By Casey W. Baker, JD* and Ralph E. McKinney, Jr., DBA**
Two recent reports suggest that a federal crackdown on cryptocurrency tax avoidance in the United States is in process. In March 2021, Damon Rowe, Director of the IRS Office of Fraud Enforcement, and Carolyn Schenck, National Fraud Counsel & Assistant Division Counsel (International) in the IRS Office of Chief Counsel, announced a partnership between the IRS’s civil office of fraud enforcement and criminal investigation unit targeting cryptocurrency tax evasion. Dubbed “Operation Hidden Treasure,” the effort is “all about finding, tracing, and attributing crypto to U.S. Taxpayers.” Reports indicate that IRS employees are working with European law enforcement agencies as a part of the effort.
Likewise, at an April 13, 2021, hearing of the Senate Finance Committee, Sen. Rob Portman (R-OH) and IRS Commissioner Charles Rettig discussed issues relating to the reporting of cryptocurrency transactions. Commissioner Rettig specifically highlighted new cryptocurrency disclosure obligations on the Form 1040 tax return. Sen. Portman announced a forthcoming bipartisan bill specifically aimed at tax reporting of cryptocurrency-related transactions.
The increased targeting of cryptocurrency transactions means users of cryptocurrency—and their counsel—should be aware of possible tax reporting and fraud issues.
Cryptocurrency Regulatory Confusion
One of the major problems with cryptocurrency regulation in the United States is an inconsistent regulatory conceptualization. Federal banking regulators disagree as to whether cryptocurrency firms are engaged in the business of banking. According to the Securities and Exchange Commission, some, but not all, cryptocurrencies are securities. The Federal Elections Commission considers cryptocurrency as currency, yet cryptocurrency campaign contributions are considered “in-kind” contributions.
The IRS position is also inconsistent, recognizing cryptocurrency as a medium of exchange but refusing to treat it as currency. Instead, the IRS treats of cryptocurrency as a capital asset. Essentially, when a person acquires a cryptocurrency, the cost associated with its acquisition is the asset’s basis. For an owner who holds the cryptocurrency for appreciation in value (as one might with publicly traded securities), the sale or disposition of the cryptocurrency results in either a gain or loss, with appropriate tax treatment.
But cryptocurrency is not acquired just for capital appreciation; it is used as a medium of exchange in ordinary commercial transactions. When normal currency is used in a commercial transaction, typically only the vendor must recognize taxable income. But because the IRS treats cryptocurrency as property with basis, when it is used for the purchase goods or services, the purchaser also must recognize taxable gain or loss on the disposition of the asset.
It is unclear whether cryptocurrency users are aware of these tax consequences. One source estimates that 18 to 21 million taxpayers will need to consider cryptocurrency transactions for 2021 income. And in reporting income, taxpayers need to be careful to properly track the basis of the cryptocurrency to correctly calculate taxable gain or loss.
Form 1040 Disclosures
The 2020 Form 1040 tax return requires taxpayers—as the very first question on the return—to answer, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” According to the Form 1040 Instructions, virtual currency includes digital currency or cryptocurrency, and virtual currency transactions include, but are not limited to:
- The receipt or transfer of virtual currency for free (without providing any consideration), including from an airdrop or hard fork;
- An exchange of virtual currency for goods or services;
- A sale of virtual currency;
- An exchange of virtual currency for other property, including for another virtual currency; and
- A disposition of a financial interest in virtual currency.
Taxpayers seeking to avoid IRS attention to their cryptocurrency transactions may be tempted to answer “no” to the question, hoping that the supposed anonymity offered by cryptocurrency will protect them. This is the specific type of activity that the IRS seeks to target with Operation Hidden Treasure:
The IRS, through its trained agents working together with specialist vendors, is “analyzing blockchain and de-anonymizing [crypto] transactions” to be “able to track, find, and work to seize crypto in “both a civil and a criminal setting.”
Schenck had a message for crypto traders who are would-be tax evaders: “We see you.”
