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crypto analysis digital assets Jul 05, 2023

Clinton explores the accuracy of various crypto tax calculation services and uncovers the alarming disparities in their results. This article highlights the challenges of reconciling crypto gains and the potential implications for taxpayers. (TCDS-02)

A crypto gain calculation crisis.

Let's delve into the accuracy of various crypto tax calculation services. With the increasing importance of reporting crypto income and avoiding trouble with the IRS, it's crucial to understand which service can provide the most reliable results. The findings of this investigation may come as a shock to many, as the industry seems to be facing a crisis that few are talking about. Let's uncover the truth about these services and their accuracy.

The accuracy challenge.

Accuracy is a significant concern when it comes to crypto tax calculation services. Surprisingly, none of these services claim to be accurate in their terms and conditions. The lack of accuracy guarantees raises questions about the reliability of their results. This issue came to light when a major service refused to stand behind the accuracy of their calculations when they learned that I was defending crypto investors in IRS audits with their data. This discovery led to a benchmarking exercise to assess the accuracy of different services.

Your accountant probably doesn't understand cryptos.

For many, they are working with accountants or other tax preparers that don't really understand, or want to work with, cryptocurrency reporting. They see it as a risk and don't want to get involved. That's another reason you may need to calculate your own crypto gains, or find a company that can.

Agonizing over your results.

After hours of collecting, entering, and adjusting for missing records, you may realize that the results are way off from what you were expecting. Is this aproblem with you or with the service? Many investors call me up with this same dilemma. They ask, "what am I doing wrong?"

Benchmarking the services.

My team of crypto accountants at CryptoTaxAudit benchmarked several crypto tax calculation services using client data from 2021. The benchmarking process followed a formal reconciliation methodology, ensuring consistent and reliable results. The team conducted separate benchmarks for centralized exchange data and decentralized exchange data to account for the different data sources and challenges involved. Before benchmarking, I assumed that all these services would produce the same results given the same input data, especially since we had a complete data set with no missing crypto transaction data.

Companies reviewed.

We reviewed major crypto gain calculation companies including:

  • Accointing by Glassnode
  • CoinTracking
  • CoinTracker
  • CoinLedger
  • CoinPanda
  • CryptoTaxCalculator
  • Node40
  • Ledgible
  • TaxBit
  • TokenTax
  • ZenLedger

What we discovered was alarming.

What these services do not promise, it turns out, is that their results are accurate. Just go to your favorite service’s webpage and search. Does it claim to be accurate anywhere? Read their terms and conditions. In fact, these services specifically disavow any warranty of accuracy or fitness for purpose.

A personal story.

Before I had my own crypto accounting team, I used to subcontract with one of the major crypto tax calculation services mentioned earlier. When they learned that I was starting to defend crypto investors in IRS audits, they refused to do any more calculations for me. They refused to stand behind the accuracy of their results which they reconciled. The fact is that none of these services will defend you in an audit.

What can we learn from the centralized exchange benchmark?

This first client only traded on US-based, centralized exchanges. We knew the data was very clean. My crypto accountants applied the same accounting methodology to reconcile the transactions.

Here are the results from one of our benchmarks of centralized exchange transaction data.

Benchmark table of centralized exchange gain calculations comparing the top gain calculation services and their dramatically different results given the same transaction data set.

For each service for the prior year, we list the total transaction counted, the total proceeds, and total gain calculated.

What do the differences in Total Transactions mean?

Each service provides a total count of the transactions they processed. Since they all received the same data, we expected these counts to be consistent.

My first observation is that the total count of transactions ranged from 170 to 26,000. Seven of the results were less than 1,000. Four results are in the 5,000 to 11,000 transaction range. One result shows 26,000.

These services do not agree on how many transactions they read from the API keys. I find this disparity astonishing every time I consider it.

What can we conclude from the transaction count data?

The transaction count data disparities tell us that each service has significantly different methodologies for interpreting transaction data. There may not be one right way to perform these calculations.

Why is the disparity in transaction counts critical for you?

In a recent audit of a client I represent, the IRS auditor cited the difference in transaction count as proof that the taxpayer had a “significant amount of transactions missing.” The IRS claimed there were around 23,000 sell transactions, whereas the taxpayer only had 2,000 transactions. They cited this as evidence that the IRS calculations were more accurate.

Ultimately, the auditor claimed that the taxpayer owed $2 million based on the IRS gain calculation numbers. How would you feel if the IRS sent you a letter demanding $2 million dollars? How would you pay for that? What would happen to your life?

The good news is that my in-house forensic staff dissected the IRS results and found about 3,000 errors which undermined the IRS's claim of accuracy.

A critical lesson about gain calculation.

A critical lesson for all viewers is this. Gain calculation is serious business. Which service is cheapest or the easiest to use should not be your primary concern. Accuracy should be.

