Given the IRS’s steady shift to a more holistic tax enforcement approach, the Author believes that the IRS is likely to take a broad-based approach to cryptocurrency tax enforcement.
This Article reviews the IRS’s previous enforcement models, and considers how these have shifted in recent decades. The IRS has increasingly moved away from a purely punitive system towards one that focuses on customer service, the theory being that a procedurally fair system will increase taxpayer satisfaction and voluntary compliance. Given the IRS’s steady shift to a more holistic tax enforcement approach, the Author believes that the IRS is likely to take a broad-based approach to cryptocurrency tax enforcement.
Rather than a world of increasingly aggressive tax law enforcement, as Davidson and Rees-Mogg suggest, we may instead witness a continued strategic shift in resources deployment by the IRS away from criminal prosecutions as the IRS ramps up its cryptocurrency enforcement efforts.
The recent experience of the IRS’s Swiss Bank efforts can give some helpful clues as to how the IRS intends to approach cryptocurrency evasion. Indeed, IRS criminal tax prosecutions have actually been in steady decline over the past decade. Yet the IRS successfully convinced tens of thousands of offshore account holders to come forward, file back tax returns and Foreign Bank Account Reports, and even pay substantial fines. To accomplish this, the IRS has used large-scale “John Doe” summons efforts coupled with general threats of prosecution, to steer people to enter these offshore voluntary disclosure regimes. Using the recent example of this IRS Swiss Bank enforcement effort, we ask how a similar enforcement model might, and might not, work to close the tax gap with respect to cryptocurrency tax collection.
Back in 1999, before bitcoin or other cryptocurrencies had even been conceived,1 Milton Friedman predicted the rise of virtual currencies which would allow people to transfer funds without going through financial intermediaries.2 “I think that the Internet is going to be one of the major forces for reducing the role of government,” he told the National Taxpayers Union. But two years before, James Dale Davidson—the founder of the Taxpayers Union—had also envisioned the future of virtual currency. Unlike Friedman, his vision included a remarkably bleak view of how world governments would respond to the adoption of new financial technologies.
In The Sovereign Individual: Mastering the Transition to the Information Age,3 Davidson and William Rees-Mogg wrote about a future world rife with offshore tax evasion and fiat currency debasement, leading to an economic flight to “cyberspace.”4 Here is how they put it:
When the state finds itself unable to meet its committed expenditure by raising tax revenues, it will resort to other, more desperate measures. Among them is printing money…. In almost every competitive area, including most of the world's multitrillion dollar investment activity, the migration of transactions into cyberspace will be driven by an almost hydraulic pressure-the impetus to avoid predatory taxation, including the tax that inflation places upon everyone who holds his wealth in a national currency.5
Davidson and Rees-Mogg described a future in which western governments will “turn nasty” and “seek to suppress the cybereconomy by totalitarian means.”6
One might argue that we are already there. Anyone who has been audited by the IRS for cryptocurrency transactions might indeed feel that way. Or maybe this future is just around the corner. But are we truly in store for massive totalitarian imposition of tax on cryptocurrency transactions or even the outlawing of such transactions, as some countries have sought to do?7
We could be, but it is also worth looking at what Davidson and Rees-Mogg got wrong. For example, they predicted that governments will find themselves virtually unable to track cyberspace transactions, especially those that end up in offshore banks. They write:
Widespread adoption of public-key/private-key encryption technologies will soon allow many economic activities to be completed anywhere you please…. Once the next logical steps have been taken, and offshore banking locations offer the services of communication in hard RSA-encrypted electronic mail using account numbers derived from public-key systems, financial transactions will be almost impossible to monitor at the bank or in communications. Even if the tax authorities were to plant a mole in the offshore bank, or burglarize the bank records, they would not be able to identify depositors.8
Moles in offshore banks? Burglarizing the bank records? Hardly. The authors underestimated the power of Western governments to ferret out tax evasion even in a global and increasingly mobile economy.
Nowadays, IRS tax collectors do not need to burglarize any offshore bank to obtain their records. Swiss banks (and almost every other country’s banks) regularly open their books to U.S. and other Western tax collectors.9 The question remains, though, whether despite increased banking transparency, cryptocurrencies will still prove to be such financial game-changers as to realize Davidson and Rees-Mogg’s prediction of a government war on cyberspace.
