Last July, the IRS announced its Virtual Currency Compliance Campaign, designed to intensify the IRS’s efforts to counter the underreporting of income related to cryptocurrency use. Through the campaign, the IRS will address noncompliance through taxpayer education, increased audits and initiations of criminal investigations.

This past week the IRS began sending “educational” letters to more than 10,000 taxpayers who either potentially failed to report income and pay the tax from cryptocurrency transactions, or did not report their transactions properly. The IRS sent out three variations of the letters — Letter 6173, Letter 6174, or Letter 6174-A — depending on the severity of the perceived violation. Letters 6174 and 6174-A ask taxpayers to review their returns and file an amended return if necessary; Letter 6173 is a more serious warning that also requires a signature under perjury from the taxpayer affirming U.S. tax law compliance.

In a release explaining the letters, the IRS warned that “[t]axpayers should take these letters very seriously by reviewing their tax filings and when appropriate, amend past returns and pay back taxes, interest and penalties.”

We believe that in the coming years, taxpayers that use cryptocurrency — in particular, taxpayers that sell, exchange, or otherwise dispose of such currencies, or taxpayers that receive cryptocurrencies as a form of payment — will see the IRS initiating rigorous enforcement action.

This new focus on the virtual currency industry is particularly controversial given the IRS’s failure to provide guidance on this subject. To date, the IRS has issued only a single guidance document addressing virtual currency. Notice 2014-21 states that virtual currency constitute property for federal tax purposes and provides guidance on how general federal tax principles apply to such transactions. However, the notice fails to address longstanding questions, including how to determine the fair market value of the currency if price indexes across exchanges differ and how to properly identify the cost-basis upon a sale or exchange, particularly upon the exchange of a large block of cryptocurrency that consists of several smaller blocks of a cryptocurrency portfolio accumulated over several years. Moreover, the market has become more complex in recent years, with the emergence of “airdrops” and “forks” that give users a secondary currency (for example, where bitcoin users receive bitcoin cash), raising new questions about how to properly assign cost basis to the newly-created asset and whether receipt of the new asset is income to the taxpayer. The IRS has stated that it intends to issue new guidance in the coming month to address these issues.

Notice 2014-21, while useful, is nonbinding. Until the IRS issues binding guidance, taxpayers should use reasonable methods and apply general tax principles applicable to property transactions. Because the IRS considers virtual currency to be property, and not currency, for federal income tax purposes, taxpayers that sell, exchange or otherwise dispose of their cryptocurrency should report any gains or losses on Form 8949 and Form 1040 Schedule D. Taxpayers should be mindful that trading cryptocurrency for another cryptocurrency or for hard currency, like the dollar, is a taxable event, as is using cryptocurrency to purchase goods and services.

Finally, in the future, the IRS may consider imposing information reporting and withholding guidance that would apply to exchanges and brokerage firms. Currently, there is no explicit requirement for these third parties to report cryptocurrency sales to the IRS. Notice 2014-21 does, however, require credit card intermediaries to report payments made to merchants on Form 1099-K in certain circumstances and employers and businesses to report payments of $600 or more on Form 1099-MISC.

By imposing information reporting obligations on to the exchanges and brokers, the IRS will be able to identify taxpayers who conduct cryptocurrency transactions through these parties and identify the taxable transaction amounts specifically related to cryptocurrencies. In fact, the Treasury Inspector General for Tax Administration has recommended that third-party tax information reporting documents be revised to facilitate identification of cryptocurrency reporting noncompliance. Given the IRS’s current intense focus on the cryptocurrency market, we believe that the IRS will likely expand information reporting and withholding requirements to cryptocurrency exchanges, as well as brokerage firms that deal with cryptocurrency.