In May of 2013, Liberty Reserve, a Costa Rican company, was indicted in the US for laundering approximately $6 billion over the course of seven years for customers who were able to make payments from anywhere in the world without having to provide any documentation of their identities. Liberty Reserve allowed customers to create accounts for blatantly criminal purposes, including identity theft, computer hacking, drug trafficking, and child pornography.
While Liberty Reserve’s demise is an extreme example of how individuals have used digital currencies to evade tax and engage in other criminal activities, digital currency exchanges are now on the IRS’s radar. Shortly after the Liberty Reserve indictment, prosecutors in the United States began scrutinizing the use of virtual currencies to evade tax. In order to assist its agents to uncover the unreported income arising from virtual currency, the IRS published Chapter 7 of the Cash Intensive Business Audit Techniques Guide.
The IRS realizes that the greatest risk of tax evasion using virtual currency is in businesses with large volumes of cash turnover and weak or nonexistent internal controls. Other red flags include:
- Transfers to unusual sources and payments to unusual payees.
- Blatant unreasonable expenditures.
- Whether the taxpayer’s net worth is disproportionate to the reported income.
- Check numbers missing from bank statements.
- Receipts that indicate the sale of an asset, pre-paid income, or another potential source for unreported income.
- General ledgers which indicate unusual items given the type of business conducted, sales of capital assets, or omitted income.
Businesses should maintain accurate records of all business activities and make sure that there are no discrepancies. Candid disclosure of cash flow, and of virtual currency especially, is a good way to show the IRS that there is no unreported income. Any business owner who thinks that he or she has unreported income or who has been contacted by the IRS regarding an audit should promptly seek the advice of a tax attorney.
Attorney Stephen J. Pieklik of the Pittsburgh tax law firm Williams Coulson regularly defends clients at audit before the IRS. Additionally, he regularly represents clients before the IRS’s Appeals Division at the United States Tax Court.