What do the Total Proceeds results tell us?

Total Proceeds are the value of everything sold in the prior year. The results in the benchmark are spread between $1.2M to $4.4M. That’s a 4x spread!

Again, each service received the same transaction records. Why didn’t they agree on the simple question of “how much was sold last year?”

There are many factors. If there were just one outlier, I would have considered it a dubious result. But since all the answers all disagree, can they all be considered dubious?

I don’t have an answer. I’m just showing that there is a crisis.

What do the Total Gain results tell us?

The total gain is where the rubber meets the road. This is the number that determines how much you pay in taxes. No one wants to pay more taxes than necessary. In our benchmark, we calculated these numbers using the most conservative first-in, first-out (FIFO) universal cost basis method.

The final observation is the total gain ranged from $70,000 to $800,000. That’s an 11x spread. That’s staggering.

Which gain amount would you like to report on your return?

The obvious conclusion is that the service you choose will significantly affect the amount of taxes you pay.

Here’s a key takeaway.

Despite how good a job you think you did reconciling your crypto gains, in an audit, the IRS results will disagree with you.

The amount of disagreement could be huge. It's not surprising that all these services disavow any claim of accuracy in their terms and conditions. None of these services will defend you when audited. At an average price of a couple of hundred dollars, you get what you pay for.

Let’s dig deeper.

Why do these results vary for centralized exchange data?

Here are the main reasons:

  • The exchanges are not committed to 100% accuracy of transaction history records. A surprising number of transactions go unrecorded.
  • Exchanges update their APIs and CSV formats frequently without notice. The services must detect and fix their import routines every time there is a change. That's expensive for the services to maintain.
  • Services struggle with normalizing dates and times from different time zones and formats. It is local timezone, GMT/UTC, or a combination of various time zones?
  • The services use different external pricing data, which vary in quality, completeness, and reliability.
  • The services disagree on which transactions are taxable or not.

These Services have a difficult task.

What about using decentralized exchanges?

Is gain calculation any different when using decentralized exchanges? There shouldn't be any missing transactions since decentralized transaction all occur directly on-chain. The transaction counts should be the same, right? Think again.

We benchmarked several of our clients’ decentralized trading data using many gain calculation services. These are unreconciled results. They are “out of the box” results before the crypto accountants start to work and figure out the errors,.

Here’s what we found for one of my clients, which is representative of our general experience.

Benchmark table of decentralized exchange gain calculations comparing the top gain calculation services and their dramatically different results given the same transaction data set.

Again, results vary significantly between gain calculation service providers.

What do the total transaction counts tell us?

The number of transactions we found on the blockchain ranged from 35,000 to almost 10,000, with none of them agreeing. When we were looking at the centralized exchange benchmark, the data was coming from CSV files and APIs from the exchanges themselves. But decentralized data comes from immutable blockchains themselves. Why didn't a few of these services agree? Why wasn't there any consensus?

With distributed ledger technology, consensus determines truth. Where there is no consensus, what is truth?

This benchmark demonstrates that these services each understand the blockchain quite differently.

Whenever I look at these benchmarks, I shake my head in wonder. Without consensus, whose results are accurate? Is accuracy attainable? If so, can accuracy be proven? And what level of effort and analysis will be required?

On a side note, what does this suggest about the promised benefits of blockchain technology? Is it as accurate, immutable, and clear as promoted?

Distributed ledger technology.

Distributed ledger technology is exciting and significant. But current blockchain technology is a far cry from a robust double-entry accounting system.

I’m not aware of any layer one blockchain that is instrumented with the fields needed by accountants to track the tax classification of transactions.

This may require a more sophisticated layer two or higher protocol.

What do the total proceeds tell us?

Back to the decentralized benchmark results, what about the total proceeds? This number is the total value of all taxable sales before reconciliation. The results ranged from $88M to $341M. Why such a massive 4x spread? Especially with information extracted directly from indelible blockchain data?

The most significant hurdle is the lack of context.

For example, ETH may be sent to an address to buy an NFT. Later an NFT token may be written to a blockchain from a different address. The blockchain does not connect these two events nor record the value of the transaction in fiat. These are not seen as parts of the same transaction.

Secondly, gain calculation services don't currently read and try to interpret smart contracts to determine their tax impact. Some services can read very select smart contracts, but it is a thimbleful of understanding compared to the ocean of smart contracts.

Advanced DeFi transactions, P2E, para-chains, and chain bridging are generally unintelligible to these services.

Which crypto gain calculation service is best?

This brings us to our analysis results. Which crypto tax calculation service is best?

The two benchmarks I showed are representative. Different clients would have different results, but results tend to follow the same trends shown in our charts based on working with hundreds of clients every year.

Most gain calculation services are trying.

