The IRS has begun sending letters to 10,000 cryptocurrency owners after having successfully acquired transaction records in a John Doe summons from Coinbase Inc., a U.S. based "wallet" for cryptocurrency. After the media attention that Bitcoin received after its meteoric rise to almost $20,000 per Bitcoin, the IRS's move should not come as a shock to anyone.
Cryptocurrency has been marketed as money and touted by some as the currency of the future. Most people do not believe that purchasing something with cryptocurrency can be a taxable event, because purchasing something with the U.S. dollar is generally not an income recognition event. However, cryptocurrency is treated as property for tax purposes, which means that cryptocurrency is more like Apple stock than it is the U.S. dollar. Consequently, if a person decides to buy a candy bar with Bitcoin, for example, that purchase is a recognition event for tax purposes. Whether a gain or loss is recognized upon the purchase depends on whether the Bitcoin has appreciated or depreciated in the person's hands.
The three types of letters that the IRS will be sending to taxpayers are intended to be instructive on how cryptocurrency is treated for tax purposes. But of the three, one of them, Letter 6173, is more than instructive. It requires an affirmative response from the taxpayer. The taxpayer must either (i) file delinquent returns or amend returns that did not correctly report the cryptocurrency transactions or (ii) reply to the IRS describing how the cryptocurrency transactions have been correctly reported on previously filed tax returns. The statement to the IRS must be signed under penalties of perjury. Given that an affirmative response is required, it is fair to assume that the IRS has received data from Coinbase indicating significant cryptocurrency transactions that did not match to the account holder's tax return.
The other two letters, Letter 6174 and Letter 6174-A, require no response from the recipient. Both letters urge the taxpayer to review filing history for compliance. Letter 6174-A warns that the IRS "may send other correspondence about potential enforcement activity in the future." Given that Letter 6174 has no such warning, it is the most benign of the three letters.
By pursuing the John Doe summons and sending the letters to taxpayers, the IRS is sending a clear message that it is taking steps to not allow cryptocurrency to become the next Swiss bank account. Taxpayers that have dealt in cryptocurrency should take some hard-learned advice from taxpayers that engaged in offshore tax avoidance. First, burying your head in sand does not work. The IRS will catch up to you eventually. Second, the cost of getting into compliance will never be cheaper than it is now. If you have dealt with cryptocurrency, and especially if you receive one of the IRS's cryptocurrency letters, your response should be considered.