IRS Audit Defense for Cryptocurrency Transactions
For the past several years, the IRS has not actively enforced the tax laws on cryptocurrency transactions. Since 2014, the IRS has stated that it considers virtual currency to be a form of property subject to the same tax laws as stocks or other securities, but it has not taken a hardline approach to enforcing this policy. Recent actions show that this is about to change. The IRS has steadily increased the number of audits it performs on U.S. taxpayers’ cryptocurrency transactions over the last few years and it is very likely that the number of these audits will continue to increase significantly in the years to come. In fact, since 2020 the IRS has been hiring outside contractors who are experts in cryptocurrency. The only reason the IRS would hire these experts is if they plan to ratchet up the volume and intensity of cryptocurrency audits.
There are some other signs that the IRS is ramping up its enforcement on cryptocurrency transactions. In 2017, the IRS sued Coinbase, one of the largest virtual currency exchanges, to obtain the names and account information of Coinbase’s account holders. The IRS pointed out that Coinbase had almost six million customers between 2013 and 2015, but less than a thousand U.S. taxpayers had filed tax returns that reported gains from cryptocurrency. In 2018, Coinbase turned over the information of around 13,000 account holders to the IRS as a result of the litigation. Unsurprisingly, after receiving this information, the IRS sent roughly 10,000 letters to cryptocurrency account holders, advising them that cryptocurrency gains are taxable and they may want to consider amending previously filed tax returns. Although not every person who received a letter necessarily had an issue with their return, the letters helped remind the account holders that they need to report their cryptocurrency transactions to the IRS or they could face an audit.
What could trigger an IRS audit? The IRS uses advanced data mining techniques and powerful computing hardware to identify specific tax returns for auditing and uses automated systems to detect underreporting of income. For example, the IRS Automated Under Reporter system compares the income reported on an individual’s tax return with the income reported on their W-2, 1099, 1098, and 1096 forms. If the individual’s return fails to address income that is identified on one of these forms, the return is flagged for an audit. This type of audit is computer-driven and usually resolved by calculating the new tax plus penalties and interest owed because of the unreported income. Many cryptocurrency traders become subject to this type of audit because they failed to report a 1099-K or a 1099-B from a cryptocurrency exchange on their tax return.
What should you do if you think you have not fully reported your cryptocurrency income for past years? First, you should understand that the IRS has the authority to audit your personal finances and determine whether you have under reported your cryptocurrency income. If such an audit occurs, and under reporting is uncovered, you will be asked to pay the appropriate amount of taxes that you would have paid if you reported your income correctly. Moreover, the IRS will demand interest on any unpaid amount and will likely impose a civil penalty. Generally, the IRS seeks a penalty of 20% of the understatement of the owed tax in civil cases if the under reporting was because of a taxpayer’s negligence. If fraud is involved, however, the IRS may demand as much as 75% of the tax due. In some cases, if the return is more recent, you can file an amended tax return to correct any under reporting. But for older returns, you will need the help of a professional. In either case, you should consult an attorney experienced in tax and cryptocurrency matters to guide you through the process. An experienced attorney can help prevent your case from becoming criminal and can guide you through a civil disclosure to the IRS or present other options.
In general, the IRS treats under reporting as a civil matter. Simply failing to report something because you did not fully understand your reporting obligations does not usually amount to a criminal violation. Even so, it is important to understand that there can be criminal consequences for knowingly or willfully evading taxes. In short, if you knew that you were supposed to report your cryptocurrency income, but failed to do so anyway, there is a possibility that you could be held criminally liable for tax evasion. If you believe that you may have criminal exposure for under reporting your cryptocurrency income, you should immediately consult a criminal tax defense attorney. It is not recommended to discuss the matter with your accountant because your conversations with your account are not privileged like your communications with an attorney. An accountant can be asked to testify against you and may be forced to share information about you with investigators.
If you regularly engage in cryptocurrency trading, it can be very difficult to accurately track your cryptocurrency transactions. Some exchanges will provide you with a tax form that reports your gains on any cryptocurrency holdings. Many exchanges, however, will not provide you with this information. If you are, or are planning to trade in cryptocurrency, it is advisable to use a cryptocurrency management software with audit support to track your transactions and accurately record any gains that you may receive from your trades. Being prepared with accurate and complete documentation will be extremely useful if you end up becoming the subject of an IRS audit.
If you have already been contacted by the IRS, or if you think you will, you should immediately get in touch with an experienced tax attorney. An attorney with experience in cryptocurrency transactions can help you navigate the audit and will help ensure that your case does not escalate into a criminal investigation. Audits requests can vary in the content sought, but in general you will be asked to disclose all of your accounts, including any wallet IDs, blockchain addresses, digital currency exchange accounts, and details on any transactions that you made. In some cases, you may be asked to provide an extensive number of documents, such as all correspondence with all counterparties to a virtual currency transaction. Having an experienced attorney assist you with this process will ensure that you do not make any mistakes and will help you resolve the audit as quickly as possible.