The IRS Has a Headache Named "Bitcoin"

In September, the Treasury Inspector General for Tax Administration released a report outlining additional actions needed to ensure taxpayer compliance in the age of bitcoin and other virtual currency. Our tax system relies heavily on taxpayers sel-reporting their taxable transactions and is backstopped by third-party reporting where "information returns" like Forms 1099, W-2, 1098, etc. are issued to the IRS. These information returns provide notice to the IRS of activity that should eventually show up on a taxpayer's return. The anonymity of virtual currency combined with the lack of a system in place to require reporting of virtual currency transactions to the IRS are a "perfect storm" that could cause substantial amounts of tax revenue to go unreported and undetected.

Although the IRS is undoubtedly aware of the potential problems presented by virtual currency, the report notes that "[n]one of the IRS operating divisions have developed any type of compliance initiatives or guidelines for conducting examinations or investigations specific to tax noncompliance related to virtual currencies. In addition, it does not appear that any of the actions already taken by the IRS to address virtual currency tax noncompliance were coordinated to ensure that the IRS maintains a strategic approach to the tax implications of virtual currencies." This is clearly a less-than-stellar rating being given to the tax agency for preparing to carry out its function effectively in the modern era.

The report recommends developing a comprehensive strategy to deal with the problem, which is always a good start, but it also advises that the Service add to the information return reporting system a separate requirement that payors identify the amount of virtual currencies used in taxable transactions. This would require anyone issuing a 1099 to another person to separately identify any payments made in virtual currency. But it is unlikely this will be an effective response to the "bitcoin problem" because it relies on the assumption that a payor paying in bitcoin is likely to issue the payee a 1099 to report that transaction, whether they pay in hard or virtual currency.

For now, the report is interesting reading only in that it lays out the existence of a problem presented by rapidly developing technology to our aging tax system. The IRS may not have the nibmleness and technological savvy to respond effectively before significant amounts of tax revenue slip past.

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