Pay Toll With Coins: Looking Back on Fbar Penalties and Prosecutions to Inform the Future of Cryptocurrency Taxation

• Publication year: 2020

Pay Toll with Coins: Looking Back on FBAR Penalties and Prosecutions to Inform the Future of Cryptocurrency Taxation

Caroline T. Parnass
University of Georgia School of Law

PAY TOLL WITH COINS: LOOKING BACK ON FBAR PENALTIES AND PROSECUTIONS TO INFORM THE FUTURE OF CRYPTOCURRENCY TAXATION

Caroline T. Parnass^*

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Cryptocurrencies are gaining a foothold in the global economy, and the government wants its cut. However, few people are reporting cryptocurrency transactions on their tax returns. How will the IRS solve its cryptocurrency noncompliance problem? Its response so far bears many similarities to the government's campaign to increase Reports of Foreign Bank and Financial Accounts (FBARs). FBAR noncompliance penalties are notoriously harsh, and the government has pursued them vigorously. This Note explores the connections and differences between cryptocurrency reporting and foreign bank account reporting in an effort to predict the future regime of cryptocurrency tax compliance.

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Table of Contents

I. Introduction....................................................................361

II. What is Cryptocurrency?.............................................365

III. The IRS's Response to Cryptocurrency...................369

A. ADMINISTRATIVE ACTS.............................................369
B. LEGAL ACTION..........................................................372

IV. Foreign Bank Account Reporting.............................375

A. REPORTING AND ADMINISTRATION...........................376
B. OFFSHORE VOLUNTARY DISCLOSURE INITIATIVES.....378
C. CIVIL PENALTIES......................................................380

1. Non-Willful Violations.....................................380
2. Willful Violations..............................................382

D. CRIMINAL PENALTIES AND PROSECUTION.................383

V. Analysis...........................................................................386

A. PARALLELS...............................................................386

1. Criminal Activity..............................................386
2. Underreporting.................................................387

B. DISTINCTIONS...........................................................388

1. Legislation......................................................... 388
2. Subject for Criminal Prosecution..................... 390
3. Voluntary Disclosure Initiatives......................391

VI. Conclusion....................................................................392

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I. Introduction

In 2018, the Internal Revenue Service (IRS) announced the Virtual Currency Compliance campaign to address what it believed to be an issue of noncompliance with virtual currency transaction reporting.¹ While this campaign begins to address the issues inherent in the taxation of cryptocurrency, the resolution of these issues is still on the horizon.² However, the IRS appears to be following a familiar pattern; the current response to taxation of cryptocurrency resembles the government's attempts to increase compliance in foreign bank account reporting. To anticipate the possible future of cryptocurrency taxation, this Note will explore that connection.

Three reasons likely explain the IRS's focus on taxation of cryptocurrency. First, cryptocurrencies could potentially generate a great deal of income.³ Of course, the market for cryptocurrencies is known to be volatile, and cryptocurrencies have their skeptics.⁴ Nevertheless, at the time of writing, one bitcoin, the cryptocurrency

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that makes up a large portion of the market, is worth around $8700, and more than 18,000,000 bitcoins are in circulation.⁵ Because the government is empowered to tax "all income from whatever source derived,"⁶ taxation of cryptocurrency may represent an attractive source of revenue for the IRS.

Second, cryptocurrency is a significant area of tax reporting noncompliance.⁷ In an address concerning cryptocurrency and tax administration at a conference held by the Urban-Brookings Tax Policy Center, the IRS Chief Counsel Michael Desmond estimated that about eight percent of adults in the United States own "some form of virtual currency."⁸ Of the approximately 150 million tax returns the IRS receives each year, Desmond estimated that the IRS should be seeing somewhere around twelve million annual tax returns that report some transaction in virtual currency.⁹ But, he said, the IRS is not receiving twelve million returns reporting virtual currency transactions—in fact, it is receiving "nowhere near that."¹⁰ Desmond noted that although the IRS wants to be helpful by issuing guidance on specific issues, like basis computation and valuation, "the greatest threat presented to us by virtual currency transactions is . . . these transactions not ending up on the tax return at all."¹¹ Thus, the IRS is interested in issuing guidance to help taxpayers accurately report income from cryptocurrency but also, and perhaps more so, in increasing compliance in reporting overall.¹²

