More than ten years ago, cryptocurrency was born. The 'Great Recession' and its financial crisis increased their popularity. An alternative to government "fiat" currencies which became more unstable as governments sought to shore up their economies, investors sought new avenues to protect and even hide their wealth. The secretive nature of these alternate currencies became a significant feature.
Drug cartels, drug dealers, terrorists, and many others seeking anonymity from government tracking flocked to Bitcoin and later a score of other cryptocurrencies.
It took a while for the IRS to realize the potential impact on U.S. tax revenues. The IRS has been slow to respond and even slower in guiding how these electronic currencies are treated and taxed.
Chuck Rettig, the new IRS commissioner, has focused his agency's efforts on an area of easier, softer targets with more significant rewards: Penalties.
How do you raise more revenue without raising tax rates: PENALTIES.
We have seen a two-pronged approach by the IRS in collecting more money with fewer resources.
First, the amount of penalties per infraction has been increased substantially. Just check out some of the penalties for a later partnership return or filing Forms 1099 late or not at all. It can take your breath away. Also, considering the staggering penalties assessed against those who don't file the proper foreign information returns or even those who didn't know they were supposed to be filing!
Don't forget that the U.S. tax system is one of self-assessment. How do you get 327+ million Americans to file their tax returns and properly pay their taxes with few resources?
One word describes it all: FEAR.
In a new battlefront, the IRS is taking aggressive steps to build cases against taxpayers who fail to report their cryptocurrency transactions. The IRS believes that millions of transactions are going unreported.
Many taxpayers believe they won't or can't be caught. Keep in mind that the government may not be fast, but the risks are now increasing substantially for those not disclosing their crypto trades. Their upside is avoiding some income tax (if they are making money). But consider the downside.
Non-reporting taxpayers know that if caught, the IRS may penalize them. But they seem to assume that they don't need to worry about criminal exposure. Don't be so sure.
Violators face hefty tax penalties or even criminal investigation. Anyone convicted of tax evasion can face up to 5 years in prison and fines as high as $250,000. Keep in mind that it ignores the cost of defending oneself against the Justice Department. Defense attorneys are expensive.
IRS Commissioner Chuck Rettig has increased criminal investigations in an aggressive strategy to influence better taxpayer compliance.
Last year's IRS letters to 10,000 crypto taxpayers were just a start. Recipients who received and ignored those letters are vulnerable to further investigation, audits, and penalties. After receiving such a letter, it is harder to say you made an innocent mistake or misunderstood.
2019 Form 1040 contains a specific question targeting cryptocurrency too. A checkbox at the top of Schedule 1 requires taxpayers to answer whether at any time during 2019 they sold, sent, exchanged, or otherwise acquired any financial interest in cryptocurrency. It is easy to discount that question. You sign that tax return under penalties of perjury! If discovered, that "NO" would be considered a "badge of fraud" when an auditor considers your case.
That should tell you something. After all, the Department of Justice Tax Division has successfully argued that the mere failure to check a box in the FBAR reporting context (foreign bank & financial accounts) is "per-se" willfulness.
Why would you care about that? As opposed to non-willful actions, willful failures carry significantly higher penalties and an increased threat of criminal investigation.
The DOJ's Tax Division is working with the IRS and is involved in several criminal prosecutions involving cryptocurrency. The IRS's Criminal Investigation Division is even meeting with tax authorities from many other countries to share data and enforcement strategies to find potential cryptocurrency tax evasion. Other governments are just as concerned about losing tax revenues thru hidden crypto transactions.
IRS Notice 2014-21 states that cryptocurrency is "property" for tax purposes. When you trade property, you pay taxes if you realize a gain, and you claim losses when you incur a loss.
You need to know when you bought the cryptocurrency, how much you paid, and what value you received for it. Stock and bond trades are easy by comparison. Cryptocurrency trades are a more significant challenge. Software and technology are catching up, and the ability to price and track your trades is getting easier.
But do you know how?
The IRS FAQs states all income, gain, or loss involving virtual currency must be reported, regardless of whether you received a particular tax form [1099, etc.]. Many cryptocurrency investors have made purchases at multiple times and for many years for everything from other cryptocurrencies to a new flat screen T.V. The IRS says that tax basis is determined by the fair market value of the virtual currency, in U.S. dollars, when the virtual currency is received.
And to add more complexity when the taxpayer obtained the virtual currency through peer-to-peer transactions. What happens when the cryptocurrency itself does not have a published value? The IRS still requires taxpayers to use some reasonable method to value the cryptocurrency and establish that such value is accurate.
Don't abandon hope. Some websites may help in figuring out a taxpayer's transaction history. Some of them will even attempt to estimate amounts owed and fill out the Schedule D form reporting gains and losses.
Cryptocurrency investors who mine cryptocurrency may have other issues.
They may have trouble deciphering exactly when they received mined cryptocurrency, making it difficult to determine its value for reporting on your tax return.
The IRS provides little specific guidance. They fall back on the term "reasonable method to determine the fair market value" for you to calculate your gain or loss. The bigger question is will the IRS agree your "reasonable method" is, in fact, reasonable?
Those dealing in larger quantities, multiple transactions, and multiple cryptocurrencies only become more complex. Taxpayers may use a first-in-first-out (FIFO) method or another method so long as it is consistently applied. Where taxpayers often fail is they have not kept a detailed log of their transactions.
Another layer of complexity occurs when you have multiple years where you haven't reported your transactions.
The IRS has only begun to scratch the surface of important issues involving cryptocurrencies. Major issues remain unresolved. We have little or no guidance on computing value, determining basis, or how estate tax rules apply to cryptocurrency. Besides, IRS FAQs are not technically legal authority.
The recent Revenue Ruling 2019-24 plus some additional FAQs helps. The revenue ruling addresses common questions regarding the tax treatment of a cryptocurrency Hard Fork and Air Drops.
If you are not compliant and haven't been reporting your crypto transactions on your returns, you have some decisions. Consider them carefully and wisely. In some cases, amended tax returns or "quiet" disclosures might work. In other cases, formal voluntary disclosures with a tax attorney's assistance may be a safer answer.
We know the IRS is making a serious effort to find unreported cryptocurrency transactions. As they discover them, the results will be far harsher than the taxpayers who take steps now to disclose and get their problems behind them.