Fifth Circuit Rules Virtual Currency Transactions and Records Held By Exchanges Do Not Have Fourth Amendment Protections from Search and Seizure by the Government By: SANDRA R. BROWN and TENZING TUNDEN
The IRS had not been shy about highlighting that taxpayers need to report any and all virtual currency transactions appropriately and that it will use its enforcement tools to ensure such compliance.[i] The IRS’s data-gathering efforts are part of those enforcement tools. In 2017, the Government used a John Doe Summons to obtain a judicial order requiring Coinbase Inc., a virtual currency exchange, to provide customer information, including user profiles, transactions logs, records of payments processed, account statements, and correspondence for approximately 13,000 individuals.[ii] In 2018, the IRS announced a virtual currency compliance campaign through the LB&I division.[iii] In 2019, the IRS announced its plan to send “soft letters” to nearly 10,000 taxpayers, educating them on tax compliance for virtual currencies.[iv] For individuals and business entities that engage in virtual currency transactions through investing in it, operating a market place or exchange, or forming and managing a private investment fund in cryptocurrency, it is imperative that they understand that records of these transactions are not out of the reach of the Government. To that point, the Fifth Circuit Court of Appeals recently ruled that bitcoin data in the hands of a third-party is not covered by the Fourth Amendment of the U.S. Constitution.[v] That means the Government does not need a judicial warrant and a showing of probable cause to obtain such data. Instead, federal agents can request the information by issuing a subpoena or, in the case of agencies such as the IRS which have summons authority, by the issuance of a summons to a third-party.
United States v. Gratkowski
Mr. Gratkowski was engaged in illicit activities related to a website on the “dark web.” The Federal Government, in analyzing a publicly viewable bitcoin blockchain, identified a cluster of bitcoin addresses controlled by an illicit website.[vi] Armed with this information, the Government served a grand jury subpoena on Coinbase for all information on the Coinbase customers whose accounts had sent Bitcoin to any of the addresses in the Website’s cluster.[vii] Coinbase identified Mr. Gratkowski as one of these customers. As a result, the Government was then able to obtain a search warrant for Mr. Gratkowskis house and there they found a hard drive containing illicit materials related to the website on the dark web.[viii] Mr. Gratkowski moved to suppress the evidence based upon an assertion that the information subpoenaed from Coinbase was protected under the Fourth Amendment from such seizure, based upon his asserted legitimate expectation of privacy in records involving his Bitcoin transactions.
Fourth Amendment Protection
The Fourth Amendment protects individuals against unreasonable search and seizures of “their persons, houses, papers, and effects” by the Government.[ix] However, for an individual to successfully assert that their rights have been infringed upon by the Government, in violation of the Fourth Amendment, the individual must have a reasonable expectation of privacy in the items searched or seized.[x] When it comes to financial records, this important legal doctrine can sometime be key to a taxpayer’s defense and ability to suppress evidence obtained by the IRS in its criminal investigation.
