IRS Steps Up Cryptocurrency Tax Enforcement Efforts
When the first versions of cryptocurrency were formulated back in the 1980s, scant evidence of concern could be found from the government. In 2017, after the Treasury Inspector General for Tax Administration criticized the IRS for failing to develop a coordinated virtual currency strategy, the IRS announced concern over “massive” underreporting of income generated by cryptocurrencies.
Today, a question appears at the top of Schedule 1 of Form 1040 inquiring if the taxpayer engaged in any virtual currency transactions during the year. This article addresses the current efforts the IRS is making to stay ahead of the cryptocurrency curve and promote compliance with income tax laws applicable to virtual currency.
How is Cryptocurrency Taxed?
The IRS explains the taxation of cryptocurrency in Notice 2014-21. It says virtual currency is treated as property, not as currency, for U.S. federal tax purposes. Generally, this means payments made using virtual currency to independent contractors are taxable, and self-employment tax rules generally apply. Wages paid to employees using virtual currency are taxable to the employee and must be reported by an employer on a Form W-2. Transactions involving an exchange between cryptocurrency and other property are taxable as gains or losses.
What Cryptocurrency Enforcement Challenges Exist?
In recently published guidance, the IRS addresses some of the common misunderstandings taxpayers have with respect to the taxation of cryptocurrency transactions. Common areas of confusion exist with respect to “coin-to-coin” exchanges, hard fork transactions and the determination of basis.
- Currency-to-currency exchanges. Some taxpayers mistakenly believe coin-to-coin trades, such as Bitcoin for Ethereum cryptocurrency, is a nontaxable exchange of essentially the same kind of currency. According to the IRS, currency exchanges are subject to the same capital gains and loss rules of property exchanges generally.
- Hard forks (chain splits). Taxpayer uncertainty abounds on a common cryptocurrency transaction called a hard fork. A hard fork occurs when cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger. Surprisingly, the IRS didn’t provide comprehensive guidance on this topic until 2019 in Rev. Proc. 2019-24.
- Tracking basis. According to the IRS, tracking basis is essential for reporting crypto transactions accurately. Yet, the IRS suspects some virtual currency users have gone years without keeping track of basis out of confusion about its relevance or sheer negligence.
How the IRS Is Enforcing the Law
The IRS has developed a multi-prong approach to prevent the evasion of tax laws applicable to cryptocurrency. Elements of the strategy include data analytics, tax examinations, soft letters and criminal charges.
- Soft letters. In 2019, the IRS sent letters to more than 10,000 holders of cryptocurrency warning that audits and other enforcement actions may result if the taxpayer failed to report income from virtual currency transactions and corrective actions are not taken.
- Data analytics. Since 2015, the IRS has contracted with Chainalysis, a company that provides data and analysis services to help the government identify cryptocurrency users with unreported income.
- Tax examinations. In 2018, the IRS announced a Virtual Currency Compliance Campaign. Through this program, the IRS is conducting exhaustive issue-based examinations of tax returns designed to address noncompliance related to the use of virtual currency.
- Criminal prosecutions. In extreme cases, taxpayers may be subject to criminal prosecution for failing to properly report income from virtual currency transactions. Criminal charges could include tax evasion and filing a false tax return.
IRS Criminal Investigation reported in its Fiscal Year 2019 Annual Report that a key focus for the organization is cybercrimes, with an emphasis on cryptocurrencies.
Taxpayers who have traded or received cryptocurrency should make sure they have reported their income properly given the IRS’s increasing interest in virtual currency.
Marcus Dyer, CPA, Esq., is the team leader of tax controversy at Withum. He is a member of the NJCPA Federal Taxation Interest Group and can be reached at email@example.com.
This article appeared in the July/August 2020 issue of New Jersey CPA magazine. Read the full issue.