Civil and Criminal Tax Fraud
Failing to properly disclose cryptocurrency transactions can trigger both civil and criminal tax fraud. If—or perhaps when—the IRS eventually traces cryptocurrency transactions back to the taxpayer, the Internal Revenue Code allows a 75% civil penalty for any underpayment of taxes attributable to fraud. While the IRS bears the burden of proving by clear and convincing evidence that the underpayment is due to fraud, the burden is met by showing that an underpayment of tax exists, and that the taxpayer intended to evade taxes known to be owed intentionally concealing, misleading, or otherwise preventing the collection of taxes.
Criminal tax fraud is also a possibility if the taxpayer fails to truthfully answer the cryptocurrency question on the tax return. However, the federal criminal tax fraud statutes include the heightened mens rea element of willfulness, which is not found in the civil tax fraud statutes. Courts have construed “willfulness” in the context of tax fraud to require the government to show that the law imposed a duty on the taxpayer, that the taxpayer knew of the duty, and that the taxpayer voluntarily and intentionally violated the duty. Given the incongruence between the common use of cryptocurrency in transactions and the tax treatment thereof by the IRS, many taxpayers may be saved by the willfulness element.
Some observers have noted the similarities in the IRS’s early approach to foreign account disclosures and the tactics currently employed with regard to cryptocurrency. Under the Offshore Voluntary Disclosure Program (“OVDP”), first instituted in 2009, taxpayers with undisclosed foreign financial accounts could avoid criminal prosecution and heightened civil penalties by fully disclosing accounts and paying a lesser amount. This “carrot”—contrasted with the “stick” of criminal prosecutions—netted the IRS $11.1 billion of voluntary payments.
Some have called for an IRS voluntary disclosure and amnesty program for cryptocurrency users, similar to the OVDP. At least one observer has described the IRS’s game plan thusly: use Joe Doe summonses directed to cryptocurrency exchanges to obtain user information, push Congress to pass legislation addressing third-party reporting of cryptocurrency transactions, and then offer amnesty for violators that voluntarily disclose. Thus far, the IRS has rebuffed calls for cryptocurrency tax amnesty, but Sen. Portman’s proposed legislation may be a vehicle to advance the outlined strategy.
Foreign Cryptocurrency Accounts
Subsequent to the initial OVDP amnesty, Congress passed the Foreign Account Tax Compliance Act (“FATCA”) in 2010. Like OVDP, FATCA is tool to reduce tax avoidance via foreign financial accounts. Under the statute, foreign financial institutions are obligated to identify and report information about U.S. account holders to the IRS. Institutions that fail to comply with the requirements face a 30% withholding tax on certain types of U.S.-sourced income.
At least one observer has called on regulators to include cryptocurrency within the FATCA regime, noting the similarity between cryptocurrency virtual wallets and financial accounts. Indeed, regulators announced in 2020 that the current foreign reporting regulations would be updated to address cryptocurrency.
But FATCA relies on cooperation between the IRS, foreign governments, and foreign financial institutions in order to complete reporting of foreign accounts. It is unclear whether a FATCA-style reporting system is workable with cryptocurrency—virtual wallet providers beyond the scope of the IRS’s jurisdiction may not voluntarily report their users’ activity, especially when supposed anonymity is one of the selling points of cryptocurrency usage.
Tax Whistleblower Statute
Cryptocurrency users should also be aware of the federal tax whistleblower statute. In a commercial transaction, the vendor and buyer necessarily have identifying information about the other, so that the vendor can ensure that payment is received, and the buyer can ensure that goods or services are delivered according to the contractual specifications. This is true even in commercial transactions with cryptocurrency serving as the medium of exchange—the vendor must be able to match the cryptocurrency to the transaction as a bookkeeping function.
Thus, if a vendor accepting cryptocurrency learns that the buyer is using cryptocurrency to avoid taxes, the vendor may be able to take advantage of the whistleblower program. Under the statute, a whistleblower is eligible to receive up to 30% of the proceeds collected by the IRS in an enforcement action, with lesser amounts available depending on the extent of the whistleblower’s assistance.
