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INSIGHT: IRS Criminal Investigations Division Issues Its Annual Report in Midst of Cryptocurrency Bear Market Blues

Dec. 19, 2018, 2:23 PM

As cryptocurrency markets experience a downturn with leading cryptocurrencies, like Bitcoin (BTC) and Ethereum (ETH) down 80 percent or more, skilled cryptocurrency hedge fund managers, who rushed to surf the cryptocurrency waves on the world-wide-web, are still standing on their surfboards.

An altogether different story is unfolding for those who have been knocked off. “I’m not sure one can really define why some traders make it, while others do not. For myself, I can think of two important elements. First, I have the ability to imagine configurations of the world different from today and really believe it can happen. Second, I stay rational and disciplined under pressure” explained Bruce Kovner a legendary hedge fund manager in an interview with Jack Schwager in the Market Wizards Book.

Is My Life Over?

Recently, a college student from California, in a reddit post, sent out “SOS” signals—which are used as a start-of-message mark for maritime transmissions requesting help when catastrophic loss of property is imminent—“Is my life over?”

Apparently, the student encouraged by the 2017 crypto market surge—which many likened to the tulip mania—without any awareness of the tax consequences, began surfing the world-wide-web by trading cryptocurrencies. “I feel like I ruined my life by dabbling into cryptos as a clueless college kid. I first caught wind of it when a buddy of mine said he was going all in on ETH in May of last year (2017). I said hell with it, signed up on Coinbase and threw $5,000 into crypto. Well, I went down the rabbit hole and struck gold a few times. I brought my 5k initial all the way up to a $880k portfolio in December 2017.”

During 2018 , when the cryptocurrency bear market began and the tides turned, the young crypto surfer—who did not know how to hedge his cryptocurrency portfolio—fell off his surf board and lost most of his cryptocurrency gains relating to 2017, which were declared to the IRS by Coinbase on an Internal Revenue Service Form 1099. “My estimated tax liability for 2017 is about $400,000. I haven’t paid any taxes or filed any returns for 2017,” the student said—as the student does not have the funds necessary to pay his 2017 taxes on his cryptocurrency gains.

Tax Crimes

Selling or exchanging cryptocurrency is a taxable event. The gains are subject to tax at lower long-term capital gains rates at three brackets ranging from 0 percent to 20 percent when the cryptocurrency is held by the U.S. individual taxpayer as a capital asset. Short term cryptocurrency trading gains are taxed at seven brackets ranging from 10 percent to 37 percent. If the taxpayer is in the three highest income brackets, he or she may also have to pay a 3.8 percent tax on net investment income. A taxpayer can use investment capital losses to offset gains and deduct the difference on their tax return, up to $3,000 per year. Any portion of a capital loss that exceeds the $3,000 annual deduction limit may be carried forward, but not carried back. A non-resident taxpayer is also subject to a U.S. withholding tax of 30 percent on 50 percent of their U.S.-source cryptocurrency capital gains. This withholding tax maybe lowered or eliminated under a tax treaty.

Taxpayers should be informed that as part of the Tax Cuts and Jobs Act passed at the end of 2017, like-kind crypto-to-crypto exchange transactions to defer any gains under tax code Section 1031 are barred beginning Jan. 1, 2018. This does not affect 2017 or other previous years, although it might influence the IRS’s decision to contest the use of Section 1031 in those years.

Taxpayers who have neglected to pay their cryptocurrency related U.S. taxes, and file their applicable U.S. tax returns should do so to avoid interest, penalties, and even jail time for tax evasion or, worse, for tax fraud. Tax evasion and tax fraud have different meanings under the tax law. Tax evasion is the illegal nonpayment or underpayment of tax by not reporting income, reporting expenses that are illegal, or by not paying taxes owed to the IRS. It is a subset of tax fraud which is an illegal, intentional attempt to evade tax laws or defraud the IRS.

These federal tax crimes and related financial crimes involving cryptocurrencies are investigated by the IRS Criminal Investigations Division’s (IRS-CI) Cybercrime unit (CCU) which was established in 2015. Given the cross-border nature of blockchain technology, CCU’s investigations are typically multi-jurisdictional and include cryptocurrency-based tax, money laundering, terrorist financing, and dark web marketplace schemes.

IRS-CI Issued Its Annual Report

In its Annual Report for fiscal year 2018 the IRS-CI stated that the division found nearly $10 billion in tax fraud—four times more than last year thanks to its focus on using data analytics. The team also found $10.4 billion in other financial crimes, a steep hike from the $1.1 billion identified in fiscal year 2017. It achieved a conviction rate of 91.7 percent and seized 1.76 petabytes of digital data. “We prioritized the use of data in our investigations in fiscal 2018” explained Don Fort, chief of the IRS-CI in a news release.

A focus for the IRS-CI this year were cases involving international tax enforcement, terrorist financing, money laundering, and cybercrime. In investigating cryptocurrency related cyber-crimes, the IRS-CI “used its expertise gained from combating cyber-crime in cases like Silk Road, Liberty Reserve, Alpha Bay, and BTC-e to investigate white-collar crimes. We now require all IRS-CI employees—not just special agents—to complete cyber training. Moving forward, it is hard to imagine future cases that will not have a cyber component to them” Fort said in the report.

The report comes as tax administrations around the world are trying to combat tax evasion and cross-border financial crimes involving cryptocurrencies by using data at their fingertips. The U.S., U.K., Canada, Australia, and the Netherlands formed the Joint Chiefs of Global Tax Enforcement (J5) alliance in July to boost the fight against global tax evasion and money laundering, after calls by the Organization for Economic Cooperation and Development (OECD) for better cross-border coordination.

“Cryptocurrencies are a key part of the J5’s work”, Fort said at J5 meeting in Amsterdam in November, citing the risk that such coins are used in the U.S. to avoid paying capital gains taxes, according to Reuters in a Nov. 14 article. Cryptocurrencies can be used to transfer funds cross-border to people without the need for foreign bank accounts, he explained. The IRS-CI is looking at the involvement of cryptocurrency exchanges and financial firms in withdrawals of digital money and their conversion to government backed “fiat” currencies. One of the ways to track cryptocurrencies is by focusing “on when the actual cryptocurrency enters the system—folks want their money—and when it comes out is what we are focused on”—the “professional enablers” of international tax fraud, Fort said.

Selva Ozelli, Esq., CPA is an international tax attorney and CPA who frequently writes about tax, legal and accounting issues for Tax Notes, Bloomberg Tax, other publications and the OECD.