The U.S. District Court for the Northern District of California, on November 28, 2017, ordered the international digital currency broker, Coinbase, Inc., to produce to the Internal Revenue Service (IRS) the records of Coinbase’s account holders, in connection with the IRS’s investigation of allegedly underreported virtual currency gains.1 As discussed below, after Coinbase refused to comply with the IRS’s initial summons to obtain information, the IRS issued a second summons with a significant reduction in the type and amount of information requested; pursuant to the order, the court even further narrowed the types of information to which the IRS would be entitled. The court’s decision raises the issue of balancing the privacy interests of virtual currency account holders with the IRS’s legitimate interest in investigating potential tax evasion and brings virtual currencies further into the regulatory scope of U.S. government agencies.
In 2014, the IRS issued Notice 2014-21 explaining how general tax principles apply to transactions involving virtual currencies, such as Bitcoin.2 In this Notice, the IRS indicates that virtual currencies which can be converted into traditional currency are considered property for tax purposes and that a taxpayer can have a gain or loss on the sale or exchange of a virtual currency. These gains could be reported as either capital gains or ordinary income, depending on the transaction.
IRS Serves Initial Summons
The IRS may issue a summons “[f]or the purpose of ascertaining the correctness of any return, making a return where none has been made, determining the liability of any person for any internal revenue tax ... or collecting any such liability.”3 In its initial summons (Initial Summons), the IRS requested that Coinbase provide “information regarding United States persons who at any time during the period January 1, 2013 through December 31, 2015 conducted transactions in a convertible virtual currency as defined in IRS Notice 2014-21.” The requested information included: the account, wallet and vault registration records for Coinbase account holders during the three-year period; all records kept for know-your-customer due diligence; any agreements that gave a third party access to an account; records of account activity and payments processed; correspondence between Coinbase and the account holders; account statements and records of payments; and reports from Coinbase’s anti-money laundering system.
In support of its Initial Summons, the IRS claimed that virtual currency gains have been underreported, as evidenced by the disproportionate number of taxpayers reporting gains from Bitcoin relative to the number of Coinbase account holders. According to the District Court’s order, Coinbase, as one of the world’s largest platforms for exchanging virtual currency, has approximately 5.9 million customers and has facilitated approximately $6 billion exchanged in Bitcoin. The order also notes that the IRS, on the other hand, has identified a total of only 800 to 900 taxpayers in each of the years from 2013 through 2015 who electronically filed a Form 8949 (the IRS form for reporting sales and other dispositions of capital assets) on which they reported gains or losses that the IRS believes are “likely related to bitcoin.” The IRS noted, in a prior petition in support of the Initial Summons, that over the same time period the total number of returns electronically filed was over 120 million in each of those three years.
IRS Seeks Enforcement of Narrowed Summons
In response to Coinbase’s refusal to comply with the Initial Summons, and following months of discussion between the parties, the IRS sought enforcement of a second summons with a narrowed request (Narrowed Summons). The Narrowed Summons sought various information for accounts with at least $20,000 in any single type of transaction (buy, sell, send or receive) in any one-year period from 2013 through 2015. The order refers to Coinbase’s claim that the Narrowed Summons “requested information regarding 8.9 million transactions and 124,355 account holders.” Coinbase also refused to comply with the Narrowed Summons, and three organizations (Competitive Enterprise Institute, Coin Center and Digital Currency and Ledger Defense Fund) filed amici briefs in opposition to the Narrowed Summons. In addition, several Coinbase customers who would have been impacted by the Narrowed Summons anonymously petitioned the court to intervene in the case for the purpose of challenging the Narrowed Summons.
The amici briefs and the petitioners’ opposing briefs cited the right to privacy as an argument against enforcing the Narrowed Summons.4 The privacy arguments covered a range of legal and policy theories, including that contractual control of the data lies with the account holder and not with Coinbase (per the Coinbase user agreement), and that the IRS’s seizure of such information would have a “chilling effect” on constitutionally protected speech. Competitive Enterprise Institute did concede in its brief, however, that “[p]rivacy interests would not defeat a well-crafted subpoena tailored to discover the identities of persons about whom there is a genuine suspicion of failure to pay taxes. But the subpoena at issue here [the Narrowed Summons] does not meet that standard ...”5
In determining whether to enforce the Narrowed Summons, the court applied the four-factor test set forth in United States v. Powell.6 The Powell test places the initial burden on the IRS to establish “good faith” by demonstrating that a summons:
- Is issued for a legitimate purpose;
- Seeks information relevant to that purpose;
- Seeks information that is not already in the IRS’s possession; and
- Satisfies all of the administrative steps set forth in the Internal Revenue Code.
The government’s burden is not a significant one, as courts have construed broadly the IRS’s authority to issue a summons, in recognition of the importance that the IRS’s enforcement powers not be “unduly restricted.”7 The challenger of a summons, however, bears a heavy burden to “allege specific facts and evidence to support his allegations of bad faith or improper purpose.”8
In applying the Powell test, the court focused on the first and second factors, conceding that the IRS had satisfied the third and fourth factors.
