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IRS Crypto Tax Criminal Cases Bolstered by John Doe Summonses

Nov. 22, 2022, 9:45 AM

The IRS has gotten a formidable new tool as it ratchets up its cryptocurrency tax prosecutions, thanks to a series of court victories backing its demands for unnamed taxpayers’ cryptocurrency records.

The Internal Revenue Service has signaled that a wave of tax prosecutions involving cryptocurrency is coming. Its Criminal Investigations division is building hundreds of cryptocurrency cases, with about half of those investigations focused specifically on tax crimes, according to division Chief Jim Lee. Others target money laundering, he said.

Lee made the comments in the wake of several federal courts authorizing the IRS to serve “John Doe” summonses on third parties for information on entire classes of unidentified cryptocurrency users.

The summonses are part of the agency’s data collection efforts as it cracks down on crypto tax noncompliance, an issue that has gained in importance with the expansion of the market. Former IRS Commissioner Charles Rettig estimated last year that the overall shortfall might be as high as $1 trillion.

“We believe that there are significant issues surrounding digital assets in terms of taxation,” IRS Criminal Investigations Special Agent Gary Alford, who works as a program manager in cyber forensic services, said in an interview with Bloomberg Tax.

Efforts to educate the public have been key to getting the IRS to the point where it can build cases, Alford said. That, he said, is because proving criminal tax evasion requires that the agency can show that a taxpayer voluntarily and intentionally violated a known legal duty.

Demonstrating that level of awareness among taxpayers who misreport would have been hard when the IRS first entered the crypto tax space, but the agency’s criminal investigators now believe they can make some cases, Alford said. He noted that news reporting on the issue, IRS outreach and instructions, and the addition of a cryptocurrency question to the front page of US tax returns had gotten the issue into the public eye.

“So now we are prioritizing tax investigation,” he said. “That’s probably why you see a lot of enforcement, let’s say with John Doe summons and things of that nature.”

The IRS used the same type of summons in the late 2000s and early 2010s to fight offshore tax evasion enabled by financial institutions in Switzerland, ultimately imposing more than $1.36 billion in penalties against 80 Swiss banks.

“What’s really clear is that the government doesn’t like to reinvent the wheel too much,” said Mayling Blanco, a partner at Norton Rose Fulbright US LLP who specializes in white collar defense and criminal tax exposure.

Having successfully used John Doe summonses in the Swiss bank prosecutions, the government “realized that this tool works really well,” Blanco said.

Making a Case

A John Doe summons differs from an ordinary summons because it goes after the records of unnamed taxpayers, and it may only be served if a court verifies the requirements of tax code Section 7609(f) have been met. To comply with the code, the IRS must narrowly tailor its demands to information related to actual or potential tax law violations—and that information mustn’t be readily available from other sources.

“There’s a level of anonymity that folks believe exists with” virtual currency transactions, “and so the John Doe summons enables the government to pierce that anonymity and to go in and start getting information on a significant number of individuals in one shot,” said Carlos Ortiz, a former Justice Department tax prosecutor who is now a partner at Baker & Hostetler LLP.

The government secured court permission in 2021 to serve John Doe summonses for virtual currency records at cryptocurrency exchanges Poloniex and Kraken, neither of which responded to requests for comment.

Since August, the government has also received the greenlight to serve John Doe summonses on crypto dealer SFOX and on M.Y. Safra Bank, which the Justice Department has alleged offered banking services to SFOX customers.

The government has made clear the summons petitions don’t allege wrongdoing by the organizations, but instead are seeking information on unidentified individuals who may not have complied with tax laws.

Ross Soodoosingh, an SFOX spokesperson, confirmed to Bloomberg Tax that SFOX has complied with the summons. He also pointed to a statement the company issued after receiving the summons, saying it “will be helpful and respectful in any investigation, while also ensuring that we protect our customers’ personal or private information.”

In an email to Bloomberg Tax, an M.Y. Safra Bank spokesperson said the bank received the court’s order and “complied with our legal and regulatory obligations.”

The government’s recent court wins come years after a court in 2017 forced Coinbase, a crypto exchange platform operator, to comply with a similar summons for documents tied to accounts that conducted a transaction worth at least $20,000 between 2013 and 2015.

The new court-approved petitions target similar data. The SFOX summons, for instance, seeks records involving at least $20,000 in cryptocurrency transactions between 2016 and 2020. Each of the recent petitions has been supported by a description of specific—but unnamed—taxpayers who the government says have misreported, such as an alleged YouTube video creator and gambler who conducted cryptocurrency sales through SFOX without reporting any gain or loss to the IRS.

“We’ve been telling folks for the last however-many-years that this is a problem,” Ortiz said. “IRS agents are trained in how to analyze these transactions, so now really the only step left is to start prosecuting these individuals.”

Information from John Doe summonses comprises only part of the IRS’s data collection effort. The agency also obtains data from money laundering investigations and third-party reporting, according to Alford. Investigators will “leverage” data from John Doe summonses against that other information to make cases, he said.

Prosecuting Third Parties?

The information gleaned from John Doe summonses and other sources could also be used to go after financial institutions or exchanges, according to Ortiz. The government has cautioned the industry to make sure that controls and compliance measures are in place to guard against tax evasion, he said.

“You are going to have folks who are going to say, ‘Hey, look, I use this particular service because they told me they weren’t going to report my information to the IRS, or a salesperson told me that,’” he said.

If there wasn’t training or a preventive mechanism in place, then the government might “come after you like they did the Swiss banks,” he said.

Alford said tax return preparers who are associated with a pattern of tax noncompliance tied to cryptocurrency could also come under criminal scrutiny.

If “there are certain cases where there looks like there’s a fact pattern amongst a lot of taxpayers with a similar tax return preparer, then that might give indicia that maybe in that case we should be looking at the return preparer,” he said.

The IRS’s use of John Doe summonses has continued alongside a constitutional challenge brought by cryptocurrency user James Harper at the US District Court for the District of New Hampshire. Harper is arguing the summonses violate constitutional privacy and due process rights.

Assuming the summonses survive legal challenge, they may prove useful in other tax areas down the line. Blanco said she expected to see an increase in anonymity as industries become more electronic and online-based.

“John Doe summonses are going to be more and more valuable, not only in the crypto space, but potentially in other places where there is some indicia that the platforms have been used in some way that potentially violates the law, and we don’t know the who, but we do have indicia of the what,” Blanco said.

To contact the reporter on this story: Aysha Bagchi in Washington at abagchi@bloombergtax.com

To contact the editors responsible for this story: Rachael Daigle at rdaigle@bloombergindustry.com; David Jolly at djolly@bloombergindustry.com