US IRS court authorizes service on cryptocurrency exchange, subpoenas John Doe for customer information

About two years ago, we wrote a post about actions being taken by the US Internal Revenue Service (“IRS”) regarding its concern that cryptocurrency owners were underreporting or failing to report gains. One such measure was the use of John Doe’s summons. The IRS issues a John Doe summons when it wants information about a group of anonymous taxpayers many of whom it suspects are non-compliant. If successful, the John Doe subpoena allows the IRS to obtain information that identifies the taxpayer and allows the IRS to determine whether the taxpayer correctly reported his or her income. A John Doe subpoena must be approved by a federal district court judge.

One such subpoena by John Doe that the IRS has been pursuing for several years is against Kraken, one of the largest cryptocurrency exchanges in the US (“Exchange”). The IRS has not alleged that the exchange engaged in any wrongdoing. However, the IRS cited two different government reports outlining tax compliance issues related to cryptocurrency, one completed by the Government Accountability Office in 2013 and the other in 2016 by the Treasury Inspector General for the Tax Administration, for its belief that tax noncompliance is an issue with cryptocurrency-related assets. Furthermore, the IRS cited the relatively small number of taxpayers reporting cryptocurrency transactions on their tax returns compared to the total number of users of the exchange, which caused the IRS to view individuals using the exchange as potential suspects in tax evasion. Additionally, as part of its Electronic Payment Systems initiative to address US taxpayers who use virtual currencies for tax avoidance purposes, the IRS hypothesized that some US taxpayers were also using Exchange to move funds to and from offshore accounts and repatriate them.

In 2021, the IRS served Exchange with a John Doe subpoena in order to obtain customer and transaction information belonging to members of the John Doe class that could then be used to conduct checks of people who may not have been complying with Internal Revenue laws. The subpoena sought information regarding unknown US taxpayers who had the equivalent of $20,000 in transaction value, regardless of type, in any type of cryptocurrency for any year between 2016 and 2020. If the user meets this value limit, the IRS request has two types. Information: (i) “User Identification Information”; and (ii) “transaction activity”. The requested user identification information included things like account registration records, user profiles, names, addresses, dates of birth, historical changes to personal information, payment methods, KYC and AML documents, and so on. The requested transaction activity information included all transaction activity on the user’s account including purchase/sale values, purchase/sale dates and times, blockchain addresses of cryptocurrency units transferred, value received as a result of chain splits, hard forks or promotional events and all other records of account funding events.

The exchange refused to comply with the summons due to its large reach and the heavy burden that compliance would place on it. He relied heavily on the fact that the subpoena he was served on was broader than the one approved in the well-publicized John Doe subpoena involving Coinbase. In turn, the IRS argued that it demonstrated a reasonable basis for enforcing the subpoenas, which it argued were narrowly designed. It also alleged that the court-imposed restrictions on Coinbase regarding the scope of the subpoena were excessive and that the limitations the IRS agreed to, without the court’s involvement, when negotiating with Coinbase had no bearing on whether a subpoena in this case was appropriate.

The US District Court for the Northern District of California applied the same standard that was used in Coinbase John Doe calls the case, as provided in United States v. Powell370 US 48 (1964). Under this standard, to obtain a court order executing an IRS subpoena, the IRS must prove that the summons: “(1) was issued for a legitimate purpose; (2) seeks to obtain information relevant to that purpose; (3) seeks to obtain information not actually in the possession of the IRS; and (iv) satisfies all administrative steps set forth in the Internal Revenue Code.” As was the case with the Coinbase subpoena, the dispute centered around whether the John Doe exchange subpoena was issued for a legitimate purpose and requested the relevant information. .

When first dealing with whether or not the subpoena was issued for a legitimate purpose, the district court found that the purpose was indeed legitimate because it was issued in connection with an IRS investigation to determine and correct the federal income tax liability of US persons who conducted cryptocurrency-related transactions between 2016 and 2016. 2020. Specifically, the district court found compelling the number of taxpayers filing tax returns that referenced Bitcoin during that time period. The district court noted that the exchange had more than 4 million customers with $140 billion in business activity since 2011 and registered up to 50,000 new users per day by the end of 2017. However, only 4,164 taxpayers in 2016, 88,040 in 2017, 93,848 in 2018, 102,278 in 2019, and 253,265 in 2020 reported bitcoin transactions on their payouts.