Certainly Western governments have proven more adept at tracking offshore banking transactions than the authors envisioned. Davidson and Rees-Mogg did not foresee the United States’ offshore enforcement efforts over the past decade,10 nor Congress’s passage of the Foreign Account Tax Compliance Act (“FATCA”).11
And how could they have? It seemed almost impossible that the Swiss would just abandon their long-held bank secrecy tradition when the U.S. came knocking.12 Indeed, even when the IRS first issued summonses to Swiss banks, the immediate reaction of commentators was not to wonder about criminal charges for the banks (which were in fact coming), but to question whether the IRS even had the right to make these requests in the first place.13
But never say never. As the IRS looks to increase tax compliance amongst cryptocurrency users, it is confronting similar issues—of how to obtain information on transactions that are in many ways currently beyond the reach of its information reporting rules, and how to manage resources effectively when there are many more non-compliant taxpayers than there are IRS Agents. The IRS’s Swiss Bank program was so extraordinarily successful that it is likely to serve as a model for the Agency’s efforts to curb cryptocurrency tax evasion. But will it suffice? This is the multi-billion dollar question.14
Despite their underestimation of the IRS’s agility in responding to offshore tax evasion, Davidson and Rees-Mogg were right to have predicted an increasing tension between government regulators and new financial technologies.
The IRS has already bristled at the lack of reporting of cryptocurrency gains,15 and has taken the opening shots (by enforcing a summons against Coinbase, the leading bitcoin trading exchange)16 in what is likely to be part of a larger and more wide-scale enforcement effort.
Due to the difficulty of tracing cryptocurrency transactions17 and the amount of tax revenue at stake, we can certainly expect more heavy artillery strikes from the IRS following their opening salvos. But what form will they take, and what issues might arise as the IRS tries to close the cryptocurrency tax gap?
This Article reviews the IRS’s previous enforcement models, and considers how these have shifted in recent decades. The IRS has increasingly moved away from a purely punitive system towards one that focuses on customer service, the theory being that a procedurally fair system will increase taxpayer satisfaction and voluntary compliance.18 Given the IRS’s steady shift to a more holistic tax enforcement approach, we think that the IRS is likely to take a broad-based approach to cryptocurrency tax enforcement.
Rather than a world of increasingly aggressive tax law enforcement, as Davidson and Rees-Mogg suggest, we may instead witness a continued strategic shift in resources deployment by the IRS away from criminal prosecutions as the IRS ramps up its cryptocurrency enforcement efforts.
The recent experience of the IRS’s Swiss Bank efforts can give some helpful clues as to how the IRS intends to approach cryptocurrency evasion. Indeed, IRS criminal tax prosecutions have actually been in steady decline over the past decade.19 Yet the IRS successfully convinced tens of thousands of offshore account holders to come forward, file back tax returns and Foreign Bank Account Reports, and even pay substantial fines.20 To accomplish this, the IRS has used large-scale “John Doe” summons efforts coupled with general threats of prosecution, to steer people to enter these offshore voluntary disclosure regimes.21 Using the recent example of this IRS Swiss Bank enforcement effort, we ask how a similar enforcement model might, and might not, work to close the tax gap with respect to cryptocurrency tax collection.
