The IRS Is Using AI to Find Crypto Underreporting

By Clinton Donnelly, CEO, Founder | CryptoTaxAudit

The IRS is using AI tools like Palantir, along with blockchain analytics, to identify taxpayers with a high probability of crypto underreporting.

This shift is driven by a long-standing problem. About 40% of IRS audits result in no change. No additional taxes collected. Just time and money spent on taxpayers who turned out to be compliant.

That 40% no-change rate tells you something important: the old system was bad at picking targets. The IRS had over 100 systems and 700 methodologies for flagging who to audit. The result was a lot of false positives, a lot of wasted audits, and a growing tax gap in crypto.

That is changing. The IRS has deployed Palantir, a data mining platform used by intelligence agencies and the Department of Defense, to identify high-probability underreporters. The era of poor audit selection is ending.

Key Takeaways

The IRS has a 40% no-change audit rate it is actively working to reduce. That rate reflects wasted enforcement resources. Palantir is the tool the IRS is using to drive it down.

Palantir combines structured and unstructured data from internal and external sources. This includes IRS filings, third-party reports, and blockchain activity. The system is designed to identify taxpayers most likely to have unreported income.

The IRS is targeting high-net-worth individuals and blockchain-visible behavior. Blockchain monitoring tools allow the IRS to observe transaction patterns associated with crypto investors.

An estimated 70% of crypto investors are not fully reporting their gains. The IRS knows this. Palantir is designed to prioritize the cases with the highest recovery potential.

Form 1099-DA reporting will become a primary audit trigger. Exchanges are now required to report digital asset transactions to the IRS. Mismatches between 1099-DA data and tax return filings will generate audit flags.

IRS Letters 6173 and 6174 are warning notices, not audit notices. They do not require a response. But they are a signal that the IRS has identified a discrepancy in your crypto reporting.

What Is Palantir and How Does the IRS Use It to Find Crypto Underreporting?

Palantir is a data analytics platform built for large-scale pattern recognition. It was developed to handle intelligence analysis and has been used by agencies including the CIA, FBI, and Department of Defense. The IRS has now adopted it to improve audit targeting.

The problem Palantir is solving is straightforward. The IRS previously relied on over 100 systems and 700 separate methodologies to flag potential audit targets. That fragmented approach produced a 40% no-change audit rate, meaning that nearly half of all audits found no additional tax liability.

Palantir consolidates data from IRS internal records and external sources, including third-party financial reports and blockchain data, to produce a unified risk score.

The system surfaces taxpayers with a high probability of underreported income. The IRS has completed a pilot program using Palantir and reported strong results. This is no longer experimental.

How Does the IRS Track Crypto Transactions on the Blockchain?

The IRS uses blockchain analytics tools in addition to Palantir. These tools allow agents to observe transaction behavior directly on the blockchain, including wallet activity, exchange flows, and on-chain transfers.

Blockchain monitoring does not require a subpoena. Most activity on public blockchains is visible to anyone with the right tools. The IRS has those tools and has contracted with specialized firms to interpret blockchain data.

What this means practically: crypto investors who believe their activity is private because it is on-chain are mistaken. The IRS can correlate wallet addresses with known exchange accounts, trace transfers between wallets, and identify patterns consistent with unreported income.

Why Does the IRS Believe 70% of Crypto Investors Underreport?

The IRS estimates that approximately 70% of crypto investors are not fully reporting their gains. That is not a small compliance gap. It is the baseline the IRS is working against.

The Palantir system is not designed to audit everyone. It is designed to find the cases where the expected recovery is highest. 

That means high net worth investors and those with large discrepancies between reported income and blockchain activity are the primary targets.

Crypto investors who have not been reporting gains should understand that the window to self-correct is narrowing. The IRS has both the data and the tools to identify underreporting at a scale it could not achieve before.

How Does Form 1099-DA Trigger IRS Crypto Audits?

Form 1099-DA is a new information return that digital asset brokers, including centralized exchanges like Coinbase and Kraken, are required to file with the IRS. It reports transactions, proceeds, and in some cases cost basis, directly to the federal government.

This matters because the IRS now has a formal third-party record of your exchange activity. When a 1099-DA is filed and the figures do not match what appears on your Form 8949 or Schedule D, the IRS has a clear discrepancy to investigate.

The 1099-DA requirement applies to the 2025 tax year for most digital asset brokers, with gross proceeds reported first. Full cost basis reporting phases in beginning January 1, 2026. 

