Ask the average person to tell you what they know about Bitcoin, and they will invariably give you two answers: it is valuable, and it is untraceable. The first point is open for debate, with the meteoric surge in Bitcoin’s value on one hand tempered by recent market fluctuations on the other. The second point, however, is flatly inaccurate: a common (and in some cases dangerous) misconception. Contrary to popular belief, cryptocurrency is not “anonymous” – and neither are those who mine, invest in, or profit from it. Though this will be unpleasant news for some taxpayers, the Internal Revenue Service (IRS) is increasingly adept at tracing digital currencies around the globe – and with support from international agencies like Europol and INTERPOL, it is only getting harder for crypto users to hide.
If you use, mine, or invest in Bitcoin, you are no doubt already aware of the IRS’ steady encroachment upon the cryptocurrency industry over the past few years – an effort which has been broadly supported by courts, legislators, law enforcement agencies, and private blockchain companies around the country and the globe. From the IRS’ controversial subpoena against Coinbase (which, despite being significantly reduced in scope, recently drove the company to begin the process of turning over thousands of user records), to the recent creation of new IRS cryptocurrency tax compliance enforcement agencies, to the international workshop on cryptocurrency and money laundering held by INTERPOL and Europol in Switzerland earlier this year, it seems safe to say that digital currencies are under siege – and by extension, so are the taxpayers who use them, or at least, those who fail to report income or gains realized from their sale.
There is no question that regulation of Bitcoin is on the rise. The real question is how the IRS manages to track cryptocurrency – a commodity which is, after all, prized as much for the “anonymity” it affords as the profits it yields.
This fascinating question has a surprisingly simple answer: the IRS goes straight to the heart of the system by consulting with blockchain companies, notably Chainalysis. This allows the Service to stay “one step ahead” of money launderers, drug dealers, human traffickers, and yes, suspected tax evaders, too.
The “blockchain” is the tamper-resistant public ledger where financial transactions using cryptocurrency are recorded. Because “blocks” (records) in the blockchain are encrypted, with the information presenting as jumbled string of letters and numbers, many people assume that the wallet or account, while publicly viewable, effectively remains private.
However, that privacy is less than total, with government records showing that the IRS has been working with blockchain companies since at least 2015. For example, this list from the General Services Administration traces the business relationship between the IRS and Chainalysis back as far as August 2015, with the IRS entering a series of contracts and purchase orders through August 2017.
To partially quote one section of the Chainalysis website directed at government clients, the company’s software uses “pattern recognition, machine learning and open source references to identify suspicious activity across billions of cryptocurrency transactions.” This seems to be the type of service described in one provision of a contract between the IRS and Chainalysis, which states, “Vendor shall provide access to the contractor through a web application that communicates to servers where data analysis, research and annotations are stored. User is able to start investigations using a breadth of data sources from known Bitcoin services to transactions hashes, Bitcoin addresses and arbitrary amounts of text.”
On a final note, it’s worth mentioning that government agencies are well aware of “tumblers,” also known as “mixers,” which increase security by mixing funds. Bitcoin mixers may cause delays or complications for IRS agents, but ultimately, are likely to be ineffective in keeping investigators at bay. In fact, the press release for the aforementioned Europol/INTERPOL workshop noted, “At the end of the workshop, participants agreed upon a set of conclusions, which included… Taking action against digital currency mixers/tumblers, designed to anonymize transactions, which burdens the work of law enforcement agencies to detect and trace suspicious transactions.” (Moreover, taking deliberate actions to conceal an account or transaction could potentially demonstrate “willfulness” and expose the taxpayer to greater penalties including potential prosecution for tax crimes.)
There are likely many taxpayers who doubt the government’s ability to successfully penetrate such a new and complex technology, but beware: this skepticism can be legally and financially perilous. While the federal government may not always be a perfect model of efficiency, detecting unreported income – whether Bitcoin or fiat – is one area where the IRS excels and should not be underestimated. Fortified by new agents, cooperation from other governments, increased interest among legislators, and in the case of Coinbase, a set of court orders, the IRS grows increasingly well-equipped to identify and penalize noncompliant taxpayers with each passing day.
The lesson for taxpayers is not to rely on the security of Bitcoin, other cryptocurrencies, or the blockchain. It is extremely risky to simply “hope for the best” where the IRS is concerned. The better strategy is to proactively consult with a knowledgeable Bitcoin tax attorney, who can assist you with matters such as unfiled tax or foreign informational returns, returns in need of amending, unreported foreign wallets, IRS tax audits, IRS criminal investigations, and other tax issues related to digital currencies. For a reduced-rate Bitcoin tax consultation, contact the Tax Law Office of David W. Klasing online, or call (800) 681-1295 to speak with an experienced tax attorney by phone.
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