Thursday, April 9, 2020

One Man's Battle With the IRS Over Bitcoin Privacy

By Stephanie Murray - April 09, 2020 at 08:30AM

What kinds of information should taxpayers be expected to share with the government during an audit? Pay stubs? Receipts? Bank statements? What about bank statements for transactions that haven't occurred yet? Should the Internal Revenue Service (IRS) be able to monitor a taxpayer's finances indefinitely?

That's what the agency is effectively asking of bitcoin user William Zietzke, who was audited after amending his 2016 tax return. Citing a lack of cooperation on his part, the IRS issued summons to Zietzke and cryptocurrency exchanges Coinbase and Bitstamp for information that, by its nature, allows for the continued surveillance of his cryptocurrency finances. Zietzke is fighting these summons, insisting that they are unnecessary, are unwarranted, and violate the Fourth Amendment. The results could affect thousands of bitcoin users.

A software engineer with only a high school diploma, William Zietzke had no idea that the bitcoins he started mining on a couple of personal computers in 2011 would eventually fund his early retirement. "This was a computer science experiment," he told me in February. "I moved them around. I traded them. And they were worthless."

On average, the coins he mined then were worth about $10 each. By February 2017, they were worth more than $1,000. So at 55, Zietzke decided to cash out a portion of his holdings and retire.

He quickly realized that—at least from a tax standpoint—he hadn't thought things through. Because of marginal tax rates, claiming a large amount of capital gains in a single year results in a higher effective tax rate than spreading them out over a few years. So in what he says he thought was a legitimate way of optimizing his taxes, Zietzke claimed some of the gains he made in 2017 on his 2016 tax return.

 "I've never been in this situation before," he told me. "I did make a mistake. Those who play these tax optimization games understand how to dot every I and cross every T, and I did not." He also pointed out that he could have achieved his aim legally by selling and immediately repurchasing the bitcoin in 2016.

It wasn't until August 2017, after hiring an accountant, that Zietzke realized he'd done anything wrong. His CPA explained that gains claimed on any given year's return must be backed by a transaction that occurred during that year. So Zietzke did what he ought to have done: He amended his return, removing $104,482 in capital gains income and triggering a $15,475 refund.

It was the corrected return that the IRS flagged, prompting the audit and kicking off a multi-year legal battle that is still ongoing today.

Zietzke was actually ahead of the curve when it comes to paying taxes on bitcoin. He's been reporting his cryptocurrency income since 2013, one of only 807 Americans to do so that year. The IRS did not issue guidelines on bitcoin taxation until 2014.

Compliance remained low for at least a couple of years after the IRS issued guidance, at least in part because cryptocurrency is very difficult to report accurately. By design, cryptocurrencies allow users to send and receive money electronically without relying on a third-party financial institution, such as a bank or credit card company. This is important because Bitcoin is considered property under U.S. tax code. If you receive it in exchange for goods and services, you must claim its fair market value in U.S. dollars as income. If it appreciates in value while you are holding it, you must report the resulting capital gains when you sell or trade it. Without a financial institution to do this, cryptocurrency users themselves must keep track of the value of their bitcoin holdings upon receipt and sale.

The process is complicated by the fact that, unlike traditional investments, bitcoin is also a currency and can be traded for goods and services. Under present law, every purchase you make with cryptocurrency—even if it's just a cup of coffee—is a taxable event. 

Regardless, Zietzke admits he made a mistake and was eager to resolve it. In the early months of the audit, the IRS issued two information document requests to Zietzke. He provided a bevy of personal information to satisfy them: an accounting of his taxable 2016 bitcoin transactions; screenshots of his activity on Purse.io and Coinbase (the cryptocurrency marketplace and exchange where the transactions occurred); an activity log from Armory (software he used to manage some of his bitcoin holdings) showing that he made no transactions from them during 2016; bank statements corroborating the cost basis of the bitcoin he purchased through Coinbase.

But Zietzke redacted his public addressesrandom strings of numbers and letters identifying his digital walletsfrom all the information he provided, citing their highly sensitive nature.

Bitcoin funds are stored on a digital wallet, which has one or more public addresses. You can't move funds out of a public address without knowing its private key, but you can send money to any wallet as long as you have one of its public addresses. Every time a wallet sends or receives the cryptocurrency, the transaction is recorded on a public ledgerthe blockchainalong with the public addresses involved in it. In other words, a bitcoin user's entire financial history is publicly available on the blockchain. As explained in Satoshi Nakamoto's original bitcoin white paper, privacy is maintained "by keeping public keys anonymous."

Once you know someone's public address, you can search the blockchain for any transactions associated with it using websites such as Walletexplorer.com or Blockchair.com. You can also continue to follow the coins held by that address indefinitely, as any new addresses they are transferred to will also appear on the blockchain.

Bitcoin users can enhance their privacy by using multiple public addresses. The original white paper suggests using a new public address for every transaction. This makes it more difficult to piece together someone's bitcoin holdings, but not impossible. Transaction graph analysis techniques leverage the transparency of the public ledger to link multiple addresses to a single owner.

