Another tool the IRS is using as part of its cryptocurrency initiative is the “John Doe summons.” In the past, the IRS used John Doe summonses to identify taxpayers who had not paid their tax obligations by serving them on credit card companies such as American Express, MasterCard, and Visa, as well as payment services such as PayPal.
Now, the IRS is applying this tool to cryptocurrency exchanges. While a typical summons is issued when the IRS knows the name of the specific taxpayer, the IRS uses a John Doe summons to obtain the names of all taxpayers in a certain group. For example, a 2008 John Doe summons was a key step in the IRS finding U.S. taxpayers with accounts in Swiss banks. A John Doe summons is not only a potential source of concern for taxpayers who may have cryptocurrency tax obligations, but it can also impose substantial burdens on the cryptocurrency exchange or other party upon which the IRS serves the summons.
A John Doe summons must be approved by a federal district court judge, and on April 1, 2021, a federal court in the District of Massachusetts entered an order authorizing the IRS to serve a John Doe summons on Circle Internet Financial Inc., a digital currency exchange headquartered in Boston. The government sought information about U.S. taxpayers who conducted at least the equivalent of $20,000 in transactions in cryptocurrency during the years 2016 to 2020. The IRS requested that Circle produce records identifying such U.S. taxpayers, along with other documents relating to their cryptocurrency transactions.
According to the Justice Department, the government’s petition does not allege that Circle has engaged in any wrongdoing in connection with its digital currency exchange business. Rather, according to the court’s order, the summons seeks information related to the IRS’s “investigation of an ascertainable group or class of persons” that the IRS has reasonable basis to believe “may have failed to comply with any provision of any internal revenue laws[.]”
The IRS is simultaneously pursuing authority to issue John Doe summonses against Kraken, a California cryptocurrency exchange. Once again, the government is asking about U.S. taxpayers who conducted at least the equivalent of $20,000 in transactions in cryptocurrency during the years 2016 to 2020. The IRS has faced a more skeptical court there. On March 31, 2021, the federal court in the Northern District of California issued an order to show cause in which it said that the IRS had likely made a sufficient showing to satisfy the requirements of the statute for issuing a John Doe summons, but the court had concerns with respect to scope of the request (which the statute requires be “narrowly tailored”). On April 15, 2021, the IRS narrowed its requests, although it continues to seek substantial information from Kraken. The IRS does not allege that Kraken engaged in any wrongful conduct.
The proposed summons seeks broad categories of information such as “complete user preferences,” “[a]ny other records of Know-Your-Customer due diligence,” (KYC) and “[a]ll correspondence between Kraken and the User or any third party with access to the account pertaining to the account,” among other similarly expansive requests. The court therefore required the IRS to show cause why the petition should not be denied for failure to meet the “narrowly tailored” requirement of the statute. In doing so, the IRS was required to address specifically “why each category of information sought is narrowly tailored to the IRS’s investigative needs, including whether requests for more invasive and all-encompassing categories of information could be deferred until after the IRS has reviewed basic account registration information and transaction histories.” In responding to the court’s show cause order, the IRS narrowed its request for KYC information to only seek the responses to the employment, net worth, and source of wealth questions, and the IRS observed that it expects that these responses will only be provided for a limited number of account holders related to Kraken “pro level” accounts.
As these two cases show, the IRS is seeking broad information related to those engaged in cryptocurrency transactions, and third-party record keepers will face onerous requirements to produce such information. “Tools like the John Doe summons authorized [in the Circle case] send the clear message to U.S. taxpayers that the IRS is working to ensure that they are fully compliant in their use of virtual currency,” said IRS Commissioner Chuck Rettig. “The John Doe summons is a step to enable the IRS to uncover those who are failing to properly report their virtual currency transactions. We will enforce the law where we find systemic noncompliance or fraud.”
The broad information gathering the IRS is conducting as part of its cryptocurrency enforcement effort will also likely lead to a scrutiny of both the broader community of businesses and people that may not be primarily engaged in cryptocurrency transactions, but who provide or receive services for cryptocurrency, and related reporting obligations. Like earlier IRS enforcement initiatives, this can lead to a focus on reporting and withholding obligations. Some of the issues that have arisen as a result of earlier similar IRS enforcement initiatives have included:
- Withholding on payments to foreign persons. Generally, a foreign person is subject to a U.S. tax of 30% on its U.S. source income, subject to certain exceptions or reductions. Withholding refers to rules that requires 30% withholding on a payment of U.S. source income and the filing of required forms. Payments in cryptocurrency are not exempt from these requirements, but its relative novelty has led some to overlook compliance issues.
- Foreign account and transaction reporting. U.S. citizens and residents who hold more than $10,000 in foreign accounts are required to report the accounts on Form 114, Report of Foreign Bank and Financial Accounts (FBAR). Currently, FinCEN has stated that a foreign account holding virtual currency is not reportable on the FBAR (unless it holds reportable assets besides virtual currency), but FinCEN has stated an intention to amend those regulations to require reporting of cryptocurrency. Separately, those with certain foreign financial assets in excess of $50,000 must also report foreign accounts (and certain other foreign financial asset information) on Form 8938, Statement of Specified Foreign Financial Assets. U.S. persons and residents should be aware that (1) there is potential ambiguity in these rules as applied to cryptocurrency, (2) the government has announced an intent to change the rules, (3) there has been continuing speculation about IRS positions regarding reporting obligations, and (4) reporting for foreign assets can be complicated and expose U.S. persons and residents to substantial penalties.
With tax season underway in the U.S., those that are transacting in cryptocurrency, whether as a trading vehicle or merely to pay for goods or services, should obtain appropriate tax advice. As a general rule, disclosing one’s transactions to a qualified tax advisor and following legitimate advice can protect taxpayers from penalties (but not the underlying tax liabilities). The IRS has demonstrated it is taking steps to gather substantial information and will be pursuing those that do not comply with the rules.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
David Zaslowsky is a partner in the disputes practice in the New York office of Baker McKenzie and is editor of the firm’s blockchain blog. Scott Frewing is a partner in the tax practice in the Palo Alto office of Baker McKenzie. They can be reached at firstname.lastname@example.org and email@example.com , respectively.
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