John McAfee Arrested in Spain Over Cryptocurrency Related Tax Evasion Charges:
Recently, the Department of Justice unsealed a Grand Jury indictment of John McAfee, charging McAfee with five counts of tax evasion and five counts of willfully failing to file a tax return, spanning tax years 2014 - 2018.
IRC §7201 makes it a criminal offense for any person to willfully attempt in any manner to evade or defeat any tax imposed by title 26 of the US Code or the payment thereof. Though IRC §7201 provides for a maximum penalty of $100,000 for each offense, the Criminal Fine Enforcement Act of 1984 increased the maximum permissible fine for felony offenses under §7201 to $250,000. In addition to monetary penalties, each offense under §7201 is also punishable by up to 5 years of imprisonment. Thus, for the tax evasion charges alone, McAfee is facing $1.25m in criminal fines and up to 25 years imprisonment, in addition to a restitution order he may be facing for having short-changed the US Treasury during the years in question.
The indictment alleges the following affirmative acts by McAfee as undergirding the tax evasion charges: (1) directing the payment of his income to a bank account in the name of a nominee; (2) purchasing real property and titling, and causing the titling of; that property in the name of a nominee, (3) dealing extensively in cryptocurrency; (4) routing his income through cryptocurrency accounts in the name of a nominee; and (5) purchasing a vehicle and titling, and causing the titling of, that vehicle in the name of a nominee.
While the use of nominees to hide income or assets from the IRS is fairly standard fare supporting a charge of tax evasion, the affirmative act of “dealing extensively in cryptocurrency” appears to be a novel allegation by the DOJ in support of a tax evasion indictment, and should serve as a shot across the bow from the IRS and DOJ aimed at those that regularly transact with, or invest in, Bitcoin or other cryptocurrencies. It is well known that the IRS and DOJ prosecute high-profile cases in order to maximize the deterrent effect such prosecution has against the broader spectrum of taxpayers in areas of tax noncompliance the IRS is focused on cracking down on. The indictment of John McAfee therefore signals the increased focus the IRS has placed on US taxpayer non-compliance with reporting reporting requirements concomitant with cryptocurrency transactions.
The Timeline of Increased IRS Scrutiny of Cyptocurrency Transactions:
In 2014, the IRS released Notice 2014-21 providing its first official guidance on the federal tax treatment of transactions involving cryptocurrencies. The notice lays out five general principles that apply to transactions conducted in convertible virtual currency (CVC), such as Bitcoin:
A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
A payment made using virtual currency made to independent contractors and other service providers is taxable, and self-employment tax rules generally apply. Normally payers must issue a Form 1099-MISC, with respect to the payment.
Wages paid to an employee using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to Federal income tax withholding and payroll taxes.
Virtual currency may be used to pay for goods or services. Certain third parties who settle payments made in virtual currency on behalf of merchants that accept virtual currency from their customers are required to report payment to those merchants on Form 1099-K.
The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
In September 2016, the Treasury Inspector General for Tax Administration (TIGTA) issued a report highlighting the fact that, despite IRS Criminal Investigation management’s pronouncement in 2014 that “agents will be targeting the use of [virtual] currency to dodge taxes,” as of September 2016, little had been done by the IRS to develop a plan for investigating and enforcing cryptocurrency non-compliance. The TIGTA report submitted three suggestions for the IRS to improve its ability to investigate and enforce non-compliance with the reporting of transactions involving cryptocurrency, namely: (1) that the IRS develop a comprehensive strategy to meet it’s BSA, criminal investigation, and tax enforcement obligations as related to virtual currencies, (2) that the IRS provides updated guidance to reflect the documentation requirements and tax treatments needed for the various uses of virtual currencies, and (3) that the IRS revise third-party information reporting documents to identify the amounts of virtual currency used in taxable transactions. The IRS agreed with all 3 recommendations made by TIGTA, but stated that due to funding shortages and a lack of available resources, the implementation of recommendation #2 and #3 would not be afforded priority.
Two months following the issuance of the TIGTA report in 2016, the Department of Justice filed a petition in federal court requesting the issuance of a John Doe summons against Coinbase, Inc., the first indication to the outside world that the IRS was beginning to take seriously the threat to the Treasury posed by the increasing ubiquity and utilization of cryptocurrencies. In court filings, the IRS alleged, “only 800 to 900 taxpayers reported gains related to bitcoin in each of the relevant years,” while “more than 14,000 Coinbase users have either bought, sold, sent or received at least $20,000 worth of Bitcoin in a given year.” After a lengthy legal dispute, Coinbase notified its customers on February 23, 2018 that they had turned over customer data of approximately 13,000 customers who conducted transactions worth more than $20,000 on the exchange between 2013 and 2015. Coinbase also started issuing 1099-Ks annually to customers and the IRS, reporting annual gains from crypto transactions.
In 2018, the IRS established a virtual currency compliance campaign, which has resulted in a number of affirmative steps taken by the IRS that demonstrate an increased focus on cryptocurrency enforcement. In March 2019, the IRS updated Form 14457, Voluntary Disclosure Practice Preclearance Request and Application, to include a space specifically for taxpayers to disclose that they have unreported virtual currency income. In July 2019, the IRS mailed out more than 10,000 letters to taxpayers for which the IRS received cryptocurrency transaction information from exchanges, warning the taxpayers of their reporting obligations. Regarding the letters, IRS Commissioner Chuck Rettig stated, “Taxpayers should take these letters very seriously by reviewing their tax filings and, when appropriate, amend past returns and pay back taxes, interest, and penalties. The IRS is expanding our efforts involving virtual currency, including increased use of data analytics. We are focused on enforcing the law and helping taxpayers fully understand and meet their obligations.”
