The recent Coinbase, Inc. case marks the beginning of a new phase in IRS investigations, and U.S. taxpayers should beware that our government is unlikely to relinquish its pursuit of digital currency holders. This won’t show.
The IRS’s success in identifying and pursuing people with foreign accounts has forever changed offshore banking. As in the Coinbase case, IRS activities began with a John Doe Summons – today there are few who dare risk the penalties associated with foreign account reporting noncompliance. Considering the tremendous increase in the value of Bitcoin over the past year, many tax experts insist that IRS cryptocurrency investigations are likely to pursue the same course as offshore accounts, which to date has brought in over $10 billion in collections.
It is now more important than ever to properly document and report your digital currency transactions. Here are a few tips on how to successfully avoid a tax audit in which your cryptocurrency is scrutinized:
Make sure that you know your cost basis
The IRS made clear in Notice 2014-21 that digital currency is considered property for tax purposes. Taxpayers are advised to use their best efforts to determine the cost basis of their digital assets – the IRS is aware that this may be challenging, particularly if you utilize multiple cryptocurrencies with difference exchange prices. Although some virtual currency exchanges like Coinbase, Inc. will provide a Form 1099-K to some of its customers, most do not. Many cryptocurrency holders may therefore need to research historical data to determine their cost basis.
Remember that mined currency is income
Whether you are paid to mine coins or if you mine your own, you need to pay taxes on your activities. If you are mining for yourself, the value of the cryptocurrency on the day it was received must be included in your gross income. If you are paid for your mining, you must pay income tax on that amount, plus self-employment taxes (if relevant).
Track and report all purchases and sales that utilize cryptocurrency
Purchases and sales of cryptocurrency are treated the same as purchases and sales of stock – in terms of determining basis, holding periods, and tax triggering events. Even if you use cryptocurrency like cash, every purchase you make is a taxable event – this includes using cryptocurrency to purchase goods and services. Be sure to track all details (including date of transaction and amount paid) of every one of your virtual currency purchases and sales.
Report payments to employees made in virtual currency
Business owners who pay their employees or independent contractors in cryptocurrency must report those payments to the government. Employment taxes and withholding apply as usual.
Report exchanges of one type of digital currency for another
The new tax reform makes clear that favorable like-kind exchange tax treatment is now limited to real property. However, the applicability of 26 U.S. Code § 1031 to exchanges of different types of cryptocurrency (e.g. Bitcoin, Ethereum, Litecoin, Zcash, etc.) prior to January 1, 2018 remains subject to debate. In any event, all exchanges of one type of digital currency for another must be reported to the IRS.
Report gifts of cryptocurrency
If someone gives you cryptocurrency, you must report it. Your cost basis is the same as the basis of the person who gifted it to you.
Consider fixing past mistakes
If the IRS determines that your failure to report your cryptocurrency holdings was fraudulent, there is no time limit for the IRS to audit your returns – if you failed to report your virtual currency holdings in past years, you should consider fixing that immediately.
For the Coinbase users who fall within the purview of the recent IRS summons, it is most likely too late to make any changes to previous years’ tax returns. The key is to make corrections on previous years’ filings before the IRS discovers your “oversight.” This may include filing an amended income tax return as well as corrected W-2s, Forms 1099-MISC and FBARs for foreign cryptocurrency wallets. You might also wish to consider participating in the IRS Voluntary Disclosure Program.
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The penalty for filing a false return is up to three years in jail and a fine of up to $250,000. Considering the IRS’ history of pursuing offshore accounts and its recent actions in the Coinbase case, it is clear that virtual currencies will remain a primary area of focus for some time, if not indefinitely.