In the 1980s the IRS began explicitly working towards closing the “income tax gap.”22 IRS Commissioner Roscoe Egger reported in 1982 that this gap in the legal sector grew from $29 billion in 1973 to $87 billion in 1981,23 and he projected it would grow to $120 billion by 1985.24 The gap in the illegal sector was projected to be much larger, and more broadly the income tax gap was increasingly viewed as a threat to the income tax itself.25
The economic model informing policymaking at the time was heavily based on economics of crime analysis, first introduced by Gary Becker in 1968.26 In the 1970s, this economics of crime model was applied to taxation by Michael Allingham and Agnar Sandmo.27
The economics of crime approach generally treats criminal activity as a rational individual decision that depends upon probabilities of detection and conviction and levels of punishment. Becker explicitly suggested that this methodology was applicable to tax evasion and avoidance.28 Allingham and Sandmo were able to derive conditions under which an increase in the penalty rate (or the probability of imposition of sanctions) increases the reported taxable income of a rational maximizing taxpayer.29 The model assumes a proportional tax schedule and certainty about both the penalty schedule and the probability of sanction imposition.30
With this economic model, the U.S. responded to the perceived tax compliance “crisis” in 1982 by increasing penalties and expanding information reporting, in order to increase both the probability of detection and the cost of punishment. This included legislation that provided penalties for substantial understatements of tax liabilities,31 for aiding and abetting understatements of tax liabilities,32 for the filing of frivolous returns,33 for failure to file information returns,34 and for extended failure to file tax returns.35
Congress also increased the penalty for failure to supply taxpayer identification numbers,36 increased criminal fines,37 and implemented new requirements for registering tax shelters with the IRS and for maintaining lists of tax shelter investors.38 Congress even gave the IRS authority to seek injunctive relief against the promoters of abusive tax shelters, seeking to head off tax evasion in some cases before it had even taken place.39
This legislative history illustrates Congress’s belief that increased penalties and information reporting would help to narrow the income tax gap. The Congressional Committee Reports on the 1982 Act describe the tax collection process as an “audit lottery,” and presumes that citizens endeavor to maximize their own narrowly perceived financial self-interests.40 Most analysis at the time involved a fairly straightforward model which pits a single taxpayer (who is attempting to maximize personal gain and weighing this against the risk of detection and penalties for non-compliance) against the IRS.41 The idea is that if risk of detection and penalties increase, so should compliance.42
However, some early critics noted that there may not be a linear relationship between increased penalties and increased compliance. In the mid-1980s, Jackson and Milliron argued that the cost of increased sanctions could outweigh the benefits.43 They suggested taxpayers may become alienated if sanctions are perceived as too severe, resulting in general antagonism and disrespect for the law.44
Some commentators have argued that the economic model should be expanded to include the IRS as a strategic actor in a game-theoretic approach.45 Even with this change, the model would still generally have the structure of a single rational taxpayer’s decision-making pitted against the IRS.
It is also worth asking whether it is a failing of the model that its analysis envisions a single taxpayer, rather than groups of similarly situated taxpayers who are forced to make game-theoretic decisions in response to enforcement efforts.46 For example, cryptocurrency investors, as dispersed as they are, may in some instances respond to perceived IRS enforcement policies as a group and look to each other’s behavior as a guide for informing their tax compliance postures.47
In the 1990s, other critiques noted that the traditional economic model fails to explain high voluntary tax compliance rates given low audit rates, and suggests that in addition to enforcement and information gathering by the IRS, psychological or cultural factors should be considered as well.48 There were also studies conducted outside the tax context which suggest that perceptions of procedural fairness can promote voluntary compliance.49
This academic shift to a focus on non-economic factors coincided with a public backlash against the more punitive approach the IRS had taken in the 1980s.50 After Congressional hearings focusing on IRS overzealousness, where “horror stories” of IRS misdeeds were recounted,51 Congress in 1998 passed the Internal Revenue Service Restructuring and Reform Act of 1998 (the “1998 Act”). The 1998 Act sought to promote a renewed focus on “taxpayer rights” and “customer service.”52
The 1998 Act included a Taxpayer Bill of Rights, a changed mission statement for the IRS that did not mention the collection of taxes, and restrictions on enforcement activity.53 It even called for termination of an IRS Agent’s employment where the employee has violated taxpayers’ rights.54 The 1998 Act also shifted the burden of proof in some civil matters from taxpayers to the IRS, and established a public review board overseeing IRS administration.55
After Congress enacted the 1998 Act, the IRS shifted significant resources from enforcement to taxpayer service.56 Some data suggests that this move may have been a strategic success. As Leandra Lederman notes, total federal revenue actually increased between 1997 and 2001, outpacing inflation, despite the decline in IRS enforcement activity, and even despite a decline in revenue generated from enforcement.57
While Lederman concedes that there is no direct link between a kinder, gentler IRS and increased revenue, there is at least theoretical support for such a link in the literature on regulatory enforcement.58 It is also worth asking to what extent budget surpluses in the late 1990s (compared with budget deficits in the 1980s),59 may have informed the shift in Congressional thinking about IRS enforcement.
