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How the IRS Could Cripple Cryptocurrency

Cryptocurrency startup Coinbase has been scrupulously compliant with government demands, until the IRS asked for millions of innocent customers' records.

Sticker on yellow plastic container in Prague - September 2016Foitlova Klara/ZUMA Press/NewscomShould the Internal Revenue Service (IRS) have authority to make financial-services companies turn over millions of customer records when they suspect a handful of customers could be evading taxes? Most people would respond with an emphatic no, yet this is exactly what the IRS is attempting to do with Coinbase, one of the most popular cryptocurrency service providers. And if the IRS prevails in this privacy-violating crusade against cryptocurrency users, it could have big implications for the future of everyone's digital privacy.

In November, the IRS initiated a "John Doe" summons against Coinbase to secure information on suspected tax cheats that use the service. But rather than tailor a subpoena to a narrow group of likely tax-evaders, the IRS instead requested all transaction records between 2013 and 2015—an alarmingly broad net that casts Coinbase customers as possibly guilty until proven innocent. In early December, a federal judge in San Francisco approved federal tax collector's request, which Coinbase is now fighting in court as too broad and unnecessarily punitive.

Coinbase is noteworthy both as one of the earliest and most successful cryptocurrency startups, as well as a Bitcoin business that is scrupulously compliant with government regulations (sometimes to the chagrin of the more anarchist-minded Bitcoin community).

In a blog post on the matter, Coinbase Chief Executive Officer Brian Armstrong writes that the company was proactive in helping its user base comply with IRS rules by building special tools and monitoring all new tax developments. This apparently was not enough to the IRS, who decided to bring out the big guns and try to scrutinize all Coinbase users as suspected criminals.

This action has alarmed people in the cryptocurrency space, many of whom applauded Coinbase's expensive stand against IRS overreach. But the tax agency's mega data-grab is in many ways an inevitable outcome of the IRS's own less-than-ideal tax rules for cryptocurrency.

Taxing the Blockchain

The IRS was actually one of the earliest agencies to consider cryptocurrency policy, perhaps for obvious reasons. In March of 2014, the agency issued an "IRS Virtual Currency Guidance" detailing the tax requirements for cryptocurrencies.

The IRS decided to treat cryptocurrencies as a kind of property, which meant that they enjoyed a lower capital gains tax rate than if they were taxed as a currency. But it also meant that cryptocurrency users would need to keep track of any price movements in between transactions for tax purposes. And what's worse, there would be no "de minimis" tax exemption for very small transactions. So the woman buying her daily cup of coffee with cryptocurrency would have to track price fluctuations as meticulously as the professional financial trader.

This created a major reporting burden for casual cryptocurrency users and institutional traders alike. To remain fully compliant with IRS rules, users would need to carefully record price differentials each time that they used cryptocurrency in a transaction. And cryptocurrencies are notoriously volatile, thus adding to the complexity of the tax burden. Service providers like Coinbase and BitPay did their best to provide tools for users that would streamline their tax reporting, and standalone tax tools were developed as well. But cryptocurrency users who did not use such services would need to keep track of this web of information themselves, and even those who did use such tools might inadvertently misreport or forget tiny transactions.

Ironically, this cryptocurrency tax arrangement ended up imposing significant costs on the IRS itself (as I pointed out with Coin Center executive director Jerry Brito in our Bitcoin Primer). The agency failed to set up an official enforcement or guidance office to help users navigate this confusing new area of tax law—an oversight that the agency's own inspector general criticized shortly before the IRS legal action against Coinbase—and relied solely on user reporting and good faith. Ultimately, the agency set up both innocent and well-meaning cryptocurrency users and the IRS itself up to fail. And in terms of priorities, the prevailing tax guidance similarly falls short.

Chasing Tax-Evaders, Crippling Cryptocurrency

The IRS is primarily concerned that some people may use Bitcoin to shield themselves from existing taxes—a kind of off-shore account for the cypherpunk age. Yet in its farflung effort to find these theoretical tax-evaders, the agency is making cryptocurrency users engaged in innocuous activities like gaming or the occasional Overstock.com purchase subject to the same reporting requirements as major cryptocurrency traders, when clearly we are talking about different ballgames here. The IRS should free itself and small-time users from such requirements through a de minimis exemption on small transactions.