Generally, an individual has no legitimate expectation of privacy in information he or she voluntarily turns over to a third party.[xi] A key set of documents which the IRS will routinely seek to obtain in its investigation are bank records. Almost 80 years ago, the Supreme Court in U.S. v. Miller held that bank records were not subject to Fourth Amendment Protections.[xii] The Court concluded that bank records were not confidential communications but rather negotiable instruments which contained only information voluntarily conveyed to the banks and exposed to their employees in the ordinary course of business which, under the third-party disclosure doctrine, negated the individuals legitimate expectation of privacy in such records.[xiii]
Flash forward 80 years. For Mr. Gratkowski, his financial transactions no longer consisted simply of banking records maintained in a brick and mortar building on paperwork or microfilm. Instead, Mr. Gratkowski used Bitcoin on the dark web, which, likely in his mind, not only carried an expectation of privacy but also secrecy. As such, Mr. Gratkowkski argued it was the Supreme Court’s 2018 decision in Carpenter v. U.S., rather than its decision in Miller, which should control in his case.[xiv]
In Carpenter, which involved cellphone location data, the Supreme Court limited the applicability of the third-party disclosure doctrine and held that the heightened protections for individual privacy interests under the Fourth Amendment did apply to searches involving cellphone location data and historical cellphone location records. Mr. Gratkowski argued records of his Bitcoin transactions were more akin to the cellphone location data than physical financial bank records, thus, the Government search of his records from Bitcoin’s public blockchain and Coinbase should be protected by the Fourth Amendment.[xv] The Fifth Circuit disagreed, holding that Mr. Gratkowski’s use of Coinbase was actually more akin to the brick and mortar bank records in issue in the Supreme Court’s holding in Miller than the cellphone location data in issue in its decision in Carpenter.[xvi] As part of the analysis, the Court noted the “nature of information on the Bitcoin blockchain and the voluntariness of the exposure weigh heavily against finding a privacy interest in an individual’s information on the Bitcoin blockchain.”[xvii] Rather, it is well known that each Bitcoin transaction is recorded in a publicly available blockchain. Every Bitcoin user has access to the public Bitcoin blockchain and can see every Bitcoin address and its respective transfers. Due to this public availability, it is possible to determine the identities of Bitcoin address owners by analyzing the blockchain.[xviii] While a Bitcoin user could maintain a high level of privacy by transacting without a third-party intermediary like Coinbase, those users who do use an intermediary cannot claim a legitimate expectation of privacy in such records.[xix]
Zietzke v. U.S.
For those outside of the 5th Circuit, it is also worth noting that the decision in Gratkowski does not stand alone; it aligns with the 2019 District Court decision in Zietzke v. U.S. [xx]
In Zietzke, the petitioner also argued the holding of Carpenter should apply to the Government’s subpoena of his records on the virtual currency exchange Bitstamp.[xxi] The District Court disagreed, finding such records do not involve surveillance like what was involved in Carpenter.[xxii] Rather, the Government’s request was for financial records which were already exposed to and owned by a third party (a virtual currency exchange) and thus Zietzke’s privacy interests were greatly diminished.[xxiii] The Court further distinguished Carpenter, noting that nothing in the records implicated petitioner’s anticipation of privacy in his physical location or his expectation of privacy in the whole of his physical movements.[xxiv] The Court concluded that the records stored on the virtual currency exchange will at most reveal one’s buying and spending history as well as one’s wealth.[xxv]
When it comes to investigating taxpayer compliance in the arena of virtual currency, records which reveal a taxpayer’s buying and spending as well as the taxpayer’s wealth, are exactly what the IRS is looking for. As both of these decisions make clear, when it comes to information published on the public blockchain, the Fourth Amendment does not preclude the IRS from readily getting what it is looking for without obtaining a warrant.
Sandra R. Brown is a Principal at Hochman Salkin Toscher Perez P.C. Prior to joining the firm, Ms. Brown served as the Acting United States Attorney, the First Assistant United States Attorney and the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) Ms. Brown specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court.
Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C. Mr. Tunden recently graduated from the Graduate Tax Program at NYU School of Law and the J.D. Program at UC Davis School of Law. During law school, Mr. Tunden served as an intern at the Franchise Tax Board Legal Division and at the Tax Division of the U.S. Attorney’s Office (N.D. Cal).
[i] See Michel Stein, Cryptocurrency Enforcement is Here, July 30, 2019 available at https://www.taxlitigator.com/cryptocurrency-enforcement-is-here-by-michel-stein/
[v] United States v. Gratkowski, No. 19-50492 (June 30, 2020 5th Cir.)
[vi] Id. at 3.
[ix] U.S. Const. Amend. IV.
[x] See, United States v. Jones, 565 U.S. 400, 406 (2012).
[xi] See, Smith v. Maryland, 442 U.S. 735, 743-44 (1979).
[xii] United States v. Miller, 425 U.S. 435, 439-40 (1976).
[xiii] Id. at 442.
[xiv] Carpenter v. United States, 138 S. Ct. 2206, 2217 (2018).
[xv] Supra note 5, Gratkowski at 6.
[xvi] Id. at 8.
[xviii] Id. at 7.
[xx] Zietzke v. United States, 426 F. Supp. 3d 758 (W.D. Wash. 2019).
[xxi] Id. at 11-12.
[xxii] Id. at 12-13.
[xxv] Id. at 13.