Cryptocurrency’s growing value and popularity as a medium of exchange has not gone unnoticed.
A Fundstrat Global Advisors study has estimated that approximately 30% of the world’s cryptocurrency is held by U.S. persons and, in 2017, the market value of all cryptocurrencies increased by almost $500 million with Bitcoin (which was valued at $67/coin in 2013) topping out at over $20,000/coin.
This has not gone unnoticed by the IRS.
The IRS’ Information Reporting Advisory Committee (IRAC) now estimates that cryptocurrency underreporting represents approximately 2.5% of the $458 billion U.S. tax gap.
A 2016 survey of the IRS’ electronic filing databases for 2013-2015 revealed that only about 900 taxpayers reported a Bitcoin transaction on Schedule D out of over 120,000,000 returns filed in each of those years.
In 2016, these concerns led the IRS to issue and enforce a John Doe Summons to Coinbase, the largest U.S.-based virtual currency exchange to obtain information about the identity and transactions of its U.S. customers. Those efforts resulted in the IRS obtaining the names of 14,000 U.S. taxpayers who had transactions in excess of $20,000 in cryptocurrency.
Because virtual currency is essentially an electronic peer-to-peer medium of exchange that does not rely on a central bank or public authority validating transactions, it offers a degree of anonymity unavailable through the use of regular currency and has great potential for tax avoidance. Cryptocurrency is one of several types of virtual currency and relies on encryption technology to validate transactions.
The IRS is fully aware of the tax avoidance potential of virtual currency and has now deployed its increasing artificial intelligence capabilities to analyze the information obtained from the Coinbase summons and other information it has gathered about the cryptocurrency reporting of U.S. taxpayers (including information exchanged with foreign governments who have similarly become concerned about the potential erosion of their tax bases presented by cryptocurrency use).
In early 2018, the IRS’ Criminal Investigation Division announced the creation of a new investigative team focused on “international tax crimes, including ones involving cryptocurrency, tax evasion and the use of the unlicensed cryptocurrency exchanges.” Simultaneously, the IRS also issued a separate news release (IR 2018-71) “reminding” U.S. taxpayers that virtual currency transactions must be reported on U.S. income tax returns and that those who do not face audit, can be liable for interest and penalties and “in more extreme situations, could be subject to criminal prosecution.”
A few months later, in July 2018, the IRS’ Large Business and International (LB&I) Operating Division listed cryptocurrency reporting as one of five new issues representing a substantial risk of non-compliance requiring the IRS to make the greatest use of its limited resources to address through multiple treatment streams including both educational outreach and examinations. The LB&I pronouncement stated that the IRS was not contemplating a voluntary disclosure program specifically to address virtual currency reporting non-compliance but urged U.S. taxpayers with unreported virtual currency transactions to remedy their non-compliance as soon as possible.
The IRS’ Collection Division has already revised its Collection Information Statement forms to include specific questions about virtual currency owned or used by the subject taxpayer and the 2019 Form 1040 contains a question about transactions in virtual currency similar to the ones that have long-existed on Schedule B about ownership of foreign bank accounts.
Most recently, in July 2019, the IRS announced that it has sent letters to approximately 10,000 U.S. taxpayers who have been identified in various ways as having not properly reported virtual currency transactions in one or more prior years. The most ominous of the three letter formats requires the taxpayer to either file an amended return and send it to a special IRS location set up for that purpose or provide a statement under penalty of perjury explaining why not. In addition, a number of audits and several criminal investigations are already under way.
Those who receive one of the IRS letters or who have concerns about their prior level of compliance should carefully consider their options before acting.
The rapid appreciation in value of Bitcoin particularly has likely created situations in which some taxpayers have potentially realized significant unreported taxable gains, perhaps over multiple years. This “pattern” of substantial understatement is frequently used in criminal tax prosecutions to demonstrate that the non-compliance was intentional. Taxpayers who have utilized ‘mixers’ (also known as ‘tumblers’) to obscure details of their transactions also should have even more reason for concern.
Moreover, correctly reporting cryptocurrency transactions can be a complicated matter. The IRS itself has been slow to provide guidance on how to report virtual currency transactions. It has determined that virtual currency is different from foreign currency because, unlike Euros, etc. Bitcoin and its progeny are “property” (like stock or securities). As property, an exchange of virtual currency is a sale or exchange giving rise to gain or loss depending on (1) taxpayer’s cost basis in the virtual currency being disposed of and (2) the fair market value of what is received in exchange. The gain or loss could be capital gain if the virtual currency is held as a capital asset and would be long or short term depending on how long it is held. However, if received for services or in exchange for i.e., a Mercedes, the gain is ordinary income to the recipient.
The IRS’ initial guidance in 2014 was limited and while it recently issued a Revenue Ruling and a more robust set of 43 Frequently Asked Questions (FAQs), many issues remain unanswered including whether or not the “wash sale” rules apply to close in time exchanges, whether “like-mind” exchange treatment was available prior to 2018 and whether holding virtual currency in a foreign based “wallet” at an offshore virtual currency exchange is a “foreign financial account” that requires FBAR reporting.
The IRS also has been tight lipped about whether taxpayers who file amended or delinquent returns as a result of receiving one of these “educational” letters or otherwise will be immunized against penalties or even if such belated compliance would be considered “voluntary”.
Filing an amended or delinquent return is a potential admission that what was filed earlier was either incorrect (false) or there should have been reporting earlier. The law is clear that even a truthful delinquent or amended filing does not purge fraudulent intent for a taxpayer whose initial mindset was “willful” or fraudulent.
The limited IRS guidance on how to properly report some types of virtual currency transactions may complicate the issue further and make the preparation of a delinquent or amended filing that the IRS would view as accurate a problematic exercise.
For example, the records required to track one’s virtual currency exchanges and calculate the gain or loss on each over multiple years may not be available and/or may not be accepted on audit.
What type of correction/remediation should be undertaken? Should one simply amend in the normal course? Would that be seen as a “quiet” disclosure? Should one use the IRS current voluntary disclosure program?
Given these concerns, taxpayers (especially those who have or expect to receive one of the IRS letters) should tread slowly and obtain advice from tax professionals knowledgeable in this new area of tax law. The consequences of not doing that can be severe.
Richard J. Sapinski, a member of Sills Cummis & Gross P.C., is vice-chair of the firm’s tax litigation practice group.