I normally keep my cryptocurrency stuff relegated to Twitter, but this is some news that should be interesting to anyone who is curious about such things…

Background

Coinbase is one of the most popular wallet services and ways to purchase Bitcoin in the United States, and their exchage GDAX is similarly prominent. I believe they were one of the first services to offer deposits from bank accounts, and one of the first to issue Visa Bitcoin “Shift” debit cards that can be used to pay for things in Bitcoin, Litecoin, Ethereum, or USD wherever Visa is accepted. Simply put, they were kind of the best in the business when it came to helping anyone from a layperson to someone like me go from USD to BTC via a relatively easy process. I have used them since I started dabbling in crypto again two years ago. Unfortunately, I think they may be in for a world of hurt…

The Tax Man Commeth

Forbes - IRS Tries Again to Make Coinbase Turn Over Customer Account Data

The IRS has taken the position that Coinbase must provide them with all of their customer transaction records, a decision influenced by the fact that only about 900 out of what I estimate are tens of thousands of Coinbase users declared Bitcoin profits on their tax returns. If Coinbase has 40,000 users, which I think is probably conservative, that’s only 2.25% of their user base claiming earnings on their taxes. Now, some of those users could’ve only incurred losses (which should also be written off, by the way), some of them made barely enough to justify claiming the earnings to the IRS, etc, but still, that number is obviously way too low. Imagine if it was discovered that only 10% of Fidelity, Scottrade, or TD Ameritrade users reported their capital gains earnings to the IRS!

Now, I personally believe that crypto should be taxed differently than it currently is, which is basically either at your income tax rate or a capital gains rate depending on if you hold a coin for one year or not. Essentially the tax rate should be much lower because it’s an unregulated market and thus people like me aren’t offered any of the protections the SEC would offer someone trading on the NYSE. If the U.S. Government is offering zero services to the crypto community, why should we pay them? Unfortunately, you don’t get to choose whether or not you pay taxes when Uncle Sam thinks you should.

For years I’ve advised people who dabble in crypto or trade / hold heavily that they need to report their income to the IRS. For one, doing so enables you to write off expenses like power consumption, computer hardware (whether it’s for mining or not), etc, reducing your tax exposure. And secondly, while crypto currencies are either by design extremely private (Monero, ZCash, Zclassic) or are more public but can be made private relatively easily (see “bitcoin tumblers”), the IRS doesn’t need access to your crypto wallet to make your life a living hell. While I absoltely believe in blockchain technologies, especially those related distributed computing like Golem, Storj, Sia, and Gridcoin, people often confuse the decentralized, autonomous, and non-disruptable attributes of blockchain tech with having privacy outside the blockchain networks themselves. Your privacy anywhere is limited by the least private action you take.

Consider Monero, one of the most private cryptocurrencies, as an example. With Monero, you can pick how private you want your transaction to be by chosing the number of times the transaction bounces through a node and is obfuscated. Users pay a small fee per obfuscation, both in time to delivery as well as actually paying the network for the service of secrecy. It doesn’t matter that you make your Monero transaction to or from an exchange like Poloniex private. If the Poloniex account is registered to youremailaddress@gmail.com, congrats, you just created a papertrail that the IRS can follow. All they need to do is subpoena the exchange for your records. Even if you were clever enough to use a burner email address that can’t easily be traced to you as your login, the IRS still has the advantage of being able to get you for lying to them if they ask you directly whether or not you have an account on Poloniex, Bittrex, Coinbase, etc. Simply put, you can definitely do some work to make it very difficult to track, and right now the IRS will likely focus on people who were naive enough to think they could register with their email address and nobody would ever figure anything out. But eventually they will build more sophisticated tools to track crypto, and you don’t want to be in a situation where you’re reporting 5-years of back taxes because you never thought the IRS would figure out crypto.

Moving Forward, not Backward

I hope Coinbase survives this legal battle with the IRS, though frankly the deposit delays experienced by some users, myself included, over the past week was enough to think about switching to another exchange (likely Gemini) even without the news regarding the IRS. Moreso, though, I hope that we don’t enter a world where users are jumping from one exchange to another simply picking based on who they think the IRS will subpoena last. It may take them five years to figure out how to best track cryptocurrencies and audit cryptocurrency holders and traders, but with market caps increasing daily and news that only 900 or so users of one of the most popular exchanges in the United States reported income on their taxes, you better believe they will invest some money to figure it out. As of today, 5/9/2017 at 11:50 AM PST, the total market capitalization, i.e. how much money is invested in cryptocurrencies, is $52,162,851,97. That’s $52 Billion. A lot of that is in China, but if only 2.25% of people reported their earnings on Coinbase, a number that will be higher than other more private exchanges, well… you do the math on how much the IRS is “owed.”