Furthermore, the district court found that compelling evidence provided by the IRS showing tax non-compliance was higher when there was no third party report involved (such as an event with the stock exchange) compared to banks that issued Form 1099-INT to the IRS and the taxpayer. The IRS was also able to point to five concrete examples of exchange users who committed tax law violations involving cryptocurrency.

Turning then to the question of whether John Doe’s subpoena sought relevant information, the district court indicated that the standard to be applied was lower than the standards of relevance of evidence used in federal court. Instead, the criterion is ‘whether or not the desired inspection is feasible [throw] Light on the health of the taxpayer’s return.” At the same time quoting Coinbase In the case, the district court noted that the summons should not be “too broad for its purpose.”

With this criterion in mind, the exchange argued that a number of items requested in the recall were overly broad. First, the IRS definition of “user” was too broad because it included a group of users who did not qualify as a user in the authorized recall in Coinbase issue. Specifically, the IRS requested information on a “user” who had the equivalent of $20,000 worth of transactions, regardless of type, in cryptocurrency in any year between 2016 and 2020. Per Coinbase, the recall has been interpreted more narrowly as applying if there is $20,000 in any one transaction. The exchange argued that accepting this broader definition would cover 59,931 Exchange accounts and sweep away many users who only transact in smaller amounts and have no taxable gains. However, the district court noted that the IRS has presented evidence showing that it voluntarily limited the definition of “user” in its filing. Coinbase The recall is based on facts it learned during its negotiations with Coinbase. The district court also pointed out that there is nothing special about it Coinbase The decision required summonses issued in later cases to follow exactly the same requirements and there was nothing in the tax code that required a minimum Exception for reporting taxable gains or losses. Hence, the court rejected the exchange’s arguments that the definition of “user” should be limited to Coinbase standard.

Secondly, the exchange argued that the recall was overly general as it includes customers who have purchased and held cryptocurrencies during the relevant period. The exchange argued that in these cases, customers only made deposits, purchases or withdrawals, and that such activities would likely not qualify as taxable events. The district court upheld the IRS’ arguments that such transactions could reflect wages paid in cryptocurrency, a hard fork, or a chain fork, each of which could be a taxable event, depending on the circumstances. Hence, the District Court found that such a request was not overly general.

Third, the exchange argued that the recall was overly general because it would include users who were not US taxpayers. Hence, the IRS would have no interest in auditing such individuals and would simultaneously put the exchange at risk of violating foreign privacy laws. The district court noted that the exchange could not point to any authority that suggested the subpoena should be restricted on this basis, and offered no alternative way to protect the privacy rights of non-US users. So the local court allowed the language to remain in the subpoena.

Fourth, the exchange argued that the recall was excessively general because it improperly violated the privacy of Exchange users due to the large amounts of personal information and financial data that would be transferred to the IRS. In particular, Exchange has argued that the IRS’ enterprise state management system does not meet all of the security requirements needed in its cloud-based system to house this data. However, the district court was satisfied with the IRS’ response that the IRS does not use this system to store John Doe subpoena information. As such, the District Court has fully sided with the IRS on the issue of privacy rights.

Finally, the exchange argued that the recall was overly broad with respect to certain categories of documents and that full compliance with the recall would take months or even years, given the total number of accounts involved and the extensive information required. The district court agreed with the exchange on certain points and designed the summons accordingly. In particular, the District Court found that the following information requests were too broad for the IRS to achieve their purpose: (1) requests for historical information about changes to user personal information, IP addresses, and payment methods; and (ii) requests for KYC due diligence survey information including employment, net worth, source of wealth, anti-money laundering records, and investigation records related to anti-money laundering monitoring activities.

In short, after about two years of litigation, the District Court issued an order requiring the exchange to provide important personal and financial information about its users. This includes identifying information such as names, dates of birth, taxpayer identification numbers, phone numbers, physical addresses, and email addresses. The exchange must also produce important financial information including all financing and transaction ledger data.

With regard to fast motions to move forward, this case is important because it demonstrates that courts will not necessarily rely on the reasoning used in relation to previously issued summonses. Instead, courts must give each summons an appropriate review to determine whether it is adequately tailored to the facts of the situation. Additionally, given the success of the IRS in this particular subpoena, exchanges and taxpayers can expect the IRS to continue using John Doe subpoenas to obtain information about users of cryptocurrency exchanges in order to identify non-compliant taxpayers. Taxpayers who fail to report their winnings or underreport them can also expect to be audited by the IRS as a result.

The full county court decision can be accessed here.