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Bitcoin and the IRS - The Battle Continues

By: Nicholas P. Mooney II

Dispute is heating up over IRS’s attempts to get personal information about users of Bitcoin and other virtual currencies.

Last November, the Internal Revenue Service (“IRS”) filed a petition in the United States District Court for the Northern District of California. It sought the court’s permission to serve a “John Doe” summons on Coinbase, Inc., a virtual currency exchanger in San Francisco. The purpose of the summons was to require Coinbase to:

“identify all of its customers who, at any time during the period of January 1, 2013 through December 31, 2015, conducted transactions in a convertible virtual currency as defined in IRS Notice 2014-21.”

The IRS’s petition goes through a lengthy discussion of what virtual currencies are and how they operate. As the petition explains, in order for a person to transact virtual currencies, he or she must have a “wallet,” which is essentially a digital file that allows the person to either send or receive units of a particular virtual currency, such as Bitcoin. The wallet is associated with one or more public and private keys. Once a person engages in a transaction involving virtual currency, a record of that transaction is added to the public ledger of all transactions. However, the identity of the individual involved in the transaction is not recorded on the ledger; only the date, time, and amount of the transaction and the wallet address is identified.

That is the problem from the IRS’s standpoint. Its petition claims that it has discovered three instances where individuals have engaged in virtual currency transactions, but never declared those transactions in their reportable income. It therefore believes that thousands of other individuals or more are using virtual currency transactions as a way to evade taxes.

Two of the three instances of tax evasion that the IRS discovered involved taxpayers who had wallet accounts with Coinbase. Thus, the IRS set its sights on Coinbase, which it says operates in 32 countries and maintains over 4.9 million wallets for its customers. With its summons, the IRS sought the identities and other information of all United States persons who engaged in any virtual currency transaction during a three-year time span from January 1, 2013 through December 31, 2015.

In December, a California lawyer named Jeffrey Berns filed a motion in the IRS’s case, asking the court to allow him to intervene and also asking the court to quash the subpoena. Berns disclosed that he was a Coinbase user whose information would be subject to the IRS’s summons. Thus, he asked permission to intervene into the case as a party.

His motion explained for the court the many layers of problems with the summons, not the least of which is its overbreadth. Berns criticized that three instances of possible tax evasion (only two of which involved taxpayers who were Coinbase users) were far from sufficient justification for the disclosure of personal information of more than 1,000,000 Coinbase users. Berns’ motion encapsulated the issue:

“For example, if the IRS provided evidence of two taxpayers who had purchased items from Amazon for personal use and declared them to be business expenses [in order to avoid taxes], it would certainly not be justified in issuing a John Doe summons to Amazon seeking its customer lists and records concerning every transaction for all of Amazon’s customers. That conduct would clearly be abuse of process.”

As a result of these issues, Berns asked the court to have quash the summons, thereby relieving Coinbase of any obligation to comply.

In response, the IRS sought to sidestep Berns’ motion. Since his motion disclosed that he was a Coinbase user whose information would be subject to the summons, the IRS now knew who he was. It stated that it no longer needed Coinbase to identify him in response to summons. Thus, it sent Coinbase a letter withdrawing the summons as to Berns and filed a response brief, asking the court to find Berns’ motion moot and to deny it.

Berns replied, taking issue with what he saw as the IRS’s attempts to evade the problems he raised by artificially mooting his motion.

In addition to Berns’ motion and the IRS’s attempt to moot it, Coinbase now has weighed in, filing its own motion asking the court for the opportunity to be heard on why the IRS’s summons should be quashed. After receiving Coinbase’s motion, the court notified all parties that the battling motions would be addressed at a hearing on February 16, 2017.

If you’d like to read more about the case or the parties’ motions, the case is In the matter of tax liabilities of John Does, Civil Number 3:16-cv-06658-JSC (N.D. Cal). If you’re new to virtual currencies and want to learn more about them, the IRS’s memorandum in support of its petition (document no. 2 in the court file) and the exhibits to that memorandum are a good place to start. They contain a lengthy discussion and diagrams of how virtual currencies work and the different players involved in virtual currency transactions.

Thanks for reading. If you have any questions about virtual currencies, please contact us.