The IRS is actively seeking out tax evaders using Bitcoin, employing tools like Chainalysis to unmask them.
Many people believe that Bitcoin is anonymous, but it is in fact pseudonymous. All transactions linked to a particular address are visible on the Blockchain, which is public and transparent.
However, it is not possible to link a particular wallet address to the real world identity of a person/company without any additional information.
While good privacy practices can prevent leakage of information, there is always a point where Bitcoin transactions touch the traditional monetary system (when you use it in a store or when you sell it at an exchange) and proof of identity can become necessary.
Working backwards, it is possible to unravel the chain of Bitcoin transactions to some extent.
IRS and Chainalysis
The IRS has been trying hard to obtain details about Bitcoin transactions and detect cases of tax evasion.
The IRS had previously requested Coinbase to give it details about its users for the period 2013-15. As per a document referenced by Daily Beast, the IRS has also awarded a contract to Chainalysis to analyse transactions and unmask users.
Chainalysis uses data scraped from public forums, leaked data sources including dark web, exchange deposits and withdrawals to tag and identify transactions.
The IRS expects to use this data to catch tax cheats as well as criminals who sell drugs and other illegal goods and services for Bitcoin.
Does Chainalysis work?
There have been Bitcoin mixing services which specialized in obfuscating the source of Bitcoins. Bitmixer.io was the leader amongst mixing services, before it announced its decision to mysteriously shut down.
Coinjoin transactions also make it difficult to trivially link Bitcoin transactions. Services like Joinmixer help like-minded individuals combine transactions to enhance privacy.
Moreover, while Chainalysis claims that it has information on a high percentage of Bitcoin addresses (25 percent), it is possible that these could be addresses with poor privacy practices.
Chainalysis may not be able to unmask transactions where users have intentionally tried to obfuscate the transaction trail.
What about altcoins?
While the IRS may be breaking its head in trying to unmask those behind Bitcoin transactions, its efforts will be futile if extended to the wider cryptocurrency space.
Certain currencies like Dash, Monero and ZCash have inbuilt privacy features, which makes it difficult to track transactions.
If people shift from Bitcoin to secondary currencies like these, the IRS would have its hands full when trying to detect specific cases of tax evasion.
Moreover, the resources that it would take to investigate these currencies would make the whole exercise infeasible.
It is possible that a simple and clear tax regime with respect to cryptocurrencies may be what is required to gain higher compliance with respect to tax in cryptocurrencies.
Cryptocurrencies are currently in a gray area and this may prevent people from fully disclosing their cryptocurrency holdings to tax authorities.