On the heels of the 1998 Act and the push towards a more taxpayer-friendly IRS, the IRS was also ramping up its efforts to go after offshore tax evasion. Its approach was a mix of the economic model of the 1980s and the more holistic model of the 1990s. The strategy involved increased sanctions and information gathering, as well as some high-profile prosecutions. However, it also involved extending carrots to noncompliant taxpayers in the form of amnesty for those who came clean about their offshore accounts through the IRS’s Offshore Voluntary Disclosure initiatives.60
These carrots are perhaps the greatest success of the IRS’s strategy. The message was clear: if you hide funds offshore, we will find you. But if you come forward and pay penalties and back taxes (in the Offshore Voluntary Disclosure Program or another disclosure program),61 we will work with you. And many taxpayers happily grabbed the carrots. Offshore account collections have topped $10 billion, and are still coming in.62 These efforts to find untaxed funds hidden in offshore accounts proved wildly successful, and are arguably a model for future IRS enforcement efforts aimed at groups of similarly situated taxpayers, such as cryptocurrency investors.
Many of those who came forward and fixed their offshore account filings sooner faced lower penalties and no criminal charges.63 However, the longer taxpayers waited to come forward, the larger their penalties turned out to be. Penalties started at 20% of a taxpayer’s largest offshore account balance, then rose to 25%, then 27.5%, and finally to 50% for some who waited too long to enter the program.64 The IRS finally announced in March of 2018 that it was closing the Offshore Voluntary Disclosure Program effective September 28, 2018, and issued a press release warning, “Taxpayers with undisclosed foreign assets urged to come forward now.”65
Finally, the IRS put the screws to both foreign governments66 and foreign banks67 to make them cough up more data about U.S. taxpayers holding accounts overseas. Through the use of “John Doe” summonses, the IRS was able to enforce wholescale records requests to foreign banks for client records that could lead to accounts held by Americans.68
The IRS also prosecuted many large foreign banks who had helped Americans stash money overseas, and obtained hefty settlements in these cases. UBS, one of the prime offenders in the offshore banking scandal, agreed to pay a fine of $780 million in its Deferred Prosecution Agreement with the Department of Justice (“DOJ”).69 Credit Suisse paid even more.70 Some banks were literally driven out of business.71 The IRS also prosecuted high-profile individual taxpayers for hiding their money in offshore accounts.72
The IRS’s combination of increased data collection, threat of penalties and criminal prosecutions, and the carrot of the voluntary disclosure program, proved extraordinarily successful with respect to offshore tax evasion, and is likely a model for future enforcement efforts.73
However, perhaps the most interesting aspect of this story is that as the IRS’s offshore voluntary disclosure programs increasingly raked in billions of dollars, IRS criminal referrals have actually been in a steady decline. A recent study from Syracuse University shows that the IRS has drastically reduced the number of cases it refers for criminal prosecution.74 The decline started after 2013, which is the same year the IRS announced its “Swiss Bank Program.”75
The Syracuse University report in March of 2018 shows that the IRS had only referred 1,824 cases for criminal prosecution during the most recent 12-month period, compared with 3,896 during the same period four years ago.76 That is more than a 50% reduction in criminal referrals to the DOJ.
Some of this reduction in criminal referrals may be due to budget cuts.77 Indeed, IRS Criminal Investigation (“CI”) Agents have seen their ranks decline from 2,749 to 2,153 in the same time period.78 But the reduction in criminal referrals is proportionately much greater than these cuts would indicate, so something else seems to be unfolding.
Donald Fort, the head of IRS Criminal Investigations who has manned the post since 2017, has been vocal about the fact that the Agency is focusing on new types of enforcement, namely international and cryptocurrency cases.79 There will surely be some criminal prosecutions to come out of the IRS’s current cryptocurrency enforcement push. But instead of focusing primarily on prosecutions, a large-scale disclosure effort may also be in the works, modeled after the IRS’s Offshore Voluntary Disclosure programs.80
It is therefore important to understand how IRS CI Agents have already shifted their focus in recent years. Specifically, the IRS’s CI Agents have played a key role in administering the IRS’s Voluntary Disclosure initiatives as part of the Swiss Bank Program.81 So, forget the typical picture of IRS CI Agents in the field, interrogating taxpayers and building criminal cases. Rather, picture CI Agents sitting behind a desk, pushing papers to help the IRS take in large hauls of cash from taxpayers who would otherwise have been their targets in criminal investigations.
