IRS turns to data analytics to track crypto tax evasion

The Internal Revenue Service is focusing on cryptocurrency tax evasion with virtual currencies like Bitcoin and nonfungible tokens, employing data analytics to uncover transactions that crypto users assumed were hidden.

The IRS has been training its spotlight on crypto users, adding a question to the front page of the tax form asking taxpayers, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” While technologies like crypto and NFTs are designed to be invisible, the IRS is aware that money laundering is being used by some crypto users, and it needs new skills in asset tracing, along with crypto expertise and digital asset auditing.

The IRS is leveraging data analytics technology and artificial intelligence to assist its overburdened staff, especially at a time when the IRS has been facing employee shortages and is stepping up its recruitment efforts. “This is not your grandfather’s IRS,” said IRS Commissioner Chuck Rettig during New York University’s online Tax Controversy Forum on Thursday. “This is an agency that has quite a bit of involvement with respect to data analytics.”

Technology like data analytics and artificial intelligence is helping the agency sift through billions of transactions in the digital world and make the process more efficient for investigators.

“It’s important to know that technology and data analytics and artificial intelligence play a large part in the future of the work that we’re going to be doing at the IRS,” said Jeff Tribiano, deputy commissioner for operations support at the IRS, during the NYU forum.

The crypto world has been changing rapidly, and the IRS has been leveraging technology to keep up with it. “In my 30 years within the government, I’ve rarely seen something evolve as quickly as virtual currency or cryptocurrency,” said Eric Hylton, who was recently commissioner of the IRS’s Small Business/Self-Employed division and previously spent over 20 years at IRS Criminal Investigation. He is now national director of compliance at the tax consulting firm Alliantgroup and director of investigation at the tax whistleblower law firm ZMF.

“I think the Service has done a great job in regards to trying to address this emerging issue,” Hylton told Accounting Today. “Quite a bit of attention has been associated with it. It’s being reported on the 1040, trying to give insight as to how widely cryptocurrency has been adopted. From a compliance standpoint, I think IRS CI has done a great job in really addressing cryptocurrency as it relates to the dark web, but also in moving further in working with a number of firms to really address the potential issue of tax evasion.”

New approaches, including greater computing capacity and artificial intelligence, are helping the IRS analyze and trace digital transactions to the real world. “When I was a criminal investigator, the whole thing was to follow the money, but now with data analytics, it’s all about following the data,” said Jeffrey Cooper, former executive director of international operations at IRS Criminal Investigation and now an executive industry consultant at the business analytics software company SAS.

“From my time with IRS Criminal Investigation, CI took on the challenge of looking at cryptocurrency several several years ago before it was a thing, so to speak,” Cooper told Accounting Today. “It’s kind of like ‘follow the money.’ Once it became a fiat currency, whether it’s cash or whatever that fiat currency is, once it went into the exchange, we were able to trace it. It is challenging, but the data is still telling the story. Individuals initially thought that they were totally anonymized by being within a blockchain, but we quickly proved them wrong because eventually they wanted to spend their money on something, and when you go back and follow the money trail, that’s helped the agency to really put some enforcement there.”

The Biden administration’s American Family Plan deals with looking at cryptocurrency and establishing new reporting requirements, the threshold being $10,000, he noted. “The Know Your Customer concept that’s in banking follows through to cryptocurrency and follows through to tax administration,” said Cooper. “No matter what they’re doing, though, there’s a trail of data that’s generated, and it’s about putting the analytics behind the data.”

Global cooperation

IRS Criminal Investigation has been working with tax authorities in four other countries — Canada, the United Kingdom, Australia and the Netherlands — through a group known as the J5 on tax cases involving cryptocurrency (see story).

“Jeff and I were in charge of IRS CI’s international office,” said Hylton. “We kind of set the groundwork even prior to the J5 being established, working with OECD [the Organization for Economic Cooperation and Development] to do a task force on tax crime and other financial crimes, really working from an operational standpoint. Initially working with OECD, we were coming up with typologies and methodologies to help out countries worldwide to address various emerging threats, and cryptocurrency was on that table. With the J5, they have taken it another step further as far as really addressing the non-compliance issues in cryptocurrency and professional enablers. They have sessions where they come together with these different countries — the Netherlands, U.K., Australia and Canada — in taking some of our top experts in cryptocurrency, pulling it all together and really addressing how you find some of the major issues, either with the dark web or just any tax signature.”

While he was at IRS CI, he was also involved with an operation called Hidden Treasures to identify various signatures within blockchain transactions to detect patterns of tax evasion from a structuring standpoint.

“In looking at the J5, that’s a basic manifestation of the whole-of-government approach with those five countries, and really working together,” said Cooper. “Whether it’s financial crime or even the flow of money, there’s really no more border. The crimes and tax evasion are borderless so those countries got together. Not only are they looking at cryptocurrency as an issue of digital currency, they also have a platform where they’re looking at the technology so that countries can speak to each other. I see the technology, as far as data analytics and AI solutions, helping trace and find the interconnections or those networks so that they then can work together.”

