The value of a bitcoin, the best-known virtual currency, was about a dime in 2010, $250 in 2015, $1,000 in early 2017, and over $17,000 in mid-December. (It’s about $11,800 as this is written.) That staggering gain in value captured the attention of investors — and the Internal Revenue Service.

Unlike the dollar, gold or other traditional representations of wealth, bitcoin and numerous other virtual currencies are not backed by a government, and have no intrinsic value.

Bitcoin doesn’t even have a physical form; it is created by using a computer to solve a complex equation, in a process known as “mining.” The newly mined currency is then recorded in a secure database known as a “blockchain.”

Virtual currencies that can be converted into traditional currency are property for tax purposes, which means a taxpayer can have a gain or loss on a sale or exchange of bitcoin. Unsurprisingly, bitcoin's surge in value left the IRS wondering if some taxpayers who conducted transactions in bitcoin had underreported their gains.

In fact, a search of electronically filed returns by the IRS found that only about 900 taxpayers declared gains or losses that were "likely related to Bitcoin" in each of the years 2013 through 2015.

So the agency served a summons in 2016 on Coinbase, Inc., America's largest platform for exchanging bitcoin into U.S. dollars. The agency demanded records of nearly all of the company’s customers over a period of several years.

Coinbase objected, and the IRS narrowed the summons to accounts with over $20,000 in any one transaction, requesting information for over 14,000 account holders, who together made nearly 9 million transactions.

Still, Coinbase refused to comply, so the IRS went to federal court (United States v. Coinbase, 17-cv-10431-JSC), seeking to enforce its demand for the information.

Federal law gives the IRS broad power to issue a summons for “ascertaining the correctness of any return,” as long it is issued for a legitimate purpose and seeks relevant information not already in the agency’s possession.

The court found that the narrowed summons serves the legitimate purpose of investigating the "reporting gap between the number of virtual currency users Coinbase claims to have had" and "U.S. bitcoin users reporting gains and losses to the IRS."

Coinbase argued that some taxpayers may have reported bitcoin transactions in ways the IRS analysis might not have spotted, such as on paper rather than electronically, and that there were some dips in bitcoin’s value during the 3 years the IRS asked about.

But the court rejected these arguments. It noted that about 85% of taxpayers file electronically, and individuals investing in a digital currency were probably not likely to disproportionally choose to file their returns on paper.

In addition, the court agreed with the IRS that the records it sought were relevant because the identities of Coinbase users and their transaction activity would permit the government to investigate whether taxable gains were not properly reported.

The court did, however, limit the information Coinbase was required to provide. It only had to supply each affected customer’s name, address, date of birth and taxpayer ID number.

Additional items the agency had sought, such as copies of driver’s licenses or passports, records of “know-your-customer” diligence performed by Coinbase to verify the identity of its account holders, customer correspondence, agreements giving third parties access to accounts and other documents, were “not relevant at this time,” the court said – but they could be later.

The court dismissed arguments filed by an anonymous party that taxpayers should be allowed to trade virtual currencies tax-free until the IRS adopts specific regulations governing them, and that the agency was using the summons to “harass” taxpayers.

No law requires the IRS to issue specific regulations before collecting taxes, the court said, and there was no evidence of harassment by the agency.

Coinbase was ordered to provide the IRS with the information the court had determined the agency needed.

The likely result of this ruling is that a lot of taxpayers who thought the gains they made in the cyber world of virtual currencies were invisible to the IRS now realize that they owe Uncle Sam some very real dollars.

By Rachel E. Balchum