Should the Internal Revenue Service (IRS) have authority to make financial-services companies turn over millions of customer records when they suspect a handful of customers could be evading taxes? Most people would respond with an emphatic no, yet this is exactly what the IRS is attempting to do with Coinbase, one of the most popular cryptocurrency service providers. And if the IRS prevails in this privacy-violating crusade against cryptocurrency users, it could have big implications for the future of everyone's digital privacy.

In November, the IRS initiated a "John Doe" summons against Coinbase to secure information on suspected tax cheats that use the service. But rather than tailor a subpoena to a narrow group of likely tax-evaders, the IRS instead requested all transaction records between 2013 and 2015—an alarmingly broad net that casts Coinbase customers as possibly guilty until proven innocent. In early December, a federal judge in San Francisco approved federal tax collector's request, which Coinbase is now fighting in court as too broad and unnecessarily punitive.

Coinbase is noteworthy both as one of the earliest and most successful cryptocurrency startups, as well as a Bitcoin business that is scrupulously compliant with government regulations (sometimes to the chagrin of the more anarchist-minded Bitcoin community).

In a blog post on the matter, Coinbase Chief Executive Officer Brian Armstrong writes that the company was proactive in helping its user base comply with IRS rules by building special tools and monitoring all new tax developments. This apparently was not enough to the IRS, who decided to bring out the big guns and try to scrutinize all Coinbase users as suspected criminals.

This action has alarmed people in the cryptocurrency space, many of whom applauded Coinbase's expensive stand against IRS overreach. But the tax agency's mega data-grab is in many ways an inevitable outcome of the IRS's own less-than-ideal tax rules for cryptocurrency.

Taxing the Blockchain

The IRS was actually one of the earliest agencies to consider cryptocurrency policy, perhaps for obvious reasons. In March of 2014, the agency issued an "IRS Virtual Currency Guidance" detailing the tax requirements for cryptocurrencies.

The IRS decided to treat cryptocurrencies as a kind of property, which meant that they enjoyed a lower capital gains tax rate than if they were taxed as a currency. But it also meant that cryptocurrency users would need to keep track of any price movements in between transactions for tax purposes. And what's worse, there would be no "de minimis" tax exemption for very small transactions. So the woman buying her daily cup of coffee with cryptocurrency would have to track price fluctuations as meticulously as the professional financial trader.

This created a major reporting burden for casual cryptocurrency users and institutional traders alike. To remain fully compliant with IRS rules, users would need to carefully record price differentials each time that they used cryptocurrency in a transaction. And cryptocurrencies are notoriously volatile, thus adding to the complexity of the tax burden. Service providers like Coinbase and BitPay did their best to provide tools for users that would streamline their tax reporting, and standalone tax tools were developed as well. But cryptocurrency users who did not use such services would need to keep track of this web of information themselves, and even those who did use such tools might inadvertently misreport or forget tiny transactions.

Ironically, this cryptocurrency tax arrangement ended up imposing significant costs on the IRS itself (as I pointed out with Coin Center executive director Jerry Brito in our Bitcoin Primer). The agency failed to set up an official enforcement or guidance office to help users navigate this confusing new area of tax law—an oversight that the agency's own inspector general criticized shortly before the IRS legal action against Coinbase—and relied solely on user reporting and good faith. Ultimately, the agency set up both innocent and well-meaning cryptocurrency users and the IRS itself up to fail. And in terms of priorities, the prevailing tax guidance similarly falls short.

Chasing Tax-Evaders, Crippling Cryptocurrency

The IRS is primarily concerned that some people may use Bitcoin to shield themselves from existing taxes—a kind of off-shore account for the cypherpunk age. Yet in its farflung effort to find these theoretical tax-evaders, the agency is making cryptocurrency users engaged in innocuous activities like gaming or the occasional Overstock.com purchase subject to the same reporting requirements as major cryptocurrency traders, when clearly we are talking about different ballgames here. The IRS should free itself and small-time users from such requirements through a de minimis exemption on small transactions.

As it stands, the tax agency's very public "war on Coinbase" could have the counterproductive effect of pushing potential tax-evaders away from using compliant services like Coinbase at all, thus rendering the entire undertaking fruitless. A truly dedicated tax evader could decide to transact solely in cash-to-Bitcoin interactions or other methods that fully conceal their tracks from the feds. This means that the promising innovations of the above-board cryptocurrency economy would be quashed while the bad guys still get to be bad. This is a lose-lose scenario that would only further frustrate the IRS's efforts.

Given Coinbase's public reputation as a compliant and regulator-friendly cryptocurrency business, you have to wonder why the IRS didn't first attempt a friendlier, more tailored approach to gathering the data they need instead of launching an all-out-war echoing the Justice Department's controversial standoff with Apple last year. Armstrong, for his part, maintains that this situation could have been better "resolved with a phone call instead of a subpoena," given Coinbase's "amicable relations" with the IRS in the past.

More broadly, the IRS action against Coinbase is concerning for the digital privacy of all Americans. As Brito pointed out at American Banker, the legal reasoning behind the IRS attack on Coinbase could easily be applied to all kinds of private data stored in the cloud. Government agencies would surely jump at the opportunity to compel platforms to turn over the data of all of their customers so that they can comb through after the fact to find violators. The battle against Coinbase is therefore another battle for the future of online privacy.