The IRS is now focusing on crypto and other digital assets. If you're a crypto trader or investor, you need a strategy to protect yourself. (G-2)
The IRS is focusing on cryptos.
The Internal Revenue Service (IRS) is now focusing on cryptos and other digital assets. That means they’re coming after non-compliant crypto investors with civil or criminal investigations. Civilly, they believe they can bring in an additional $1 TRILLION from crypto traders who aren’t properly filing and paying their taxes on crypto gains. Criminally, they look to make examples of those who have been hiding their crypto wealth.
When the IRS announced they could bring in $1 TRILLION more tax dollars (above the $4 TRILLION they currently bring in each year), Congress agreed to give them an additional $80 BILLION in supplemental funding. Of that money, $46B is going toward digital asset enforcement primarily for digital asset tax compliance.
Industry observers estimate that there are about 33 MILLION crypto owners in the United States. Preliminary numbers from Electronic Tax Administration Advisory Committee (ETAAC) show that only 8M taxpayers checked “yes” on the virtual currency question on their 2021 tax returns. That means that 25 MILLION people, or more than 70% of all crypto owners, may be non-compliant.
The reason why the IRS is focusing on crypto and digital assets is simple. They see crypto investors as wealthier than the average taxpayer. And, they think there’s a lot of money they can harvest from the non-compliant crypto owners.
Three types of crypto owner non-compliance.
There are 3 major types of non-compliance among crypto owners. There are those who forgot to report their crypto income, those who deliberately hid their crypto income, and those who didn't file a tax return at all. Let’s start with the first category.
Forgetting to file.
It’s a fundamental legal principle that ignorance of the law is no defense. Is it really defensible that someone forgot to file? Maybe. Until recently, the IRS had done a poor job in properly advising crypto owners of their obligation to file, when to do so, and how to characterize their gains and losses. This isn’t all the IRS’ fault, however. Congress has done an even worse job in defining the rules regarding crypto ownership and taxation.
While we’re at it, Congress hasn’t sorted out much of anything about cryptos and digital assets. The Securities and Exchange Commission (SEC) thinks they control cryptos, characterizing many cryptocurrencies as securities in a recent proclamation. The Commodity Futures Trading Commission (CFTC) thinks that many cryptos are commodities, basically digital gold and silver. The Financial Crime Enforcement Network (FinCEN) is involved, especially regarding crypto onramps and offramps where US Dollars are exchanged for cryptocurrencies. And, of course, the IRS is in on it too. It considers cryptos to be property, like a house, a stock, or a bond. That means every time you sell a digital asset (or trade one), it’s a taxable event. Perhaps ignorance is a defense in light of this confusion and the obvious lack of leadership by the US Congress.
Hiding crypto income.
The next category is those who deliberately hid their crypto income. Put simply, this is a crime. It is tax evasion, and there are plenty of laws to deal with people who hide their income, whether from crypto or other sources. The problem is that early on, many people thought that cryptos were exempt, or that the IRS was too stupid to know about their cryptos. Perhaps this was true back before 2018, but today the IRS has access to crypto exchange records, blockchain analysis tools, and bank records showing transfers to and from centralized crypto exchanges. You can’t hide anymore.
Not filing a tax return.
The final category of non-compliance includes those who didn’t file a tax return, or perhaps haven’t one for years.Failure to file a tax return when there was significant income can cause the non-filer to be charged with tax evasion. Tax evasion is a felony subject to up to a $250,000 fine and five years in prison per infraction. Not filing is a dangerous gamble.
Four things that the IRS can do.
Given these possible scenarios, what can the IRS do? They have four primary enforcement methods: audits, criminal investigations, anti-money laundering (AML) laws, and the civil statute of limitations.
The most commonly used enforcement method is the audit. The IRS has been given the authority to conduct audits and investigations, a type of audit, by Congress.
Over the past few years, the IRS took additional steps to ensure tax compliance among digital asset owners. In 2019, the IRS sent letters to over 10,000 taxpayers who had potentially failed to report cryptocurrency transactions or to pay taxes on their crypto gains. The IRS also launched a new enforcement initiative aimed at identifying and pursuing individuals and businesses that had not reported cryptocurrency transactions.