As it stands, the tax agency's very public "war on Coinbase" could have the counterproductive effect of pushing potential tax-evaders away from using compliant services like Coinbase at all, thus rendering the entire undertaking fruitless. A truly dedicated tax evader could decide to transact solely in cash-to-Bitcoin interactions or other methods that fully conceal their tracks from the feds. This means that the promising innovations of the above-board cryptocurrency economy would be quashed while the bad guys still get to be bad. This is a lose-lose scenario that would only further frustrate the IRS's efforts.

Given Coinbase's public reputation as a compliant and regulator-friendly cryptocurrency business, you have to wonder why the IRS didn't first attempt a friendlier, more tailored approach to gathering the data they need instead of launching an all-out-war echoing the Justice Department's controversial standoff with Apple last year. Armstrong, for his part, maintains that this situation could have been better "resolved with a phone call instead of a subpoena," given Coinbase's "amicable relations" with the IRS in the past.

More broadly, the IRS action against Coinbase is concerning for the digital privacy of all Americans. As Brito pointed out at American Banker, the legal reasoning behind the IRS attack on Coinbase could easily be applied to all kinds of private data stored in the cloud. Government agencies would surely jump at the opportunity to compel platforms to turn over the data of all of their customers so that they can comb through after the fact to find violators. The battle against Coinbase is therefore another battle for the future of online privacy.

Photo Credit: Foitlova Klara/ZUMA Press/Newscom

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  • Charles Easterly||

    It was just a matter of time, really.

  • gaoxiaen||

    Any excuse serves a tyrant.
    Aesop

  • UnCivilServant||

    Cryptocurrency - a medium of exchange with value as fictional as fiat currency but which nobody accepts.

  • generalisimo14||

    Do you even understand the blockchain? Value is subjective, yes, but would you rather subjectively trust math or politicians/banksters?

  • UnCivilServant||

    You're not trusting math, you're trusting the people you're trading with. Likewise with fiat currency, it is only of any worth because the people you're trading with will accept it and know there are others who accept it.

  • Charles Easterly||

    However, UnCivil,

    Some might say that Bitcoin does have oneadvantage over fiat currencies.

  • UnCivilServant||

    No audio at work, can't watch videos.

  • Social Darwinist||

    I'm no cryptocurrency expert but it seems to me that governments at some point could make them unusable if not illegal. In the US, the root of the problem between the IRS and cryptocurrency is the same as fiat currency and payments in kind transactions, someone might be gaining "income" without the IRS getting their slice. Just one more reason to evolve our tax policy from income to consumption based.

  • Veilosh||

    To make Bitcoin unusable, you would have to disable the internet or the bitcoin network, which is already the largest network in the world and spread throughout just about every country, so that would be a tall task. They could make it illegal, sure, but for a preview of how effective that would be, take a look at the war on drugs. On top of that, addresses/wallets in bitcoin are not specifically tied to individuals' names and would be difficult to prove.

  • Social Darwinist||

    I'm for the use of Bitcoin and other cryptocurrencies but I can see governments and central banks not being to happy with them. If the US government were to make Bitcoin illegal, then there still could be transactions between individuals but not at banks, ATMs, businesses, and other legal processing institutions. What affect would that have on the value of Bitcoin? If it reduced it to the point that mining was no longer profitable, what would happen the blockchain? Wouldn't it become essentially unusable?

    As far as a comparison to prohibitions (drugs, alcohol, prostitution, etc.), the users have never had a problem obtaining those goods and services with fiat currency. The users demand the goods and services not the form of payment. Who is demanding cryptocurrency that wouldn't take fiat currency? I don't know so I'm looking to learn.