He sees some challenges, however. “Globally there is not one unified understanding or definition of cryptocurrency and how to tax it, what it’s called or what it is,” said Cooper. “In the United States, it wasn’t until 2014 that we classified it as property. Some countries just do not yet, so those regulations haven’t really caught up to the technology that’s out there. In the U.S., whether or not you own cryptocurrency is on the front of the 1040. Basically what that says is that the IRS and the United States government are putting emphasis on that.”

The IRS has also been issuing John Doe summonses to cryptocurrency exchanges like Coinbase and Kraken to disclose information about their anonymous users. “I think you can really see the Service as being pretty aggressive with those John Doe summonses to see if any taxpayers are potentially not reporting all of their [transactions] with cryptocurrency,” said Hylton. I think we have to take into consideration the market capitalization for this. This hit $2 trillion globally.”

The IRS has needed to work with other countries to trace the transactions across borders. “Tax authorities globally (and not just the IRS) are increasingly looking to data gathering with analytic savvy to improve tax compliance generally,” said Peter Larsen, a principal at Deloitte Tax. “It’s a trend we see not just with respect to crypto. But crypto presents an interesting use case because the crypto ledgers present a public transaction history that the IRS (like anyone else) can access. There’s a lot of data there, but supplementing analytic insights from that public data with information from tax returns, information returns, audits or summons could be of interest to the IRS and other tax authorities.”

Biden administration proposals

The Treasury Department’s Green Book includes proposals from the Biden administration for the IRS to increase its tax enforcement budget to pull in more tax revenue, including requiring banks and other financial institutions to report more information about their customers’ accounts.

“Between the commissioner’s recent indication that the IRS will be putting more focus and dollars in enforcement, and the Green Book inclusion of specific proposals for the broadening of third party information reporting, including reporting on cryptocurrency and a new financial account reporting regime we are seeing more evidence of our anticipated trend in the expansion of information reporting in an effort to capture revenue for tax authorities,” said Denise Hintzke, Deloitte’s global information reporting practice leader.

“If you think about this new proposal from the president and what the Treasury has proposed last month, requiring U.S.-based crypto assets exchanges to report data about their foreign users to the U.S. government and share that information, you kind of have something like a FATCA situation in that regard,” said Hylton. “I think that’s going to be an important aspect of that cross-border exchange if they move forward with that proposal from the Treasury as well. The particularities still remain to be seen, but it really just highlights that not only are we looking at additional reporting for crypto for individuals over $10,000, but also the brokers have to think about disclosing beneficial ownership information. Now you’re also looking at this exchange regarding foreign users. Here you can see the regulatory regime really ratcheting itself up in that regard as it relates to crypto to get a firm understanding. It should not prohibit innovation within the industry, but I think it’s definitely going to be a positive.”

Others are skeptical that increased funding for IRS enforcement will yield more money to pay for the administration’s priorities. “$80 billion for IRS with enforcement is supposed to raise $700 billion,” said Mark Peterson, executive vice president of advocacy at the American Institute of CPAs during an online AICPA Town Hall on Thursday. “Just giving the IRS more money to raise money doesn’t give you the money.”

Hylton anticipates that more tax whistleblower claims will be filed relating to cryptocurrency, and the IRS will be able to trace those more with the help of tipsters. At Alliantgroup and ZMF, he will be working with former IRS acting commissioner Steven Miller and former Senate Finance Committee senior counsel Dean Zerbe on research and development tax credits, tax advisory services for digital currency, and whistleblower claims against taxpayers who aren’t reporting their cryptocurrency gains. “A number of individuals are aware that a substantial amount of individuals are not [reporting] their income from cryptocurrency, or they become millionaires and haven’t reported it,” he said. “I think you’ll see that coming about as well, and so the firm is also representing individuals for whistleblower claims.”

IRS tech hiring

Cryptocurrencies and NFTs are only one part of the IRS’s digital transformation challenge, and the IRS is looking to hire more tech employees to help with that effort, thanks to the “critical pay authority” it was granted in the Taxpayer First Act of 2019 for technology upgrades. The agency is also working to transform the taxpayer experience and ensure fair and impartial enforcement of tax law, spurred by the Taxpayer First Act. On top of that, the IRS is actively fighting against the increase in fraud and non-compliance brought about by COVID-19.

“As we talk about digital transformation, you still have to look at, as you’re going to do your upcoming hiring, this isn’t just in the United States as to the IRS, but globally,” said Cooper. “Well, I was a revenue agent and a tax auditor and I was a criminal investigator, and I needed certain skill sets to do that job extremely well. Now, as you talk about digital transformation in this journey that countries are making, now you have to hire data scientists. Because of cryptocurrency, you not only have to be good at those things, but you have to be good at really understanding cryptocurrency. Now organizations are hiring, saying they need a cryptocurrency expert. This is really shaping the landscape of how organizations will look in the future.”

