How The IRS Penalizes For Tax Evasion On Cryptocurrency Investments

Taxpayers who have been dealing in cryptocurrencies and who have delinquent state and federal tax filings, or unreported tax years’ transactions going back to 2017 or earlier, it may be necessary to liquidate a fair amount of their cryptocurrency portfolios at a significantly lower value to settle outstanding tax liabilities, including the interest and penalties, to the IRS.

 

2017 saw the incredible rise of virtual currencies such as Bitcoin but was followed, in 2018, by a gut-wrenching drop, which burst the bubble of virtual currency valuations.  This persistently volatile market tests the mettle of investors and businesses facing the tax planning challenges surrounding the virtual currency investment market. 

 

Penalties, Disclosures, and Evasion of Tax

An attorney from the U.S. Department of Justice’s office suggested in May 2018 that the time had possibly come to create new voluntary disclosure procedures, but Daniel Price (from the IRS’s Office of Chief Counsel) had already stated at the tax symposium held by the State Bar of Texas Tax Section held in November 2017, that the stories about the IRS intending to establish a disclosure program that was separate and voluntary for unreported income related to offshore virtual currencies, were simply not true.

 

Expectations were raised by some tax practitioners and taxpayers that the Internal Revenue Service (IRS) would create a separate program for voluntary disclosure to assist taxpayers who had previously failed to report on their taxes due to virtual currency transactions.  This has, however, not happened.

 

What remains available to taxpayers is the IRS Voluntary Disclosure Practice, but this does not, in general, guarantee immunity from prosecution for taxpayers, or any penalty relief.

 

Generally, for penalties to be put aside, a taxpayer would be required to show reasonable cause as to why he or she failed to report and/or disclose their taxes due to convertible virtual currency transactions.  For these taxpayers, there is the distinct possibility of having to face several civil, and even criminal, penalties or charges for crimes, of which tax evasion would be one.

 

Being convicted of tax evasion is likely to result in a prison term of as much as five years, and a fine of up to $250,000.  Filing false returns and being convicted for such may result in a maximum three-year prison term and a fine of up to $250,000.

 

Taxpayers need to be aware that many states still offer the voluntary disclosure programs, affording them the opportunity to come clean and settle their back-taxes, so it would be unwise to simply ignore their income tax non-compliance.  Since the failed attempt by Representatives David Schweikert and Jared Polis to get Congress to pass the Cryptocurrency Tax Fairness Act in 2017, it is unlikely that Congress will pass any virtual currency tax legislation in the near future.

 

Criticism Leveled at the IRS

The IRS has come under fire from critics for failure to give adequate guidance to taxpayers with regard to Notice 2014-21 (“Notice”), and the associated perception of lack of enforcement of this notice.  The U.S. Congress’ members, professional organizations and even the public have made recommendations to the IRS to resolve this, but these have not been taken into consideration by the IRS it would seem.  All this Notice offers in the way of guidance is a total of sixteen questions and answers, and nothing has materialized since.

 

The Increasing Compliance Action Regarding Cryptocurrency

The IRS’ compliance drive has gained momentum since the Notice was issued in 2014.  The cryptocurrency company Coinbase received a “John Doe” summons in late 2016, which required the submission of records relating to about 500,000 of its customers. 

 

A year down the line Coinbase was ordered by the Court to supply customer information as follows:

⇒ Taxpayer identity number.

⇒ Name.

⇒ Date of birth.

⇒ Address.

⇒ Account activity records such as transaction logs which would include details of the transactions such as date, amount, transaction type (exchange/sale/purchase), post-transaction balance, transaction counterparty names.

⇒ All periodic statements of the account or invoices.

 

A limit of $20,000 per transaction type (send, receive, buy or sell) was placed by the Court on the information sought from the accounts in any single year in the period 2013 to 2015.

 

The 2018 tax filing deadlines were preceded by the IRS issuing information in Release 2018-71 that reminded taxpayers to report on income from virtual currency transactions in their income tax returns.  Cryptocurrency is classified as property for U.S. federal tax purposes, making it consistent with the contents of Notice 2014-21.  By July 2018, the Large Business and International (LB&I) Division of the IRS announced new compliance campaigns, totaling 5, and these included campaigns related to virtual currencies.

 

The IRS as Provider of “Adequate Guidance”

In the third quarter of 2018 five lawmakers stated their intention to request an audit of the agency from the Government Accountability Office to examine why the IRS failed to “put forth adequate guidance” for taxpayers.  The Chairman of the House of Ways and Means Committee was among them.

 

The Information Reporting Program Advisory Committee (IRPAC) issued a report to the public in October 2018, providing a number of specific recommendations along with expressing concerns regarding issues related to tax reporting and compliance.  The IRPAC is a collaboration between tax professionals and the IRS and this forum has set its intention to help develop information reporting and withholding guidance for virtual currency transactions.

 

The recommendations of this report followed two years after the release of the Treasury Inspector General (IG) for Tax Administration Report.  The report, made available in September 2016, levelled criticism at the IRS for the lack of strategy, guidance and reporting.  This included their failure to display management oversight or adequate controls.  In spite of the IRS’ agreement of the report’s contents, they made no specific recommendations to their Office of Chief Counsel.

 

On assessment of available public records, it would seem that no official coordinated plan has been formulated with the Department of the Treasury’s Office of Tax Policy since the report was issued.

 

Criticism vs. Reality – Creating a Balance

It would be fair to criticize the IRS for not taking action in response to the public inquiry and the resultant recommendations around seeking clarity on the multitude of unresolved convertible virtual currency tax issues.  The criticism from the public needs to be balanced with a strong dose of reality.