  • 2whlrider||

    At one time the government tried to make alcohol illegal. That, of course, ended all alcohol use. /sarc

    The problem with changing from an income-based tax policy to a consumption-based policy is that it cheats savers, especially retired savers who have spent a lifetime of paying income taxes only to face have their savings taxed all over again with a consumption tax. That's probably why we'll get one.

  • Social Darwinist||

    The difference between a prohibition on vices (drugs, alcohol, prostitution, etc.) and cryptocurrencies is that the users of vices need those goods and services and don't have a better or legal substitute available. There are plenty of alternatives to cryptocurrency even if they are not as easily transportable and private.

    My fear with a consumption tax is that we would end up with both an income and consumption tax. I don't see progressives ever giving up the income tax, it is a great way to divide people through jealousy. I believe the income tax to be immoral. In any evolution there is going to be winners and losers, but you need keep working for a better system of taxation. I'm old enough that I'd be one of the savers impacted by a change like that but it is still the right thing to do.

  • Cynical Asshole||

    Bitcoin does have oneadvantage over fiat currencies

    Yeah, videos featuring Naomi Brockwell.

  • Cynical Asshole||

    From the comments on that video:

    Vention1MGTOW2 years ago
    Sometime in 2015 we'll probably see mandatory reporting for Americans on how much bitcoin you have, just as you currently have to report foreign assets. And if you've bought your bitcoins at coinbase they'll be able to request that data from them and they'll start asking questions if you don't file the amount you've purchased. I'm not telling anyone to take any kind of action, that's all up to you. I'm just suggesting that you might want to consider the possibility and perhaps make some plans.

    [Emphasis added] Someone called it 2 years ago, they were just off by a year or so.

  • Charles Easterly||

    Indeed, CA.

    In a recent discussion about Bitcoin an individual claimed that he thought such currencies were doomed to failure not because of their very nature, but because no government would allow any successful currency to exist for very long unless the government in question could somehow control that currency.

  • ||

    Some might say that Bitcoin does have oneadvantage over fiat currencies.

    I don't know what that video links to, but if it's on Youtube and accepts bitcoin, it can't possibly compare to it's non-Youtube and/or cash-only counterparts.

  • tarran||

    There's more to it than that:

    Jeffrey Tucker on the Intrinsic Value in Bitcoin

    At first glance, bitcoin would seem to be an exception. You can't use a bitcoin for anything other than money. It can't be worn as jewelry. You can't make a machine out of it. You can't eat it or even decorate with it. Its value is only realized as a unit that facilitates indirect exchange. And yet, bitcoin already is money.
    ...
    Bitcoin is both a payment system and a money. The payment system is the source of value, while the accounting unit merely expresses that value in terms of price. The unity of money and payment is its most unusual feature, and the one that most commentators have had trouble wrapping their heads around.

    We are all used to thinking of currency as separate from payment systems. This thinking is a reflection of the technological limitations of history.
    ...
    payment systems we have today are not available to just anyone. ...The financially disenfranchised are confined to only local trade and cannot extend their trading relationships with the world.

    A major, if not a primary, purpose of developing Bitcoin was to solve this problem. The protocol set out to weave together the currency feature with a payment system.... This connection is what makes bitcoin different from any existing national currency, and, really, any currency in history.
  • Unemployed Armenian Tranny||

    The entire point of the blockchain is that you don't have to trust the people you are trading with.

  • Cynical Asshole||

    How the IRS Could Cripple Cryptocurrency

    By being their shitty, authoritarian selves?

  • Raston Bot||

    they don't make anything better

  • Cynical Asshole||

    Should the Internal Revenue Service (IRS) have authority to make financial-services companies turn over millions of customer records when they suspect a handful of customers could be evading taxes? Most people would respond with an emphatic no...

    I think you're giving most people way too much credit. All most people need to hear is "we're going after dirty, no good tax cheats."

    Given Coinbase's public reputation as a compliant and regulator-friendly cryptocurrency business, you have to wonder why the IRS didn't first attempt a friendlier, more tailored approach to gathering the data they need instead of launching an all-out-war

    Probably because they were "compliant and regulator-friendly." The IRS probably assumed they'd roll over without a fight and then once they've set the precedent of being to get all of a company's customer records...