The IRS provided additional crypto-reporting guidance, related to the tax consequences of “airdrops” and “hard forks,” in October 2019 via Revenue Ruling 2019-24. Furthermore, for the first time, the IRS added a question to Schedule 1 of the 2019 Form 1040 asking whether taxpayers have received, sold, sent, exchanged, or acquired an interest in virtual currency. This question on Schedule 1 closely parallels the question added to Schedule B asking taxpayers whether they hold an interest in a foreign bank account and directing them to file FBARs, if required
.In February 2020, the US Government Accountability Office (GAO) issued a report stating that a number of third party exchanges still do not report virtual currency transactions to the IRS, frustrating not only the efforts of the IRS to identify taxpayers with unreported crypto-income, but the ability of taxpayers to accurately report such transactions. It highlights the fact that it is not clear, and the IRS has not provided any guidance, as to how virtual currency exchanges should even be reporting these transactions to the IRS, whether via Forms 1099-K or 1099-B. As a result, information reporting is handled differently by different exchanges, and the information that does get reported is frequently incomplete or insufficiently granular so as to be of much use to either the IRS or taxpayers.
The report also highlighted IRS shortcomings related to issuing guidance on the intersection of virtual currencies and foreign informational reporting obligations on forms such as the 8939 and FBAR. The report correctly points out that FinCEN officials have stated that FBAR regulations do not define virtual currency held in an offshore account as a type of reportable account (though there isn’t really any harm in including crypto-currency accounts on FBARs). Unfortunately, the IRS’s hasn’t had the same willingness to expound on the reportability of cryptocurrency on Form 8938, “According to IRS officials, they have not issued guidance about virtual currency and FATCA because the instructions for Form 8938 clearly explain how taxpayers are to interpret FATCA requirements. However, those instructions do not mention virtual currency and do not provide information needed to determine whether virtual currency holdings must be reported. For example, the instructions state that a financial account is any depository or custodial account maintained by a foreign financial institution, but do not explain under what circumstances, if any, an account that holds virtual currency could be considered a depository or custodial account.” Due to the lack of definitive guidance, the conservative position at this point is to include crypto-assets on the 8938, especially in light of the fact that IRC §6662(j) provides harsher accuracy-related penalties for understatements of income attributable to undisclosed foreign financial assets.
Despite the increased pressure on IRS to gather transaction information from exchanges related to crypto transactions by US taxpayers, a recent TIGTA report released on September 24, 2020 reiterated the overall lack of compliance with third-party reporting obligation by cryptocurrency exchanges/facilitators, the disparate reporting methodologies used by exchanges that do report, and the issues presented by the fact that 1099-Ks report aggregated information only. The report also reveals that as of October 2018, the IRS had conducted a number of pilot examinations of taxpayers with potential cryptocurrency reporting issues identified via third-party information. The report reveals that in Fiscal Year 2020, the IRS identified for exam more than 4,000 virtual currency-related cases, and plans to identify more cases in 2021.
The Path Forward:As the above timeline illustrates, the IRS has been battling on multiple fronts to close the tax gap related to unreported cryptocurrency transactions. As with most IRS initiatives, initial progress has been slow, but it would appear that we’re on the precipice of the IRS having the information and tools in place to begin cracking down on unreported cryptocurrency income across a broader base of taxpayers. And there’s no indication things will slow down in the future. Since the establishment of an IRS cryptocurrency task force in 2018, the IRS has put additional pressure on exchanges to report taxpayer information to them, has sent warnings to taxpayers that may not be in reporting compliance, has begun specifically targeting returns for exam based on identified cryptocurrency issues, and has begun pursuing tax evasion charges against taxpayers like John McAfee who “deal extensively in cryptocurrency” and fail to report such transactions accurately.
Any tax practitioner engaged in practice over the last decade can tell you that there are a number of parallels between the steps the IRS has taken in regard to cryptocurrency transactions and the increased focus the IRS placed on unreported foreign financial accounts and assets previously. As the IRS develops its investigation tools and exchanges are pressured to increase informational reporting to the IRS, the days of transacting in cryptocurrency under the radar of the IRS are quickly coming to an end. The addition of a question to Schedule 1 asking taxpayers whether they received, sold, sent, or exchanged any virtual currency in the year is a pretty good indication that the IRS is laying the groundwork for asserting that a taxpayer’s failure to reported crypto-income was willful, increasing the likelihood that the IRS may pursue civil fraud penalties or criminal charges against those who are later found to have unreported crypto-income.
While the lack of specific guidance and inconsistent informational reporting by third parties make it possible that the IRS may offer some sort of streamlined disclosure program to provide relief for taxpayers with unreported or underreported cryptocurrency income, nothing has been announced as of today’s date. If such a program is announced, it’s likely that falsely answering “No” to the cryptocurrency question on Schedule 1 would make you ineligible for whatever relief provisions such a program may provide. Every indication is that the IRS is going to be increasingly targeting for exam the returns of taxpayers they believe have been transacting in cryptocurrency. If you believe you have unreported crypto-currency income, or are concerned that you haven’t been accurately reporting your cryptocurrency income, please give us a call to discuss your options for rectifying your past mistakes, including options for seeking relief from applicable penalties. We have the expertise necessary to accurately report cryptocurrency gains and losses based on the most recent IRS guidance to ensure that your risks of an IRS audit or criminal investigation are minimized, both for past year returns and going forward.