By Jacob Gershman 

The federal government is ramping up pressure on a leading digital-currency company to turn over a vast amount of its customer records as part of a tax-evasion probe, an effort that is raising privacy alarms.

The Internal Revenue Service is focusing on Coinbase Inc., a popular exchange and "wallet" service for bitcoin, which has surged in value over the past year as a kind of digital alternative to gold.

Some consumers use bitcoin as a potentially faster, cheaper and more secure way to shop and transfer funds online. Its growing adoption, and perceived anonymity, has made the IRS more concerned about people using digital currency to evade paying taxes.

Coinbase claims it has more than 6.2 million customers and has helped exchange more than $6 billion worth of digital currency across 33 countries.

After getting court approval, the IRS in December served a so-called John Doe summons to Coinbase that demanded transaction and user profile records and other information on all of the company's U.S. customers from 2013 to 2015, a request covering hundreds of thousands or more account holders. The Justice Department, representing the IRS, petitioned a federal court this month for an order enforcing the summons.

Coinbase, which is based in San Francisco, has refused to hand over the records and has asked the government to drastically narrow its scope and focus. The company says its general practice "is to cooperate with properly targeted law-enforcement inquiries." But it says the IRS summons is "indiscriminate and over broad" and has vowed to fight it unless it is scaled back.

The breadth of the IRS's request, and the implications for digital consumer privacy, is troubling to bitcoin advocates and Silicon Valley.

What the IRS is asking for "is unprecedented," said Jerry Brito, executive director of Coin Center, a virtual currency advocacy group in Washington, D.C. "You can imagine how this would rankle any consumer."

A John Doe summons allows the IRS to obtain information about all taxpayers in a group or class of people, even if the government doesn't know their individual identities. The IRS has used that authority in the past to identify U.S. taxpayers hiding money in offshore bank accounts.

It isn't clear how many Coinbase customers fall under the summons. Coinbase says it had three million accounts world-wide at the end of 2015 (customers may have more than one account). Legal experts say they can't recall another John Doe summons with such sweep.

"It amounts to nothing more than asking for large amounts of hay in the hope they might find a needle," said Michael Beckerman, chief executive officer of the Internet Association, in an emailed statement. The Internet Association is a trade group whose members include Coinbase and tech giants Google, Facebook Inc., Twitter Inc., Amazon.com Inc., eBay Inc. and Netflix Inc.

Coinbase has emerged as a top player in the virtual currency universe since its founding in 2012. It operates a commercial trading platform, helps consumers acquire and use bitcoin, and is a bitcoin payment processor for thousands of merchants, including Overstock.com and Expedia.com.

Getting a valid John Doe summons requires the IRS to show "a reasonable basis for believing that such person or group or class of persons may fail or may have failed to comply" with the tax law.

That is a relatively low bar for the IRS, said Jeremy Temkin, a white-collar defense lawyer in New York City. Partly for that reason, said Mr. Temkin, challenges to IRS summonses are rarely successful.

"Does it make sense that people would use virtual currency to evade taxes? Yes," said Mr. Temkin. "Does it make sense that there are other legitimate reasons why people would use a virtual currency? Yes."

The IRS has suggested in court papers that a review of tax-return data shows a suspiciously small number of filers reporting virtual currency-related transactions.

In a court filing, the agency also referenced two unidentified corporate taxpayers that had "used virtual currencies as a means of evading taxes" and had Coinbase wallet accounts used to securely store funds.

"The IRS not only has a suspicion that the John Doe class includes U.S. taxpayers who are not complying with the law -- it knows that the class in the past included such violators, and very likely includes others," the IRS said in a November court filing.

Digital currency advocates say the IRS is to blame for the lack of reporting, faulting the agency for a lack of clear guidance on reporting income produced from virtual currency.

One complication is that the IRS treats bitcoin as property, rather than currency. The property classification has its advantages for investors by treating bitcoin like stocks, a capital asset subject to a more favorable long-term capital gains rate. For bitcoin consumers, though, the downside is a ton of paperwork. Even the smallest transactions using bitcoin to pay for goods or services are technically taxable events, whose gains or losses must be individually tabulated. That is in contrast to more streamlined rules regarding foreign-currency holdings.

Coinbase says it could potentially send customers a 1099-B, the form issued by brokers summarizing proceeds from stock transactions. But using the tax form for bitcoin is problematic, the company says, because there is no way at the moment to track every bitcoin purchase and sale.

The Treasury Inspector General for Tax Administration, the bureau responsible for overseeing the IRS, offered the example of the complexity of properly reporting the purchase of a cup of coffee using bitcoin as payment.

In a report last year, the watchdog bureau said "further guidance is needed to help taxpayers voluntarily comply with their tax obligations." The IRS told the inspector general that an overhaul of "reporting documents to capture virtual currency amounts is not a priority at this time."

Write to Jacob Gershman at jacob.gershman@wsj.com

(END) Dow Jones Newswires

March 27, 2017 11:44 ET (15:44 GMT)

Copyright (c) 2017 Dow Jones & Company, Inc.