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A court approved the issuance of a John Doe summons by the IRS to major cryptocurrency platform Kraken, aimed at identifying individuals who are potentially avoiding their income tax obligations relating to cryptocurrency transactions.

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The IRS and other prosecuting agencies have made clear that John Doe summonses are a powerful tool in pursuing virtual currency nonreporting and underreporting.

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In a recent ruling, a California federal judge held that Kraken, an online cryptocurrency exchange program, has to turn over user information to the IRS as a result of a John Doe summons originally served on Kraken in 2021.<a href="https://www.bakerlaw.com/alerts/kraken-loses-bid-to-avoid-turning-over-customer-information-to-irs#_ftn1">[1]</a>&nbsp;The IRS launched Operation Hidden Treasure in May 2021 in an effort to root out tax abuses among cryptocurrency users. As part of these efforts, the IRS has been issuing John Doe summonses to major cryptocurrency platforms, seeking information that will enable the IRS to identify users who are not in compliance with tax reporting and payment obligations. Cryptocurrency platforms and users should expect this decision to further embolden an already aggressive IRS and Department of Justice.

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Because of the perceived pseudo-anonymous nature of cryptocurrency, the IRS has identified the multitude of tax compliance risks related to its use. As an IRS agent stated in a declaration in support of the Kraken summons, the number of taxpayers reporting cryptocurrency “fall[s] far short of what would be expected given the number of users, transactions, and value that the virtual currency exchanges publicize occur on an annual basis.”<a href="https://www.bakerlaw.com/alerts/kraken-loses-bid-to-avoid-turning-over-customer-information-to-irs#_ftn2">[2]</a>&nbsp;A 2016 study by the Treasury Inspector General for Tax Administration found that “taxpayers’ use of virtual currencies, including cryptocurrencies, had expanded significantly in recent years” and that “while there are legitimate reasons to use virtual currency … some virtual currencies are … popular because the identities of the parties involved are generally anonymous, leading to a greater possibility of their use in illegal transactions.”<a href="https://www.bakerlaw.com/alerts/kraken-loses-bid-to-avoid-turning-over-customer-information-to-irs#_ftn3">[3]</a>

In response to concerns related to cryptocurrency tax noncompliance, the IRS expanded its Electronic Payments Systems Initiative, which was launched in 2005 to address U.S. taxpayers who use electronic funds transfer and payment services for tax avoidance purposes. The agent noted that this expansion is “to address U.S. taxpayers who use virtual currencies for tax avoidance purposes, recognizing that some U.S. taxpayers use such currencies to expatriate and repatriate funds to and from offshore accounts.” As part of this initiative, the IRS has established the Virtual Currency Issue Team to, among other things, “consider the compliance impact related to virtual currencies.”<a href="https://www.bakerlaw.com/alerts/kraken-loses-bid-to-avoid-turning-over-customer-information-to-irs#_ftn4">[4]</a>

Also evidencing the strong focus on these areas, IRS Criminal Investigation (IRS-CI) recently announced the launch of a pilot program in which “cyber attachés” will deploy to four continents to combat tax and financial crimes involving cryptocurrency, decentralized finance, and peer-to-peer payment and mixing services. The four individuals tapped to serve as cyber attachés have significant expertise investigating cybercrime and will work with IRS-CI’s law enforcement counterparts in Asia, Europe, South America, and Australia. The 120-day program, which takes place from June to September 2023, is aimed at strengthening relationships with foreign law enforcement and ensuring that foreign counterparts have access to the same tools and expertise used in the United States to effectively combat cybercrime on a global scale.

John Doe summonses are an incredibly powerful tool for the IRS because they allow the agency to obtain user information for these platforms and match it up to taxpayer information. The IRS then uses that data to initiate tax audits and civil and criminal investigations of cryptocurrency users who have failed to report or have underreported cryptocurrency activity.

In Kraken’s case, the court ordered the company to hand over customer and transaction data, including names, birthdates, taxpayer identification numbers, phone numbers, addresses, email addresses, blockchain addresses and transaction hashes for accounts having at least $20,000 in transactions between 2016 and 2020. The judge did deny some of the requests included in the summons, including for information related to wealth sources and employment, holding that the information was not required to prove user identities.

Similar John Doe summonses have successfully been used to obtain customer information from other major cryptocurrency platforms, including Coinbase, sFox and Poloneix. In one prior instance, a summons issued to a major cryptocurrency exchange resulted in information that led to the IRS issuing 10,000 letters to taxpayers reminding them of their tax reporting responsibilities. The IRS estimated that these letters resulted in 577 amended income tax returns and an additional $15 million in assessed federal tax liabilities. Individuals should therefore expect that the IRS will continue to investigate such transactions to find those who have shirked their responsibilities and to make those individuals pay back past-due taxes, as well as potentially impose civil penalties and, in extreme cases, pursue criminal liability.

The IRS has made no secret of the fact that it intends to hold accountable those who fail to report or underreport their virtual currency transactions, including stating the obligation to report such transactions on the first page of taxpayers’ 1040s. It is also no secret that more John Doe summonses to cryptocurrency platforms are likely to come, given the IRS’ successes both in litigation where the summonses have been challenged and in using the information obtained from the summonses to catch taxpayers failing to report or underreporting cryptocurrency transactions.

Cryptocurrency platforms should be prepared to receive a John Doe summons from the IRS that requests information about their users, and users of cryptocurrency platforms should ensure that they are in compliance with applicable tax laws and regulations.

The BakerHostetler Tax Practice Group provides clients with sound and practical advice in federal, international, tax controversy, employee benefits, private wealth, tax-exempt, and state and local matters. The group’s experience extends to structuring transactions and representing clients in the course of IRS examinations. The Criminal Tax Defense team assists individuals and institutions with assessing and identifying issues of concern and implementing measures to reduce potential exposure. The team has successfully represented clients at each stage of the criminal tax process in administrative IRS investigations, joint IRS-Department of Justice grand jury investigations, and indictments and prosecutions by U.S. attorneys’ offices. The Blockchain Technologies and Digital Assets team has members across all our core groups, and our attorneys have extensive experience across all sectors of the blockchain and cryptocurrency markets, including investigations, securities law, commodities law, Bank Secrecy Act/anti-money-laundering compliance, tax, privacy, transactions, advertising law, intellectual property and technology design, as well as government affairs, public policy and advocacy across federal departments and agencies and Congress.

Please feel free to contact any of our experienced professionals if you have questions about this alert.

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<a href="https://www.bakerlaw.com/alerts/kraken-loses-bid-to-avoid-turning-over-customer-information-to-irs#_ftnref1">[1]</a>&nbsp;United States v. Payment Ventures, Inc.,&nbsp;<a href="https://www.law360.com/tax-authority/cases/63dd6080352442020488cade?article_sidebar=1">3:23-mc-80029</a>, June 30, 2023 Order (Order).

<a href="https://www.bakerlaw.com/alerts/kraken-loses-bid-to-avoid-turning-over-customer-information-to-irs#_ftnref2">[2]</a>&nbsp;Order at 5.

<a href="https://www.bakerlaw.com/alerts/kraken-loses-bid-to-avoid-turning-over-customer-information-to-irs#_ftnref3">[3]</a>&nbsp;Id. at 4.

<a href="https://www.bakerlaw.com/alerts/kraken-loses-bid-to-avoid-turning-over-customer-information-to-irs#_ftnref4">[4]</a>&nbsp;Id. at 5.

Kraken Loses Bid to Avoid Turning Over Customer Information to IRS

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