With respect to the first factor, the court determined that the IRS had shown that the Narrowed Summons was “issued for a legitimate purpose” by demonstrating the discrepancy between the low number of taxpayers reporting gains from bitcoin relative to the high number of Coinbase account holders and transactions during the 2013 through 2015 period. Coinbase argued that the Narrowed Summons was not issued for a legitimate purpose because, among other reasons: (i) the IRS’s investigatory purpose was a “mere conclusion” not supported by a “proper enforcement purpose;” (ii) the narrowing of the subpoena was arbitrary; (iii) Form 8949 (which the IRS used to search for bitcoin-related filings) is not the only place a taxpayer could report bitcoin gains; (iv) the IRS’s figure of 800-900 reports of bitcoin gains could be artificially low because taxpayers reporting gains from virtual currency could disproportionately file paper returns; and (v) taxpayers who purchased at high prices in late 2013 and sold in 2014 and 2015 likely experienced losses due to a fall in the price of bitcoin over this period.
The court rejected each of Coinbase’s arguments, acknowledging that the IRS was reasonable in presuming that bitcoin gains would be filed on the correct form and that “it seems likely that users of virtual currency would be more likely than the average taxpayer to file electronic returns.” The court also noted that the Narrowed Summons sought information only for accounts with at least $20,000 in any one transaction type, and therefore the fall of the price of bitcoin during 2014 and 2015 was unpersuasive.
With respect to the second Powell factor, Coinbase argued that the Narrowed Summons was still too broad, and would therefore seek irrelevant information. Although the court noted that a summons should be “no broader than necessary to achieve its purpose,” the court agreed to enforce the Narrowed Summons for enough information for the IRS to determine “if there is potentially a taxable gain and if there is some doubt as to the taxpayer’s identity” (emphasis in original). The court determined that the relevant information for this purpose included the following, for all accounts with at least the equivalent of $20,000 in any one transaction type (buy, sell, send or receive) in any one year during the 2013 to 2015 period:
- The taxpayer’s ID number, name, birth date and address;
- Records of account activity, including transaction logs or other records identifying the date, amount and type of transaction (purchase/sale/exchange), post-transaction balance, and names of counterparties to the transaction; and
- All periodic statements of account or invoices (or the equivalent).
While the order represented the same number of accounts in scope as the Narrowed Summons, the court further narrowed the types of information to which the IRS would be entitled. The court determined that the know-your-customer information, third-party control information, and correspondence with account holders were not necessary for the IRS’s purpose.
In a company blog post, Coinbase called the order a “partial victory,” stating that the order represented “a 97% reduction in the number of customers impacted” from the IRS’s Initial Summons, and that “more than 480,000 customers’ records were preserved from disclosure.”9 According to the blog post, less than 1% of Coinbase’s customer base (approximately 14,000 account holders) would be impacted by the order, and Coinbase intends to “notify impacted users in advance of any disclosure.”
As virtual currencies gain more prominence in the public eye, they are also coming into the focus of the IRS and other U.S. regulators. Many regulators, including the IRS, claim that virtual currency activities can fit within the existing legal and regulatory frameworks that apply to the financial industry and its participants.10 This means that holders of bitcoin and other virtual currencies should be cognizant of how their activities may be regulated, including reporting their gains (or losses) on their tax returns.
1) Order Re Pet. To Enforce IRS Summons, U.S. v. Coinbase, Inc., No.17-cv-01431-JSC, (N.D.Ca Nov. 28, 2017) (Dkt. No. 78).
2) IRS Notice 2014-21, in which the IRS defines “virtual currency” as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.”
3) 26 U.S.C. § 7602(a).
4) For example, one petitioner argued that, in granting the summons power to the IRS, Congress wanted to ensure that “the use of this important investigative tool should not unreasonably infringe on the civil rights of taxpayers, including the right to privacy.” Intervenor John Doe 4’s Opposition to Petition to Enforce Internal Revenue Service Summons, U.S. v. Coinbase, July 27, 2017 (quoting H.R. Rep. No. 94-658, at 311 (1976)).
5) Brief Of Amicus Curiae Competitive Enterprise Institute In Opposition To Petition To Enforce Internal Revenue Service Summons, U.S. v. Coinbase, Inc., No.17-cv-01431-JSC, (N.D.Ca Aug. 3, 2017) (Dkt. No. 50-2).
6) 379 U.S. 48 (1964).
7) See Liberty Fin. Servs. v. United States, 778 F.2d 1390, 1392 (9th Cir. 1985).
8) United States v. LaSalle Nat’l Bank, 437 U.S. 298, 316 (1978) (quoting United States v. Jose, 131 F.3d 1325, 1328 (9th Cir. 1997)).
9) Coinbase Obtains Partial Victory Over IRS, The Coinbase Blog, Nov. 29, 2017.
10) See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Rel. No. 81207, July 25, 2017. For a discussion of the SEC’s focus on virtual currencies, please refer to Dechert OnPoint, SEC Focuses on Initial Coin Offerings: Tokens May be Securities Under Federal Securities Laws.