Because public addresses offer the opportunity for continued surveillance of his finances, Zietzke requested that the IRS accept alternative means of verifying that he'd fully paid his 2016 taxes.

Nearly a year after the audit began, the IRS sent Zietzke a letter explaining that there were still some "uncertainties" regarding his bitcoin activity during the 2016 tax year. The letter alleges that he falsely claimed "all of the coins [he] disposed of during 2016 came from acquisitions made through Coinbase." Using transaction IDs that Zietzke provided, the IRS determined that one of his transactions, involving a backpack purchased on the marketplace Purse.io, did not appear to originate from Coinbase. The IRS also claims that although Zietzke "indicated" that all of his Bitcoin holdings were split between personal wallets and Coinbase, it was also able to link some of his addresses to wallets associated with other exchanges, BTC-e and Bitstamp.

The letter concludes that Zietzke failed to satisfy the agency's requests. The IRS would be "issuing a summons seeking the previously requested information," and it would be contacting Bitstamp and Coinbase in order to do so.

Yet the backpack had in fact been purchased using money from a Coinbase address, as the IRS later acknowledged. And Zietzke says he never claimed that his holdings were split between private wallets and Coinbase. The IRS document requests did not ask for an account of his holdings, only for information regarding his 2016 transaction activity. The BTC-e transaction it discovered occurred prior to the year of audit. The Bitstamp transactions were transfers between two of his own accounts and are therefore not taxable. According to Zietzke, he offered the IRS these nontaxable 2016 Bitstamp transactions during a conference call two months prior to receiving the April letter but was told they weren't relevant to the audit.

The IRS went on to issue summons to Coinbase, to Bitstamp, and to Zietzke himself. The Coinbase and Bitstamp summonses request "all account history information" for any accounts affiliated with Zietzke, including "digital wallet information, blockchain addresses, transaction ids, and any other information related to the identity or location of the parties involved." The IRS was asking not just for Zietzke's public addresses, but for the identities and wallet addresses of anyone he had transacted with through those exchanges. From Zietzke, the IRS requested, among other things, "all documents and records pertaining to all blockchain addresses and associated wallet ids" belonging to him during 2016. In other words, he must turn over every public address linked to any bitcoin he held during 2016, regardless of whether or not he used it that year.

Zietzke filed motions to quash the summons to Bitstamp and Coinbase, and he has thus far refused to comply with the summons to himself, arguing that the information the government requested would grant it "near perfect surveillance" of his financial activity. The only way for him to regain assurance of privacy would be to dispose of his bitcoin holdings—at which point he would owe taxes on them—and then repurchase them with entirely new wallets. Zietzke agrees that there are some circumstances under which a request for such information would be appropriate, but he doesn't believe he's done anything to warrant such a sacrifice of privacy.

The IRS insists that the only way to verify that Zietzke did not dispose of the bitcoin he originally claimed on his 2016 tax return is to examine the transaction histories of all of the wallets he owned that year. Activity statements are insufficient, it argues, because there is no way of knowing if they represent the entirety of his holdings. The IRS dismisses Zietzke's privacy concerns, likening public addresses to account numbers, which are regularly requested for the purposes of an audit. But unlike account numbers, public addresses grant the IRS the capacity to monitor a taxpayer's financial movements in real time, indefinitely.

In 2016, the IRS issued a "John Doe" summons to Coinbase for millions of users' private information, including wallet addresses. The court upheld the summons but substantially narrowed it to apply only to users involved in transactions worth at least $20,000. In that case, the court ruled that wallet addresses were not relevant to the IRS's purposes, though it left open the possibility that they "may become necessary for a specific account holder once the IRS reviews the relevant records."

A Washington district court reached a similar decision in Zietzke's Bitstamp case, upholding the summons but narrowing it to transactions that occurred during 2016. Yet the court granted the IRS's request for the wallet addresses involved in those transactions. The court dismissed Zietzke's privacy concerns, citing the third-party doctrine—the legal principle holding that you do not have a reasonable expectation of privacy for information "revealed to a third party and conveyed [by that third party] to the Government authorities." The court has yet to hand down a decision on Zietzke's attempt to quash the Coinbase summons, but a magistrate judge produced recommendations to the California district judge very much in line with the Bitstamp ruling.

If the Department of Justice grants the IRS permission to enforce Zietzke's individual summons, the outcome is less clear. It involves no third party, so the third-party doctrine will not apply. The stakes are also higher, because it requests not a subset of his wallets but all of them.

Whatever the outcome, these cases will have implications for thousands of taxpayers. The IRS has made it clear that it intends to crack down on cryptocurrency taxation. In 2018, the agency launched a Virtual Currency Compliance campaign, urging taxpayers with unreported virtual currency transactions to "correct their returns as soon as practical." Last year it announced plans to send letters to approximately 10,000 taxpayers suspected of failing to report or misreporting their virtual currency transactions.

In other words: If the IRS succeeds in getting what it wants from Zietzke, thousands of Bitcoin users may find themselves in his position.


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