The IRS is hoping to hire experts who can perform complex audits, investigations and compliance checks on cryptocurrency using data analytics and other advanced technologies.

“As far as the IRS utilizing technology across the board, that has definitely shown the agency how to work differently and how to work smarter,” said Cooper. “The IRS has a modernization plan where they’re looking at upgrading not only their infrastructure and architecture, but also the tools that are needed to do the job so that the agent or auditor then has assistance from technology. To what extent can the computer do robotic process automation? What steps can be done by technology? That frees up that agent so they can focus on other things. For those routine tasks that we’re doing, link analysis, network analysis and predictive analytics show the flow of those things can be done up front. Then maybe you don’t need as many people as you would have needed as far as your hiring process.”

The administration proposal is likely to lead to a significant increase in hiring at the IRS for tech experts. “You’re talking not only data scientists and behavioral scientists,” said Hylton. “You’re talking about individuals with significant cryptocurrency or financial services experience that the Service is looking toward. Yes, it will take some time. You have a faucet that hasn’t been on for a period of time and, if you just turn it on full blast, that is going to have some challenges there. But I have full faith that the Service will step up. The Service has consistently stepped up over the 30 years that I’ve been there, even with all the additional responsibilities they have been given this past year. The Service has stepped up quite a bit with all of the relief legislation that has come about over this past year. The sweet spot is you have to have a balance between technology and resources because it’s not really just about working or having additional individuals, but you want to employ the technological advancements that you need, like using AI and using some of the complex software that the Service has right now to address some of these issues of noncompliance.”

IRS Criminal Investigation is increasing its use of artificial intelligence and data manipulation tools to find connections and patterns that wouldn’t necessarily be readily identified with being a human being. “CI in 2017 stood up a national coordinated investigative unit,” said Guy Ficco, executive director of IRS Criminal Investigation during the NYU forum on Friday. “Their stated mission was to do that, and they had success immediately, and they’ve gotten better. This has been so much an emphasis point for CI that just recently within the last few months our headquarters at CI is going through a realignment. This is really our first major realignment in about 20 years. What we’re basically doing is we’re elevating some sections to executive level and one of them is investigative analytics, and it’s really these data scientists. We’re increasing our staffing there and we’re increasing our software tools. This is going to be a real focal point.”

The IRS is also working with outside technology companies like SAS for data analytics. “We provide an end-to-end solution to the whole lifecycle of data, from discovery to deployment to putting it in operation, and especially with cryptocurrency,” said Cooper. “All it is is data and that’s how we look at it. It’s just another data point, a very large one, so we’re able to look at that at scale to help organizations like the IRS and other agencies around the world. We’re able to scrape data off the darknet as it relates to cryptocurrency or wallet and bring that into the real world. Ultimately, the whole goal is to really get a 360-degree view of the taxpayer, of the business, of the entity, using data analytics to help you do that in the solutions. Our solutions are used throughout the IRS and various organizations at IRS.”

Other federal agencies have also been adjusting to the crypto world. The Justice Department was recently able to use its cryptocurrency experts to seize back $2.3 billion worth of Bitcoin that had been paid to hackers in the Colonial Pipeline ransomware attack. The IRS is developing similar skills.

“The Service, working with various cryptocurrency consulting firms, have done a tremendous job in regard to that, in looking at digital wallets and looking at the dark web in which they’re using complex, sophisticated technologies like Tor and the Onion network and things of that nature,” said Hylton. “I think the Service has proven itself in that regard. It’s primarily been from a money-laundering standpoint, but you can definitely use it for tax as well. The Service has worked a lot with chain analysis, which I think was primarily responsible for helping track some of those ransomware funds. The Service is definitely a strong part of that.”

The Taxpayer First Act has also been spurring the IRS to make other technology improvements to help with taxpayer service. “We’re inserting QR codes on some of the notices in which now taxpayers will be able to take the notices they receive and it actually [sends] you directly to the IRS page to be able to make installment agreements and payments,” said Hylton. “How do we transfer those various services forward to make it easier for taxpayers?”

The IRS, like other organizations, has to upgrade its systems to leverage the latest technology. “As far as technology, organizations definitely have to embrace technology going forward,” said Cooper. “It’s no longer a to-do. It’s a must do. And the companies that utilize technology make the digital transformation journey a lot smoother. As it relates to following the money, so to speak, you have to also follow the data. And basically, if you have data without analytics, it’s just value that’s not yet realized. It’s basically a science project. You can’t make a decision without that. And that’s part of our goal is to help organizations to understand that.”