Of course, the threat of prosecution for those not accepted into the Offshore Voluntary Disclosure Program (“OVDP”) looms, so the CI Agent’s involvement obviously is not without possible consequences. Denial of admission to the OVDP typically occurs when a taxpayer is already under criminal investigation at the time they submit their application.82 But even in these cases of denied entry, prosecution is rare, and many taxpayers initially denied entry to the OVDP have later been admitted to the program.83 Moreover, as a practical matter, even with an occasional offshore tax evasion prosecution, many CI Agents are now spending more time processing civil fine paperwork than developing criminal cases.
This does not mean the IRS is switching to an entirely civil enforcement scheme. Some commentators have suggested we might be better off under such a system, where tax crimes are treated the same way as parking in a red zone.84 But while the IRS certainly is not giving up on criminal prosecutions, it also appears to be strategically shifting resources away from prosecuting individuals one case at a time, and towards collecting back taxes in large-scale data collection efforts and voluntary disclosure programs. The IRS’s Swiss Bank efforts suggest that this is an effective and efficient shift in resource deployment. Money talks, after all, even for the IRS.
Given that offshore collections will be slowing down over the next decade,85 a hungry IRS will likely be looking for new sources of untapped revenue. A significant number of U.S. taxpayers who hid funds overseas have already come forward, and the IRS will now be looking for the “next big thing.” Judging by recent events, the IRS seems to be hoping to find it in the new world of cryptocurrencies.
In order to be able to spend fewer resources on criminal prosecution and still improve taxpayer compliance, the IRS needs to be able to gather significant amounts of data on cryptocurrency transactions. Otherwise, it has few “sticks” to reinforce any carrots it is offering for taxpayer compliance.86
Eventually, the IRS is likely to implement regulations requiring wholescale information reporting from cryptocurrency exchanges.87 But for the time being it needs to gather data on past transactions in order to compile sufficient information to piece together large and otherwise anonymous transactions, as well as to give it a credible threat of enforcement action.
Again, if we look at the Swiss Bank program as our example, the IRS did not merely extend an olive branch to taxpayers with unreported offshore accounts. It first began with data collection in the form of broad “John Doe” summonses to the banks that held those accounts.88 These sought to gather data on U.S. account holders who might owe back taxes, essentially targeting all Americans with foreign bank account holdings.
The IRS created an effective “feedback loop” of banks, bankers, and lawyers providing information on U.S. customers with offshore accounts, and in turn U.S. customers giving information on bankers and lawyers that had helped them establish offshore accounts.89
Seeking to start a similar feedback loop for cryptocurrency tax enforcement, in 2016 the IRS served a “John Doe” summons to Coinbase.90 Coinbase is an online platform and digital currency “wallet” that allows its users to exchange and transact with digital currencies such as bitcoin.91 The IRS was hoping to gather a treasure trove of data cataloging who was buying and selling bitcoin and other digital currencies. Some of these transactions, possibly most of them, had never been reported to the IRS.92
As for the IRS’s summons to Coinbase, the more data the IRS accumulates, the more it might be able to identify transactions that many digital currency users assumed were anonymous.93 This is especially true given the nature of blockchain technology, which can record all transactions in a public ledger.94 As the IRS begins gathering data on past transactions, it is able to make headway into discovering the identities of individuals behind otherwise anonymous transfers of cryptocurrency.