I know most of the heads of these gain calculation services. They are smart, passionate, and want the best for their customers. Their staff is knowledgeable. These services have each adopted a different mathematical and philosophical approaches to their task, which is why the results differ. It’s expensive for these services to keep up with innovation and change. Most of these services should be charging five times more in fees than they do. But they struggle with making the tools affordable to help keep average crypto traders out of jail while needing to at least breakeven on their retail clients.

Users of these services are enamored with the ease of use and ease of importing data, but there are other matters to be considered when choosing a service. The cost basis selection methods they support, such as FIFO, LIFO, or HIFO, are important. Also, can the tool support "what if" analysis?

Do they offer a backup file proving the cost basis of each sale? Can you generate an end-of-year closing lot position report? How about exporting the total transaction record file? Can you annotate the reasons for reconciliation actions?

I cannot say which is the most accurate or best. Is it possible that the emperor is "not wearing any clothes"? You decide.

Where does this leave us?

Crypto tax accuracy can be quite elusive. This is a classic accounting problem. How do we count things when we can’t be exact?

The reconciliation method.

All these gain calculation services use the traditional reconciliation method, where every sell transaction is matched to a buy transaction. These benchmarks demonstrate the limitations of this method.

The aggregation method.

Another method of counting is aggregation, where we look at the total value of movement in and out of a wallet to calculate a profit and loss for the wallet. This is a powerful approach for traders on decentralized platforms, DeFi, NFTs, peer-to-peer, and play-to-earn gamers.

The estimation method.

A third method is estimating. This method leans on the trader’s self-perception and notes about his net trading gains. Traders generally have a rough idea of how much they’re making. That is the accuracy range in which they measure the results from these gain calculation services. The estimation method splits the difference between the ends of the range to come up with an amount of income to report. While not as detailed as a bottom-up reconciliation, it may be more accurate.

Each of these alternate counting methods has limitations.

What does the law require?

The taxpayer must have a reasonable cause and act in good faith in tax reporting.

Tax code section 6662 says that the taxpayer must reasonably attempt to comply with the law.

His efforts should not be careless, reckless, or intentionally disregard the law. The courts hold that the taxpayer must “exercise ordinary business care and prudence” in preparing the tax return.

What does my company do for our clients?

The team at CryptoTaxAudit currently uses five different services depending on the client’s needs. We use two reconciliation services, two aggregation services, and one estimation tool. Because of our experience, we know how to address each service’s limitations. We use the right tool for the right job. A good craftsman never blames his tools.

What can you do?

My suggestions are these:

  • Report on your return the amount of taxable income you believe is correct in good faith, then you will be paying the amount of tax you believe is correct.
  • If you don’t like the answer from one service, try another service. It may be incorrect or just calculating your gains too conservatively.
  • Considering hiring a professional crypto accountant to do your gain calculation. If you trading is complex, this is a necessary investment.

For some traders, gain calculation services are mostly useless because they:

  • They have too many missing transaction records.
  • They made too many trades, more than the service can reconcile.
  • They used obscure blockchains, DeFi, NFT, P2E, or other techniques to generate crypto income which these services can't process.

Consider using a good faith estimate for your crypto income in these situations.

Professionally prepare your tax return.

If you are actively trading or have a growing crypto stash to protect, invest in a crypto tax professional to properly prepare your tax return. That $100 you spend using TurboTax or another service won’t feel like a savings when you get audited. The real goal of these service is not just to report accuracy, it's to have a defensible position in the event of an IRS audit. If you aren't preparing your crypto gain calculations and tax returns as if you're likely to be audited, you're missing the point. Crypto traders are being audited now in record numbers, and if you're selected, you want to go to battle knowing you've done an outstanding job.

What happens if you get audited by the IRS?

That’s the million-dollar question, literally. When the IRS audits your cryptocurrency tax reporting, they often do their own calculations. Rest assured, their calculations will likely come in much higher than yours. They will say you were wrong and owe them money. Claiming additional taxable income of $1 million or more is common by these guys.

Even honest and diligent taxpayers get audited.

If you have over cryptos or other digital assets, consider getting protection.

Get IRS Guard Dog membership.

Our IRS Guard Dog membership plans are like getting car insurance for your tax return. If you ever get audited by the IRS, our protection plans will provide representation and defense. And our monitoring plans allow you to keep tabs on what the IRS is doing with your tax returns. In fact, there are Audit Defense plans for the needs and budgets of every crypto trader.

For crypto owners with large crypto holdings, the Audit Defense Full Protection provides the highest level of monitoring and protection benefits. If the IRS comes knocking, you'll be glad you had that protection. And, that when I unleash my forensic accountants to dismantle the IRS auditor's calculations and document all their errors all the way to tax court.

Don't be surprised by what the IRS knows about you. They are watching you. Start watching them with Audit Defense!

You'll sleep better at night.

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.

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