    As Brito pointed out at American Banker, the legal reasoning behind the IRS attack on Coinbase could easily be applied to all kinds of private data stored in the cloud. Government agencies would surely jump at the opportunity to compel platforms to turn over the data of all of their customers so that they can comb through after the fact to find violators.

    ...they get to their intended end game for all of this.

  • Jerryskids||

    While I certainly agree with the general premise that what the IRS is doing is "wrong" I'm not so sure what they're doing isn't perfectly legal. I'm required, under penalty of perjury, to provide evidence against myself every April 15th despite the 5th Amendment's protection of the right not to be forced to incriminate myself. And third-party records simply don't fall under the protection of the Constitution, according to the government, despite the fact that many of us think that's some outrageous bullshit. FYTW really is the controlling legal authority here and how much FYTW do you need to make this perfectly legit?

  • Jerryskids||

    Of course, the FYTW clause is on full display in the various Stingray cases - the government claims the non-disclosure agreement they've signed with the Stingray people absolutely protects them from disclosing any information whatsoever about their use of the devices, but try claiming you're protected by non-disclosure agreements you have with your bank or your doctor or your credit card company and see how fast that argument gets slapped down.

  • Raston Bot||

    it's a good thing prohibition has been proven to work. else this might not turn out so hot for everyone.

  • ||

    Think less prohibition, more alcohol and/or consumption taxes and liquor licences.

    I mean, after all, people have been completely free to print their own money since Gutenberg.

  • ant1sthenes||

    So long as a system has any sort of central organization, government will target that organization. It basically needs to be made too costly for them to do more than just make examples of out random people, like filesharing and the IP industries.

    Anyway, I hope Trump replaces all currency with gold Trump Coins. $1 would just have thin gold plating, larger bills would have more gold content. It would be the classiest currency, just great.

  • John C. Randolph||

    If the government prevails over Coinbase, the upshot is that Coinbase will be replaced by a new service based in the Bahamas, Panama, Lichtenstein, the Isle of Wight, or anywhere else that doesn't feel the need to accommodate the US STASI.

    -jcr

  • kenzy9||

    In a blog post on the matter, Coinbase Chief Executive Officer Brian Armstrong writes that the company العاب
    العاب فلاش 69 was proactive in helping its user base comply with IRS rules by building special tools and monitoring all new tax developments. This apparently was not enough to the IRS, who decided to bring out the big guns and try to scrutinize all Coinbase users as suspected criminals.

  • Charles Easterly||

  • Charles Easterly||

  • rxc||

    "The IRS is primarily concerned that some people may use Bitcoin to shield themselves from existing taxes—a kind of off-shore account for the cypherpunk age. Yet in its farflung effort to find these theoretical tax-evaders, the agency is making cryptocurrency users engaged in innocuous activities like gaming or the occasional Overstock.com purchase subject to the same reporting requirements as major cryptocurrency traders, when clearly we are talking about different ballgames here."

    THis is exactly the sort of thing that the IRS and the Treasury have been doing with foreign bank accounts. They attach so many onerous and costly controls on bank accounts held by US citizens living outside the US that many foeign banks have stopped allowing US citizens to open bank accounts. Now the EU wants to so something similar to its own citizens, too.

    It is part of the desire to control and tax. Nothing should go un-reported and un-scrutinized.

  • flashgordon||

    I've actually been talking about this for a long time. If the IRS decides to treat Bitcoin, Gold, etc. as an investment then every little buy and sell you do has a gain and a loss. Buying a loaf of bread with bitcoin would be a transaction with tax implications. Record keeping way beyond what most people will do. I'm not sure I agree with the author that treating cryptocurrencies as currency is worse tax wise. If our new, ostensibly, hard money Congress/President want to help hard money and make a capable competitor to the dollar they would declare Bitcoin and Gold "currencies" and thus exempt from capital gains. I guess that would mean people couldn't declare losses on them if they went down but I think being a "currency" is better than being an "investment" for most hard money types.

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