On May 5, Judge Joseph Spero of the U.S. District Court for the Northern District of California, issued a one-page Order authorizing the IRS to serve a “John Doe” summons on Payward Ventures, Inc. d/b/a Kraken (“Kraken”). Kraken is a San Francisco based cryptocurrency exchange which bills itself as “consistently rated the best and most secure cryptocurrency exchange.” The Court’s order raises several pressing questions for taxpayers: What is a John Doe summons? What is the IRS after here?And why should taxpayers take notice?
John Doe and the IRS
The IRS uses John Doe summonses (a summons is the IRS equivalent to a subpoena) when it does not know the identity of taxpayers who it believes have not have been correctly reporting taxable transactions, but knows a source that can identify those taxpayers. So what the IRS wants from Kraken is access to the names and trades of everyone who has used the Kraken cryptocurrency exchange, so the IRS can see if those taxpayers are reporting their cryptocurrency transactions. As we previously discussed, certain transactions in virtual currency must be disclosed on Form 1040 and may also represent taxable capital gains or losses.
The Department of Justice (DOJ) stated in its press release that it was “seeking information about U.S. taxpayers who conducted at least the equivalent of $20,000 in transactions in cryptocurrency during the years 2016 to 2020.” At the heart of the matter is the taxation of cryptocurrency, which the DOJ described as follows:
The IRS issued guidance regarding the tax treatment of virtual currencies in IRS Notice 2014-21, which provides that virtual currencies that can be converted into traditional currency are property for tax purposes. The guidance explains that receipt of virtual currency as payment for goods or services is treated as income and that a taxpayer can have a gain or loss on the sale or exchange of a virtual currency, depending on the taxpayer’s cost to purchase the virtual currency (that is, the taxpayer’s tax basis).
The Internal Revenue Code, however, requires the IRS to comply with unusual procedures in the case of a John Doe summons, because it is viewed as a broad attack on individual privacies. The usual procedures allow the IRS to issue a summons to a specific taxpayer or entity (e.g., a bank) for books, records or information related to a specific designated taxpayer. It is up to the taxpayer then to move to quash the summons, but as you can imagine, the bar the IRS must pass to uphold the summons is fairly low. With a John Doe summons, on the other hand, Section 7609(f) requires the IRS to seek a court’s permission to issue the summons before it can serve it on the intended target. The IRS has to establish three things before the Court will permit the summons to be served:
- The summons relates to the investigation of a particular person or ascertainable group or class of persons,
- 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
- The information sought to be obtained from the examination of the records or testimony (and the identity of the person or persons with respect to whose liability the summons is issued) is not readily available from other sources.
The Case with Kraken
In this case, the IRS lost its initial application to the Court, and “the United States filed a response narrowing the proposed summons and further explaining the need for the information it seeks.” This resulted in the Court allowing the IRS to now serve the summons.
Is the game over? Not quite. The Court noted that the Order was “without prejudice to any argument that Kraken or its users might raise in a motion to quash,” and that any “further disputes as to the scope of the summons would benefit from adversarial briefing.” So neither Kraken nor any users of the exchange have had their day in court. It is unlikely that Kraken will “go gentle into that good night;” instead it is much more likely that Kraken will “Rage, rage against the dying of the light” with a full throttle attack on the John Doe summons. But the IRS has been historically successful in getting courts to allow the summonses and in getting taxpayers’ identities, as a result. For example, the IRS used the same procedure against Swiss bank UBS and affiliates in 2009 and again in 2013, resulting in the disclosure of the names of over 52,000 U.S. taxpayers having accounts in those banks.
The DOJ press release also touted another recent victory: “On April 1, 2021, a federal court in the District of Massachusetts granted an order authorizing the IRS to serve a similar John Doe summons on Circle, a digital currency exchange headquartered in Boston.”
Closing Thoughts and the Implication for Crypto
So what is the takeaway? Like its recent activities ramping up enforcement of Promoter transactions focused on micro-captive insurance and promoter sponsored conservation easements, the IRS is cracking down on cryptocurrency. This has spawned a cottage industry from nefarious scofflaws claiming to have ways to avoid paying tax on your cryptocurrency transactions. As the tagline read for the 1986 Jeff Goldblum movie, The Fly, “Be Afraid.Be Very Afraid.”
Two things are now very clear: the IRS is going to treat transactions involving cryptocurrency as the taxable sale or exchange of an asset (like stock, for example), and the IRS is absolutely committed to finding cryptocurrency users who have not reported their transactions correctly on their Form 1040s or business returns.
For more information about how the recent developments related to cryptocurrency may affect your reporting, please contact your CBIZ tax professional.
Published on May 11, 2021