Finally, another possible motive for the IRS's focus on cryptocurrency is the perception that cryptocurrencies are used in

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illicit online dealings. One study in 2018 estimated that nearly half of all bitcoin transactions involve illegal activity.¹³ Famously, Ross Ulbricht was convicted in 2013 for founding and operating the website "Silk Road," an illicit online marketplace where users transacted in bitcoin.¹⁴ Through stricter tax compliance measures, the government will be able to track more of the illegal activity that occurs through cryptocurrency transactions.¹⁵

For these reasons, the IRS has initiated efforts to increase tax compliance by cryptocurrency users.¹⁶ But taxation of cryptocurrency and the possible implications of the IRS's focus also pose problems for taxpayers because there are many unanswered questions in the tax treatment of cryptocurrency.¹⁷ The IRS has clearly expressed that it regards cryptocurrency and other virtual currencies as property, not currency.¹⁸ However, questions linger about the taxation of cryptocurrency and the penalties that might be assessed for failure to report cryptocurrency transactions.¹⁹ The IRS has not addressed some of the myriad problems created by the broad-stroke description of cryptocurrency as property, and it recognizes that taxpayers require more specific and specialized guidance to accurately report the tax consequences of their virtual

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currency transactions.²⁰ Nevertheless, the IRS will still hold taxpayers responsible for accurately reporting their dealings in cryptocurrency.²¹

Some commentators have noted that the IRS's enforcement efforts in the area of virtual currency mirror to some extent the enforcement efforts the government has employed in the case of foreign bank account reporting.²² While some of the concerns surrounding virtual currency transaction reporting and foreign bank account reporting are the same—secrecy, criminal activity, and tax evasion—the subjects are fundamentally different. A bank account is a bank account,²³ but cryptocurrency is an emerging technology that has only begun to scratch the surface of the world economy. Nevertheless, an analysis and comparison of the Treasury's past treatment of foreign bank accounts with the current issue of cryptocurrency transactions may shed light on what the future holds for taxpayers dealing in cryptocurrency. Therefore, this Note explores the similarities and differences between the development of enforcement efforts, penalties, and criminal prosecutions in the case of foreign bank account reporting and the emerging efforts to address virtual currencies.

Part II of this Note explains what cryptocurrencies are, how they are obtained and used, and how a taxpayer might realize a taxable gain when dealing in them. Part III describes the IRS's response, so far, to taxation of cryptocurrency. Part IV explores the history, enforcement, penalties, and prosecutions associated with foreign financial accounts. Part V compares and contrasts the IRS's current response to the taxation of cryptocurrency with the treatment of

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foreign bank accounts. This Part also discusses the possible paths the government may take to address the multifarious issue of taxation of cryptocurrency. Part VI concludes. If history is any indication of the IRS's future actions, a storm of strict enforcement with harsh penalties is likely on the horizon for those who fail to comply with cryptocurrency reporting requirements.

II. What is Cryptocurrency?

Unlike traditional currencies, which are centrally regulated by issuing authorities, cryptocurrencies²⁴ are decentralized. This means that account holders can carry out verified transactions without a trusted central authority, such as a bank or a clearinghouse.²⁵ Cryptocurrency transactions are trusted and verifiable because of the nature of the blockchain—a cryptographic ledger in which "blocks" of information about transactions are publicly verified and added to a "chain" by multiple users to avoid falsification.²⁶ The key characteristic of a blockchain is its decentralized ledger, meaning that the ledger is not stored in a singular place and is accessible by everyone.²⁷

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Maintenance of the blockchain's ledger requires that transactions be verified.²⁸ Only when the validity of a transaction is agreed upon by all nodes (or users) will the transaction appear in the ledger.²⁹ Cryptocurrency "miners" are those who devote computing power to verifying transactions.³⁰ Verification is a process that requires solving a mathematical problem, and the first miner to solve it is rewarded with cryptocurrency.³¹ Thus, cryptocurrency is the asset that incentivizes maintenance of the blockchain's public ledger.³² Part of cryptocurrency's value is its inherent scarcity, as only a limited amount can be mined over the life of the blockchain.³³

Ownership of cryptocurrency is represented by...