How Are Virtual Currency Audits Initiated?
A John Doe summons is an order that compels virtual currency exchanges to release user information so that the IRS may determine the identity of taxpayers who have failed to report their virtual currency earnings.
The IRS has pushed cryptocurrency tax enforcement to the forefront of its operation. This is most readily displayed by a small (yet pivotal) addition to 2020 Form 1040, the most common tax document. In an attempt to encourage American taxpayers to disclose their virtual currency earnings, the IRS posed the following question:
“At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
Now, you may be wondering: what does asking this question accomplish? By forcing all Americans to check either "yes" or "no" to this question, taxpayers no longer can “feign ignorance” and they will be put on notice that virtual currency transactions are subject to tax liability.
Furthermore, by forcing American taxpayers to answer this question, the IRS may impose stricter penalties upon those who intentionally answer this question untruthfully.
I Received a Notice for an Audit Request. What Happens Now?
Virtual currency audits are typically conducted via mail. A taxpayer will receive an audit request in the mail. It is important that you not panic.
The purpose of an audit is to assess tax liability. Receipt of an audit request does not necessarily mean that you will be required to pay a penalty.
The audit request will typically contain a myriad of questions pertaining to your transaction history. It is imperative that you answer each question truthfully and its entirety. Do not attempt to misrepresent your earnings.
How Does the IRS Identify Virtual Currency Holders?
Prior to 2016, the IRS had minimal tools at its disposal to identify virtual currency holders. After realizing they were unable to identify millions of liable taxpayers, the IRS pursued a judicial remedy known as a “John Doe” summons.
A John Doe summons, unlike a traditional summons which merely calls a party to a court of law, is an order that compels virtual currency exchanges to release user information so that the IRS may determine the identity of taxpayers who have failed to report their virtual currency earnings. 26 USC § 7609(f). A John Doe summons may be issued if:
- The summons relates to the investigation of a group of persons.
- There is a reasonable basis for believing that the involved persons may have failed to comply with an IRS provision; and
- The information sought from the examination of records is not readily available from other sources.
In essence, a John Doe summons requires third parties, such as Coinbase, BlockFi, and Binance, to provide user information to the IRS.
It is important to note that John Doe summons are NOT limited to domestic businesses.
The IRS may utilize federal courts to compel disclosure from any third-party business anywhere in the world, so long as the IRS can articulate a reasonable belief that United States taxpayers are evading their obligations.
Therefore, purchasing virtual currency through/from a foreign business will NOT assist an investor bypass IRS tax liability.
To date, the IRS has obtained user data, consisting of legal names, dates of birth, addresses and transaction logs, from Coinbase, Kraken, and Poloniex.
The downfall to using only the data acquired from these virtual currency databases to conduct audits is that the IRS won’t have the access to the entirety of the investor’s portfolio.
Rather, they will only have access to the information that the third-party database does. Say, for example, you traded cryptocurrency through both Coinbase and Coinmama. If the IRS can procure a John Doe summons for Coinbase but not for Coinmama, they may assume that you have improperly prepared your tax returns.
Since the IRS doesn’t have access to your Coinmama transactions, they may not be able to identify your losses or expenses. For that reason, it is imperative that you keep cohesive records of ALL activity involving virtual currency.