The tax whistleblower statute is in contrast with the federal False Claims Act, which permits qui tam actions by individuals to encourage whistleblowing. In a qui tam action, a private person may file a suit under seal on behalf of the government against the defrauding party. The government may take over the case, in which case the relator is entitled to 15% to 25% of the amount recovered; alternatively, the government may decline the case, in which case the relator may continue the action and receive 25% to 30% of the recovery. A successful relator is also entitled to recover attorney fees and other expenses.
Because commercial counterparties will have greater access to information about cryptocurrency usage than the IRS., the qui tam scheme may be especially helpful in eliminating tax fraud. However, the federal False Claims Act specifically excludes tax cases, so qui tam actions are not available to private persons who may know of a tax avoidance scheme. Some have argued for an expansion of the False Claims Act to include federal tax fraud, in an effort to encourage private participation in eliminating tax fraud.
Speculating on Forthcoming Cryptocurrency Taxation and Regulation
Thus far, Sen. Portman has been coy about the specifics of his forthcoming bill. His comments raise two general areas of concern: defining cryptocurrency for tax purposes, and improving information reporting. With regard to the first concern, a more consistent overall federal regulatory approach treating cryptocurrency as a true medium of exchange would be welcome for commercial parties.
With regard to the second, foreign cryptocurrency account reporting certainly seems to be on the regulatory radar, as discussed above. Vendors accepting cryptocurrency as payment may also see additional information reporting requirements—such as Form 1099s specifically for cryptocurrency transactions. This could potentially open the door for private enforcement mechanisms such as qui tam actions, but there is no indication that policymakers are considering that tactic.
Portman’s comments also specifically highlighted a $1 Trillion “tax gap” between amounts owed by taxpayers and collected by the IRS, with taxes owed on cryptocurrency transactions constituting part of that gap. Treasury Secretary Janet Yellen has also criticized the use of cryptocurrencies in certain commercial transactions as “extremely inefficient.”
One may speculate as to whether enhanced information reporting requirements will be sufficient to close the gap, or whether stronger disincentives towards cryptocurrency use may be on the regulatory horizon. Users of cryptocurrency should consider what a cryptocurrency-specific taxation scheme could look like. A financial transfer tax, such as the “Tobin tax” or “Section 31 Fees” could serve as a model for a federal excise tax on cryptocurrency transactions.
* Assistant Professor of Legal Environment, Brad D. Smith Schools of Business, Marshall University
** Associate Professor of Management, Brad D. Smith Schools of Business, Marshall University
 Guinevere Moore, Operation Hidden Treasure Is Here. If You Have Unreported Crypto, Get Legal Advice, Forbes (Mar. 6, 2021), https://www.forbes.com/sites/irswatch/2021/03/06/operation-hidden-treasure-is-here-if-you-have-unreported-crypto-its-time-to-get-legal-advice/?sh=3dcaff4439c9.
 Daniel Kuhn, IRS Initiates ‘Operation Hidden Treasure’ to Root Out Unreported Crypto Income, Coindesk (Mar. 7, 2021) https://www.coindesk.com/irs-operation-hidden-treasure-unreported-crypto.
 Press Release, At Senate Finance Hearing, Portman Discusses Concerns Regarding IRS’ Processing Backlog of Tax Filings, Modernization (Apr. 13, 2021), https://www.portman.senate.gov/newsroom/press-releases/senate-finance-hearing-portman-discusses-concerns-regarding-irs-processing.
 See, Ralph E. McKinney Jr., Casey W. Baker, Lawrence P. Shao & Jeff Y. L. Forrest, Cryptocurrency: Utility Determines Conceptual Classification Despite Regulatory Uncertainty, 25 Int. Prop. & Tech. L.J. 1, 3-4 (2021).
 IRS Notice 2014-21, 2014-1 C.B. 938; 2014-16 I.R.B. 938.
 McKinney, et al., supra note 5, at 12-13.
 Roger Russell, IRS Sharpens Focus on Crypto Transactions, Accounting Today (Apr. 13, 2021), https://www.accountingtoday.com/news/irs-sharpens-focus-on-crypto-transactions.