Since then, the IRS has ramped up its use of crypto audits. These audits are designed to ensure that crypto owners are in compliance with IRS reporting requirements.
This is the scary part. Armed agents can show up at your home, unannounced, asking to talk with you about your taxes. This is increasingly happening to crypto non-filers and under-reporters.
As serious as this sounds, it’s actually easier for the IRS to initiate a criminal investigation than to do an audit. Why? Because the IRS only has to prove that you traded cryptos and either didn’t file a return or didn’t report the transactions they already know you made. Then, they can pursue both civil and criminal prosecution. And at this time, the IRS is looking for examples of crypto non-compliance to warn others by fear and intimidation about what the consequences may be if you don’t comply.
The US anti-money laundering (AML) laws required US persons to report the maximum balances in USD kept at foreign financial institutions. Failure to report the maximum balances is subject to steep fines.
This is a powerful tool for the IRS because reporting the maximum balances held anytime during the year at foreign exchange is relatively quick and easy to prove or disprove.
The penalties can be assessed in addition to whether the taxpayer reported his crypto income on his return or not.
Civil statute of limitations.
Finally, there is a time limit in which the IRS can assess and collect taxes. The IRS has 3 years after the return is filed to audit the return. But you aren’t necessarily safe after 3 years. If you substantially underreported your gains or income, defined as underreporting taxable income by 25% or more, the statute grows to 6 years. This is a common issue for crypto traders who don’t understand how the IRS calculates their gains.
For example, a crypto trader who starts with a trading portfolio value of $10,000 and trades it weekly for a simple $1 gain per week may only have a $52 gain for the year. However, the IRS sees the top line gains on each sale and calculates this activity as over $500,000 in total positive income (TPI). If you don’t account for the TPI, and only state the $52, the IRS could think you’re hiding $490,948, which is well over the 25% threshold. It’s far better to account for the entire amount and declare the cost of each transaction, showing the IRS how you got to your $52 net gain. As you can see in this example, it’s quite easy for the IRS to extend audits to 6 years past for crypto traders who don’t understand the rules.
If the IRS detects fraud, there is no statute of limitation protection.
The IRS can then audit any year you filed, or didn’t file, for compliance.
The IRS has its own challenges.
The IRS has its own challenges. It has significant issues with maintaining its computer systems, processing taxpayer information, and maintaining sufficient levels of well-trained staff. The extra $80 billion from Congress will enable the IRS to modernize into a far more powerful enforcement machine.
They are investing regularly in crypto technology, tools, and staff to track your crypto transactions. They’ve been collecting data back to at least 2016. And, they are creating databases of crypto owners, trading patterns, and money flow patterns for all of us. Add to that new artificial intelligence (AI) capabilities that have become more common in the last few years, and you have an agency acquiring fearsome abilities..
The IRS can seize your bank accounts and assets, put liens on your house, garnish your wages, and turn your life into a real nightmare.
It’s not an agency you want to take lightly.
What can you do to protect yourself?
Cryptocurrencies allow you to diversify your portfolio into the new digital asset class. Very few CPAs and tax attorneys understand crypto taxes. This leads to many people being out of compliance with the IRS which can lead to a higher incidence of IRS audits. If you aren’t sure you’ve reported everything properly, we can help.
Founded in 2015, CryptoTaxAudit defends crypto traders and investors during IRS crypto tax audits and appeals. The company has an experienced team of crypto tax experts including CPAs, enrolled agents, forensic accountants, and gain calculation staff. Our IRS Guard Dog membership plans and personalized services help you get into compliance, stay in compliance, and defend you against IRS claims of non-compliance now or in the future.
DISCLAIMER: Opinions and perspectives of the author, host, and guests. It should not be construed as U.S. taxpayer advice. There are often multiple interpretations of tax law. Various strategies may be suited to specific individuals and for particular situations. Seek out professional tax, legal, or financial advice from CryptoTaxAudit or from other reputable companies.