The IRS’s summons to Coinbase sought records on the site’s users whose identities were yet unknown to the IRS. This is a classic “John Doe” summons, of the type that the IRS used to masterful effect in its offshore account enforcement efforts.95 Section 7609(f) of the Internal Revenue Code authorizes such summonses, but the burden is slightly higher than that of a typical summons targeted at one individual.96 For a “John Doe” summons to be allowed:
· it must relate to the investigation of a particular person or ascertainable group or class of persons,97
· there must be 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 the tax law,98 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) must not be readily available from other sources.99
The IRS summons to Coinbase at first glance appeared to meet these criteria. The United States District Court for the Northern District of California initially entered an order authorizing the IRS to serve the summons on Coinbase.100 Courts typically give the IRS wide latitude to enforce summonses that may uncover information regarding potential tax evasion.101 “John Doe” summonses have a higher bar than a regular summons,102 but the bar is still relatively low.103
However, Coinbase customers fought back. A Coinbase customer and attorney, Jeffrey K. Berns, filed a motion in the District Court on behalf of himself and other Coinbase users which sought to intervene in the federal case and block the IRS from enforcing its summons for information on the site’s users.104 Coinbase had also protested the summons, arguing that it was overly broad, and that the IRS cannot use the summons power to conduct “general research” absent an investigation.105
The Court largely agreed with the IRS, although it noted that the summons should be “no broader than necessary to achieve its purpose.”106 After meeting with Coinbase’s representative to discuss summons enforcement, the DOJ had already agreed to narrow the scope of the summons, to include only users who had sent or received at least $20,000 worth of bitcoin in a given year.107
However, the Court ruled that even the narrowed summons sought more information than was needed. The Court stated that although all the IRS needed was the user’s transaction records and the account holder’s identity,108 the summons had sought all wallet addresses, all public keys for all accounts/wallets/vaults, Know-Your-Customer records, agreements or instructions granting a third-party access, control, or transaction approval authority, and correspondence between Coinbase and the account holder.109 The Court limited the scope of the summons further, and held that if the Government later determines that it needs more detailed records, it can issue a summons directly to the taxpayer, or to Coinbase with notice to a named user, which it stated was a “process preferable to a John Doe summons.”110
But otherwise the Court permitted the IRS to enforce its summons and obtain transaction information on more than 10,000 Coinbase account holders.111 On February 23, 2018, Coinbase sent an official notice to approximately 13,000 customers whose information it was turning over to the IRS in response to the summons, and urged them to seek counsel from attorney if they had any questions.112
The IRS’s (mostly) successful enforcement of its “John Doe” summons against Coinbase suggests more such summonses may be coming, in order to uncover information on cryptocurrency transactions. As with the early years of the IRS’s Swiss Bank enforcement efforts, “John Doe” summonses can help set the stage for future IRS enforcement actions.
Another point worth remembering is that the IRS did not merely gather information from foreign banks. It also issued “John Doe” summonses to FedEx, DHL, and UPS, to see which Americans were corresponding with foreign banks.113 The IRS may make a similar push to creatively triangulate data on cryptocurrency transactions, perhaps with summonses to Internet Service Providers (“ISPs”), social media platforms like Facebook, Google, and Twitter, or other technology service providers that do not expressly work with cryptocurrencies.
If the Swiss Bank efforts are an accurate guide, the IRS might also be considering whether to bring charges against cryptocurrency trading platforms or other way stations that facilitate cryptocurrency trades. It is not clear what such charges would be, but a decade ago few saw prosecutions of UBS and other well-heeled banks coming, either.114 Indeed, some observers commented that UBS might face legal troubles at home for breaking Swiss banking secrecy laws, if it complied with the IRS’s summons.115 So the tides can change quickly.
Now that the IRS has the Coinbase data, what next? The vast amount of information will surely be time-consuming for the government to sort through. Simply selling or buying bitcoins does not necessarily mean someone owes additional tax, even if large quantities of bitcoin have changed hands.116 There are still many dots to connect. The IRS in the meantime is hoping that many Coinbase users will come forward voluntarily to amend past filings, or to file returns if they had not filed.
But what if they do not? Many cryptocurrency transactions did not pass through Coinbase, and instead took place in private peer-to-peer transactions or on foreign exchanges.117 The IRS needs a critical mass of intermediaries and/or individuals to report cryptocurrency trade information, or it is going to have a near-impossible task of making significant headway in its enforcement efforts.118 It needs, in short, a “feedback loop” of information reporting regarding blockchain transactions, as it developed through its Swiss Bank enforcement efforts.119
Also, the IRS faces a potential problem it did not face in its offshore account enforcement efforts: namely that many early adopters of cryptocurrency, who are now among some of the wealthiest, are fiercely libertarian and anti-government in their political leanings.120 The IRS’s offshore account enforcement efforts were largely targeted at individuals who were simply engaged in opportunistic tax evasion. With cryptocurrency enforcement, the IRS may be facing large groups of politically motivated individuals who are acting on political principles, rather than merely trying to grab a buck.
