Tax Investigations & Crypto

By JamesIrving | Legal Mongrel | 26 Jul 2020


Photo by Stephen C Dickson of Gwyneth Ellis

 

What power does the US Internal Revenue Service (IRS) have to demand information from a crypto exchange? This is the topic of a new lawsuit filed in the US District Court by a user of three exchanges, who has objected to the way the IRS obtained information about his activities. James Harper claims that the IRS violated his constitutional rights by how it demanded the information, and because he wasn't notified and given a chance to object. See the Complaint: HARPER v IRS, COMMISSIONER, USDC District of New Hampshire (1:20-cv-0771). (The references below to are to Complaint paragraphs.)

IRS Investigation Powers

From time to time, tax authorities believe that certain people aren't paying the right amount of taxes. The authorities are given powers to gather information, including a right to make people surrender other people's information. In 2016, the IRS asked the Coinbase crypto exchange (and some other exchanges) to turn over data on everyone who had bought, sold or traded cryptocurrency on that exchange during 2013-2015.  The IRS asked for account/wallet/vault records for every account holder, KYC records, agreements allowing third parties access to accounts, transaction logs including the names of counterparties, and correspondence: [45]. To learn why capital gains made from trading crypto is taxable in the US, see the IRS FAQ about virtual currency. 

Coinbase thought the IRS demand, called an administrative summons, was too wide. Where the IRS issues a summons for information about unidentified persons, it must get court approval. Coinbase opposed the summons in court, but the court approved it after its scope was narrowed down. As amended it didn't apply to persons with transactions below USD $20K , or who had only bought and held cryptocurrency, or for whom the exchange issued a tax report (Form 1099-K): [42 & 43]. Despite this, the summons still applied to 8.9 million transactions by 14,355 account holders, according to Coinbase: [44]. 

Harper's Complaint 

Mr Harper was an account holder with Coinbase, and also two other exchanges requested to produce information. He says he properly reported all capital gains to the IRS, and paid all due taxes: [30], [31], [64], [94], [118]. Therefore, he could not reasonably have been under suspicion for tax evasion. Despite that, he received an IRS letter which began: "We have information that you have or had one or more accounts containing virtual currency but may not have properly reported your transactions involving virtual currency ... " [67].

Mr Harper's position, indicated in his Complaint, is that:

  • The IRS could not have had any reasonable suspicion that he had under-declared his tax on capital gains from crypto trading. He did declare his gains and did pay any applicable tax.
  • Accordingly, the IRS must have obtained the court's approval to gather his personal information incorrectly. The approval should not have been given, and the IRS demand to the exchange was unlawful.
  • His personal information is his private property. It was disclosed to the exchange under a contract which included a confidentiality clause. He did not consent to its disclosure to anyone, including the IRS. The law authorising the seizure of the information was unconstitutional because it didn't require a search warrant based on probable cause: [102].
  • In the US, a person's private property is protected by the Fourth Amendment to the Constitution from unlawful search and seizure, and by the Fifth Amendment from being seized without due process. Mr Harper says these constitutional rights were abused, because the seizure was unlawful (4th Am) [101], and because he wasn't notified and given an opportunity to object (5th Am): [124].

Photo: US Postage Stamp

Legal Issues

Apart from these constitutional question, this Complaint raises questions about IRS processes and the relevant laws. Is it fair on taxpayers like Mr Harper for their personal information can be obtained in bulk together with that of hundreds or maybe thousands of other people in a situation where there could be no definite suspicion that he personally has committed tax evasion? If what Harper says about declaring his crypto capital gains is true, then either the IRS did not bother matching his seized information against his tax returns before writing to him, or it sent the letter indiscriminately, or - if it did check his returns - it couldn't tell whether he had paid the correct tax or not, which might be the case if the capital gains weren't identified separately. Regardless of what happened, Harper says the IRS should be required by law to prove the basis for its suspicions about him by applying for a search warrant before it seizes his information, which is his property 

In the range of powers that the IRS has, issuing an administrative summons is an easier option than some others. Mr Harper says that the IRS should have been required by the law to get a warrant based on probable cause in order to do something as intrusive as seize all of his records from the crypto exchanges. The summons issued by the IRS was approved by the judge on the basis of a "reasonable basis for believing" that there had been a failure by unidentified persons to comply with a tax law: [132]. Even on this standard, could the IRS have reasonably held such a belief in relation to Harper, specifically? Did it do so, or was he simply lumped in with hundreds of other people in a vast information-fishing exercise? Harper says he declared his capital gains. What made the IRS think he had filed incorrect returns, as it suggested in its letter to him?

Conclusion

Constitutional law is a dry topic. If you are still reading this post, congratulations! But it is  important. Without the Constitution, there is little to stop government officials abusing their authority. Governments must operate within proper boundaries, otherwise we end up living in dictatorships. The filing of a Complaint is, of course, only the beginning of the trial process. The Complaint is only one side of the story. We must wait to find out what the US Government has to say about the tax laws and the powers of the IRS.

We seem to be living in an era where governments have an appetite to increase their power over ordinary citizens. Whether it happens in the name of national security, or counter-terrorism, or protecting "civic monuments", or a response to the COVID pandemic, or something else, governments seem to want to expand their powers every day. The "balance of powers" system that the US has in its Constitution, where the courts are meant to prevent abuses by executive officials, breaks down if judges are appointed who approve ever-increasing government scope and authority. Ultimately, this case is not just about whether it was fair for the IRS to demand the production of one taxpayer's records from some crypto exchanges. Like all constitutional cases, it is ultimately about the fundamental rights of all citizens, and their freedom. 

[Photo credit: (1) Thumbnail: cropped photo of the cast for the first showing of The Untouchables (TV series) on Desilu Playhouse (1959), a public domain image courtesy of Wikimedia Commons; (2) Photo by Stephen C Dickson: Classic pose with a magnifying glass - model Gwyneth Ellis CC BY-SA 4.0; (3) Photo of US Postage Stamp, issued 1937, in Smithsonian National Postal Museum. All photos courtesy of Wikimedia Commons. This post is a basic level, educational and informational discussion of legal concepts. It does not constitute legal advice for any person, nor does it create a lawyer/client relationship with any person. Although care has been taken to ensure that the law is described correctly at the time of publication, no guarantee of accuracy is provided. The author is a lawyer involved in blockchain projects. You can visit his website at https://irvinglaw.com.au ]

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JamesIrving
JamesIrving

I'm interested in new technology, especially blockchain. I'm a lawyer for some blockchain projects.


Legal Mongrel
Legal Mongrel

Commentary and analysis - legal and other.

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