• A court approved the issuance of a John Doe summons by the IRS to a bank aimed at identifying individuals who are potentially avoiding their income tax obligations relating to cryptocurrency transactions. The bank was targeted in connection with services it offered to users of sFOX, which received a summons of its own last month.
  • The IRS and prosecuting agencies have made clear that John Doe summonses are a powerful tool in pursuing virtual currency underreporting and their use will likely continue into 2023.

On Sept. 23, 2022, a U.S. District Court judge approved an IRS John Doe summons served on a New York-based bank seeking account records, including account opening documents and records of deposits, withdrawals, transfers and wires, of clients who used sFOX for cryptocurrency services. The summons was issued in connection with partnered services the bank offered to sFOX clients granting customers access to FDIC-backed cash deposit accounts. sFOX users were able to use their funds at the bank directly to buy and sell digital assets on the sFOX platform. The IRS expects the information will identify sFOX users who may have underreported their tax obligations.

The summons stems from a John Doe summons issued to sFOX last month probing into its users’ potential noncompliance with tax reporting and payment obligations. The IRS’s belief that it will find instances of noncompliance is based on several known sFOX clients who did not meet their tax filing obligations. The sFOX summons alleged that some individuals were “involved in a Ponzi scheme” and failed to report $1 million in deposits through sFOX, while others allegedly used their sFOX accounts to deposit thousands of dollars in cryptocurrency and exchange it for fiat currency before transferring the money to personal bank accounts and failing to report any gain or loss from the transactions. sFOX commented that since receiving the “John Doe summons in August, [it has] been working collaboratively with the IRS and will continue to review matters internally while conferring with external legal counsel around next steps.”

Since 2021, the IRS has utilized John Doe summonses pursuant to its efforts under Operation Hidden Treasure, aimed at catching those attempting to use digital assets to evade their tax liabilities. The IRS issued three summonses to other large cryptocurrency platforms before pursuing sFOX. “The government’s ability to obtain third-party information on those failing to report their gains from digital assets remains a critical tool in catching tax cheats,” said IRS Commissioner Charles Rettig. U.S. Attorney Damian Williams of the Southern District of New York reiterated that “[t]he government is committed to using all of the tools at its disposal, including John Doe summonses, to identify taxpayers who have understated their tax liabilities by not reporting cryptocurrency transactions, and to make sure that everyone pays their fair share[.]”

These two John Doe summonses issued in such a short span indicate that the IRS is apt to continue to use this tool to root out abuses in tax reporting. The IRS has made no secret of the fact that it intends to hold accountable those who fail to report or underreport their virtual currency transactions, including making the obligation to report such transactions present on the first page of taxpayers’ 1040s. It is also no secret that the IRS has been successful in previous instances where it issued summonses on exchanges. In one prior instance, a summons issued to a major cryptocurrency exchanged resulted in information that lead to the IRS issuing 10,000 letters to taxpayers reminding them of their tax reporting responsibilities. The IRS estimated that these letters resulted in 577 amended income tax returns and an additional $15 million in assessed federal tax liabilities. Individuals should therefore expect that the IRS will continue to investigate such transactions to find those who have skirted their responsibilities and to make those individuals pay back due taxes, as well as potentially impose civil penalties and in extreme cases, pursue criminal liability.

The BakerHostetler Tax Practice Group provides clients with sound and practical advice in federal, international, tax controversy, employee benefits, private wealth, tax-exempt, and state and local matters. The group’s experience extends to structuring transactions and representing clients in the course of IRS examinations. The Criminal Tax Defense team assists individuals and institutions with assessing and identifying issues of concern and implementing measures to reduce potential exposure. The team has successfully represented clients at each stage of the criminal tax process in administrative IRS investigations, joint IRS-Department of Justice grand jury investigations, and indictments and prosecutions by U.S. Attorneys’ Offices. The Blockchain Technologies and Digital Assets team has members across all our core groups, and our attorneys have extensive experience across all sectors of the blockchain and cryptocurrency markets, including investigations, securities law, commodities law, Bank Secrecy Act/Anti-Money Laundering compliance, tax, privacy, transactions, advertising law, intellectual property and technology design, as well as government affairs, public policy and advocacy across federal departments and agencies and Congress.