Investors who have understated gains, failed to report transactions, or ignored cost basis rules should treat 1099-DA as a significant enforcement escalation, not a paperwork change.

What Are IRS Letters 6173 and 6174 for Crypto Investors?

IRS Letters 6173 and 6174 are crypto-specific warning notices. They inform the recipient that the IRS has reason to believe they have been trading cryptocurrency and may not have reported their transactions correctly.

Letter 6174 is purely informational. It does not require a response. Letter 6173 is slightly stronger. It requests that the recipient either confirm compliance or amend their return.

The IRS has been issuing these letters at a rate of approximately 10,000 per month. They are generated based on data the IRS has already collected, which may include exchange reports, blockchain data, or third-party financial records.

Receiving one of these letters does not mean you are being audited or that the IRS has concluded you owe taxes.

What Should You Do If You Receive an IRS Crypto Warning Letter?

The first thing to understand is that responding directly to the IRS is not always the right move. The IRS records all phone calls, and those recordings can be used as evidence in a later proceeding. Speaking with an IRS agent without representation puts you at a disadvantage.

If you receive a Letter 6173 or 6174, the recommended approach is to consult a qualified tax professional before taking any action. In many cases, the appropriate response is no response at all. 

A tax professional with crypto experience can review your past filings, assess your actual exposure, and determine whether amending a return makes sense.

CryptoTaxAudit's Tax Shield service is designed for exactly this situation. It provides ongoing monitoring of your crypto tax position and authorized IRS representation if a notice or audit arises. 

A tax professional can contact the IRS on your behalf without the conversation being recorded against you.

Frequently Asked Questions About IRS AI, Crypto Audits, and 1099-DA 

Q: What is Palantir and how does the IRS use it for crypto?

A: Palantir is a data mining and AI platform originally built for intelligence analysis. The IRS uses it to combine internal tax records with external data sources, including blockchain data and third-party financial reports, to identify taxpayers with a high probability of underreported income. The IRS completed a pilot program using Palantir and is expanding its use.

Q: Can the IRS actually see my blockchain transactions?

A: Yes. Most blockchain transactions are recorded on public ledgers. The IRS uses blockchain analytics tools to trace wallet activity, identify exchange flows, and correlate on-chain behavior with known accounts. Public blockchain activity is not private from the IRS.

Q: What is the no-change audit rate and why does it matter?

A: The IRS Commissioner has acknowledged that 40% of IRS audits result in no change, meaning no additional taxes were collected. That rate indicates the old targeting system was inefficient. Palantir is the IRS response to that inefficiency. Going forward, audit targets will be selected with much greater precision.

Q: I received an IRS Letter 6174 about my crypto. What do I do?

A: Letter 6174 is a warning notice, not an audit notice. It does not require a response. Before taking any action, consult a tax professional with crypto experience. Calling the IRS directly is not advisable. IRS phone calls are recorded and can be used as evidence later. A qualified representative can assess your situation without putting you at risk.

Q: What is Form 1099-DA and when does it take effect?

A: Form 1099-DA is a new information return that digital asset brokers must file with the IRS. It reports transaction proceeds and, in some cases, cost basis data directly to the federal government. For most brokers, reporting applies to digital asset sales effected in 2025, with most 2025 statements not including basis, and broader basis reporting phasing in after that.

Q: What happens if my 1099-DA doesn't match my tax return?

A: A mismatch between a 1099-DA and your Form 8949 or Schedule D creates a discrepancy in IRS records. That discrepancy can trigger a CP2000 notice, a math error notice, or an audit referral depending on the size of the gap. The IRS will have both the 1099-DA data and your return on file and can compare them automatically.

Q: Is 70% really the non-compliance rate for crypto investors?

A: That figure reflects IRS estimates and publicly reported compliance research. The IRS has acknowledged that crypto tax compliance is a significant enforcement priority, and the deployment of Palantir and mandatory 1099-DA reporting are direct responses to the compliance gap.

Q: Need help reviewing your crypto tax filings before the IRS contacts you?

A: CryptoTaxAudit offers a consultation to review your situation. If you want ongoing monitoring and representation coverage, Tax Shield is designed to keep you protected as IRS enforcement expands.

About CryptoTaxAudit: We're a CPA firm specializing in cryptocurrency tax preparation and IRS representation. Clinton Donnelly (CPA, EA) founded the firm to handle the specific tax complexities of digital asset investing that general accountants miss. We work with crypto investors before and after the IRS makes contact, and we stay current on enforcement developments including the Palantir deployment and 1099-DA mandate.