Complicating matters, the IRS also faces widespread confusion about how exactly to report cryptocurrency profits. The IRS issued a Notice in 2014, stating that bitcoin is property, not currency.121 The Notice gave some detail about W-2 and 1099 reporting, but significant questions remain among practitioners. For example, how are bitcoin derivatives and loan agreements to be taxed?122 Can exchanges of one cryptocurrency for another qualify as like-kind exchanges under Code Section 1031, and thus avoid current taxation?123 What if a taxpayer receives a “fork” of cryptocurrency—is this a taxable event, and if so how is the tax to be determined?124
Additional confusion stems from the fact that cryptocurrency users have been deploying cryptocurrencies as though they were currencies, using them as a cash substitute to make purchases online.125 Yet the IRS position that cryptocurrencies are in fact property could mean that each of these transactions is a taxable event, similar to a stock sale. The reporting burden, and the confusion regarding what tracking methods to use, can be overwhelming for taxpayers. And it may make voluntary compliance efforts even more challenging, especially since many cryptocurrency investors are already ideologically disposed against government enforcement.
Given these issues, what would a cryptocurrency voluntary disclosure program look like? If the IRS’s Offshore Voluntary Disclosure initiatives are any guide, and the signs suggest they might be,126 such a program might involve disclosures to IRS CI Agents, filing past returns, and paying back taxes and, critically, large penalties.
Yet the IRS might want to take extra care not to adopt too combative a stance, given that it cannot rely only on third-party reporting to ensure cryptocurrency compliance. Given that some cryptocurrency transactions pass through no intermediary at all, the IRS will need to promote voluntary compliance from large segments of the cryptocurrency community. This means perhaps both more carrots and more sticks than with its offshore enforcement efforts.
Perhaps more worrying for the IRS is its lack of resources to prosecute most instances of cryptocurrency tax evasion. Given the decline in the IRS’s CI Agent ranks, and budget cuts to enforcement, it may not have a credible threat that it will prosecute more than handfuls of cryptocurrency tax evaders. This, combined with significant anti-government backlash in the cryptocurrency community, makes it possible that the government enforcement efforts might be undermined.
The IRS’s coming cryptocurrency enforcement push may prove to be an interesting test of the principle competing theories of tax enforcement. Whereas the 1980s model used an economics of crime approach that viewed taxpayers as rationally responding to the possibility of detection and weighing sanctions that could be imposed, the 1990s saw a shift among academics towards a holistic model that saw taxpayer compliance as connected to perceptions of fairness in enforcement and regulation.
As the IRS approaches cryptocurrency enforcement, it would be wise to keep both models in mind. Perceived fairness will surely be a key metric to evaluate any IRS response. Given the current confusion regarding tax reporting requirements for cryptocurrency, the IRS may be on increasingly shaky ground if it takes too combative an approach. Prosecuting individuals for cryptocurrency tax “crimes” when those tax rules are not even clearly stated could run the risk of jury nullification, negative judicial precedent, or even public backlash.
Any large-scale voluntary disclosure regime should probably be coupled with increased clarity regarding cryptocurrency reporting rules, as well as some relief for innocent taxpayers trapped by honest mistakes. The IRS itself may even bear some of the brunt of confusing and burdensome reporting rules, once it begins slogging through audits involving high volumes of cryptocurrency transactions.
At the same time, the IRS views its Swiss Bank enforcement efforts as a success, and is likely to stick to the script for the time being. This means some will be prosecuted, “John Doe” summonses will be enforced to gather data on cryptocurrency transactions, and some large institutions and advisory firms will be charged as well, for facilitating tax evasion transactions using cryptocurrencies.
But whatever approach the IRS takes, it should take into account the political views and cultural considerations of the cryptocurrency community to anticipate likely responses. In other words, it should consider the cryptocurrency community as a strategic actor in its enforcement model. In contrast to the view of tax enforcement as “the government” versus “the taxpayer,” largely reflected in both the 1980s model and the 1990s models, it is increasingly clear that group dynamics can be at play in responses to government enforcement efforts.