 Shehan Chandrasekera, What Crypto Taxpayers Need To Know About FIFO, LIFO, HIFO & Specific ID (Sept. 17, 2020), https://www.forbes.com/sites/shehanchandrasekera/2020/09/17/what-crypto-taxpayers-need-to-know-about-fifo-lifo-hifo-specific-id/?sh=b85b47336aa3.
 IRS Form 1040 (2020), U.S. Individual Income Tax Return, https://www.irs.gov/pub/irs-pdf/f1040.pdf.
 IRS Form 1040 (2020), Instructions, https://www.irs.gov/instructions/i1040gi#idm140260168286256.
 Moore, supra note 1.
 26 U.S.C. § 6663.
 Parks v. Commissioner, 94 T.C. 654, 660-61 (1990).
 See, e.g., 26 U.S.C. §§ 7201 (tax evasion), 7207 (fraudulent return).
 Cheek v. United States, 498 U.S. 192, 201; 111 S. Ct. 604, 610 (1990).
 See, Caroline T. Parnass, Pay Toll with Coins: Looking Back on FBAR Penalties and Prosecutions to Inform the Future of Cryptocurrency Taxation, 55 Ga. L. Rev. 359 (2020); Nathan J. Hochman, Policing the Wild West of Cryptocurrency: Part Two: The Ability of Federal and State Regulators to Work Together Will Determine Whether the Wild West of Cryptocurrency Enforcement Will Be Won, 41 Los Angeles Lawyer 14 (2018); Arvind Sabu, Reframing Bitcoin and Tax Compliance, 64 St. Louis L.J. 181 (2020).
 Jay R. Nanavati & Justin A. Thornton, DOJ and IRS Use “Carrot ‘N Stick” to Enforce Global Tax Laws, 29 Crim. Just. 4 (2014).
 IRS, News Release, Offshore Voluntary Compliance Program to End Sept. 28 (Sept. 4, 2018), https://www.irs.gov/newsroom/irs-offshore-voluntary-compliance-program-to-end-sept-28.
 Hochman, supra note 17, at 18.
 Moore, supra note 1.
 Pub. L. No. 111-147, §§ 501, et seq.; 124 Stat. 71, 97-117 (2010).
 26 U.S.C. § 1471.
 Elizabeth M. Valeriane, IRS, Will You Spare Some Change?: Defining Virtual Currency for the FATCA, 50 Val. U.L. Rev. 863 (2016).
 Financial Crimes Enforcement Network, Notice 2020-2, Report of Foreign Bank and Financial Accounts (FBAR) Filing Requirement for Virtual Currency (Dec. 30, 2020), https://www.fincen.gov/sites/default/files/shared/ Notice-Virtual%20Currency%20Reporting%20on%20the%20FBAR%20123020.pdf.
 26 U.S.C. § 7623.
 31 U.S.C. §§ 3729-3733; see, U.S. Dep’t. of Justice, The False Claims Act: A Primer (2011), https://www.justice.gov/sites/default/files/ civil/legacy/2011/04/22/C-FRAUDS_FCA_Primer.pdf
 31 U.S.C. § 3729(d).
 Franziska Hertel, Qui Tam For Tax?: Lessons From The States, 113 Colum. L. Rev. Sidebar 1897 (2013). But see, Sung Woo “Matt” Hu, Fine-Tuning the Tax Whistleblower Statute: Why Qui-tam is not a Solution, 99 Minn. L. Rev. 783 (2014).
 See, Press Release, supra note 4.
 Jeff Cox, Yellen Sounds Warning About ‘Extremely Inefficient’ Bitcoin, CNBC.com (Feb. 23, 2021), https://www.cnbc.com/2021/02/22/yellen-sounds-warning-about-extremely-inefficient-bitcoin.html.
 James Tobin, A Proposal for International Monetary Reform, 4 E. Econ. J. 153 (1978).
 Sec. and Exch. Comm’n, Office of Investor Education and Advocacy, Section 31 Transaction Fees (Sept. 25, 2013), https://www.sec.gov/fast-answers/answerssec31htm.html.