on virtual currency transactions, the IRS is using a variety of tools, including court-ordered John Doe summons and a new Operation Hidden Treasure program.
• Virtual currency exchanges are being ordered by courts to supply the IRS with specific taxpayer-related data. The IRS then uses this information to locate and contact taxpayers in an effort to collect unpaid taxes.
• Through Operation Hidden Treasure, the IRS will identify tax evasion with virtual currency. Both civil and criminal cases will be pursued.
• Taxpayers should monitor and contemporaneously document virtual currency transactions and provide relevant data to their tax preparers and include on their annual tax return.

Background

Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account and/or a store of value. In certain circumstances, it operates similar to government-issued coins and paper money, like what is issued by the Federal Reserve in the United States, but does not have legal tender in any jurisdiction. Virtual currency that has an equivalent value in physical currency is known as “convertible” currency (e.g., Bitcoin).

Instead of being issued by a national government or bank, this is purely an unregulated, electronic form of currency. It can only be transacted though certain designated software, mobile or computer applications. It is typically held within a blockchain network in digital wallets.

Private issuers, developers or organizations can create and issue their own forms of virtual currency. The use of such currency can be restricted to a specific online community or it can be made available to the public. A virtual currency’s value is generally derived on some underlying mechanism or asset (which can lead to significant fluctuations in value).

The IRS taxes virtual currency as property. Gains or losses are recognized on the sale or exchange of a virtual currency, including when a virtual currency is converted in order to purchase goods, services or other forms of currency. The IRS believes there is a substantial amount of virtual currency transactions not reported via third parties (i.e., reported on Forms 1099 or 1098). Regardless of whether third-party documentation exists, taxpayers must still disclose such activity on their tax return in the year of transaction. The 2020 Form 1040 has a question for taxpayers regarding their use of virtual currency. Since a significant number of these transactions seem to go unreported by taxpayers each year, the IRS is expanding its investigation and accumulating necessary data to bring taxpayers into compliance.