 

A report issued in April 2016, by the Center on Budget and Policy Priority, declared that the IRS budget had been reduced by 17% over the period from 2010, adjusted for inflation.  This reduction in funding had never been seen before.  This drop in funding meant the IRS operations were affected significantly, forcing job cuts at the agency, cutting back on training for employees, and holding back on the implementation of sorely needed information technology.

 

A 9% increase in 2017 made a significant impact, the IRS funding would still be below the 2010 levels once adjustments for inflation were made.  The Tax Cuts and Jobs Act, signed into law by the President on December 22 2017, has been a pressure point for the IRS, who are responsible for its implementation.  The implementation has to take priority and the IRS will need to reconsider the allocation of resources to zoom in on the implementation.

 

There is a concerted effort by tax professionals and several organizations, such as the American Institute of Certified Public Accountants and the American Bar Association, to get clarity on the many cryptocurrency tax issues. The dialogue is open between these organizations and the IRS, members of Congress and the Treasury.

 

Over the past few years the number of tax attorneys and CPAs specializing in digital assets and virtual currency transactions, accounting issues and tax, have grown.  This makes it easier for taxpayers who have fallen short of the required reporting of virtual currency transactions when filing their income taxes, to get suitable assistance.  Professional advice on these matters is no longer in short supply.

 

3 Ways To Stay Crypto Compliant With The IRS

 

Crypto Compliance With IRS: Quick Tips

By now, the word is out: you have to declare your trades in cryptocurrency with the IRS or face peril.  The IRS has made crypto compliance on of its primary focal points, and to remain non-compliant is not a very good idea. It is precautious to not only become compliant now but to file for past transactions too. If you are not in compliance yet, you can amend your ways.

 

File Delinquent Returns

In the lexicon of the IRS, you are delinquent if you had not been filing your crypto returns. The only way to maneuver yourself out of delinquent status is by submitting your delinquent returns.  There is one major obstacle in your way: you need much information. If you kept detailed records of your crypto transactions, you would possess the knowledge required: you need the value of your cryptocurrency before you sell it and after you sold it. This is the value recorded on the exchange.  Without this information, you cannot report loss or gains to the IRS.

 

The IRS will not enforce delinquency for longer than six years except if your misconduct is massive, if the source of your funds remains a mystery or if you have a very long history of non-compliance.  If you decide not to ride it out, compliance will not come cheap.  You will face numerous penalties, including an initial 5% for late filing and an additional 5% for each MONTH the return is late, up to a maximum of 25%.

 

File Amended Returns

Another route to compliance is to come clean by reporting the cryptocurrency transactions you forgot to file or did not know you had to declare, like crypto you received through an airdrop or after a hard fork.  Therefore, you can submit an amended return to correct your unintentional noncompliance.

 

This route is not without hazards, however. You might face criminal, or fraud penalties and the new returns can become subject to ongoing IRS investigation.  DO NOT AMEND YOUR RETURNS BEFORE CONSULTING A TAX ATTORNEY OR A CPA – especially not if your non-compliance was relatively small.

 

Voluntary Disclosure To The IRS

If you have a massive non-compliance problem with cryptocurrency, this is the way to go.  If you follow the voluntary disclosure procedure, you can come forward without facing any criminal charges. You will still face some hefty penalties, but you can be reasonably confident you will escape criminal prosecution.  What you will face is six years of corrected income taxes and a civil fraud penalty for your highest income year. Based on the sanctions, this option should be selected if you face real criminal charges or if you require a high degree of certainty on the charges and penalties you will face. It seems that this option is reserved for those individuals who had a non-compliant or even criminal intent when they failed to comply, rather than sloppiness or naivete.

 

How Crypto Investors Can Deal With an IRS Audit

A lawyer who represents himself in court, so the saying goes, has a fool for a client.  Does the same go for taxpayers who face an IRS crypto audit? Should you face it all alone, or should you hire a professional to guide you through it all? As it happens, the legendary lawyer F. Lee Bailey felt strong enough to represent himself in Tax Court in a $4 million dispute.  It ended disastrously.  Bailey ended with huge losses and had to pay negligence penalties, which he would have avoided had he appointed tax counsel.

 

Crypto Is Complicated

Considering that  crypto tax matters are very complicated and dependent on meticulous record-keeping, the question almost answers itself.  Many crypto investors failed to comply with all the record-keeping requirements and did not file their returns over the last couple of years, with the ramification that the IRS is now very focused on crypto. According to the IRS, virtual currency is now a hotbed for criminal investigation – and the agency is actively hunting crypto user identities using sophisticated software.

 

From the IRS point of view, noncompliance in respect of virtual transactions is rife, and they are using taxpayer education, audits, and criminal investigations to root it out.  Recently the IRS sent thousands of letters to participants in virtual transactions – which they identified through various methods – to warn them to comply.

 

IRS Criminal Division

Let’s face it: the IRS Criminal Investigation Division is a nightmare, albeit a rare consequence of non-compliance. Most criminal investigations are the result of referrals from the IRS civil division as a result of audits or tax collection matters. When an IRS auditor finds something considered suspicious – or odd – the case might be referred for criminal investigation – and you may not even know you are under investigation.

 

If the IRS criminal investigation division contacts you, never, ever, agree to be interviewed, albeit as a target or a witness. Politely decline an interview and refer the IRS to your attorney.

 

The IRS Is Coming For Crypto-“Crooks”

Industry insiders believe that cryptocurrency will be the next “big issue” for the IRS.  IRS criminal investigators have been training intensively in Bitcoin and other virtual currencies.  Remember, when the IRS suspects you, they can force you to produce records even records that can incriminate you. For offshore bank accounts, they are very well versed in coming after you with a grand jury subpoena to provide your documents.

 

The fifth amendment will also not help you much when this happens. The fifth provides you with the right to remain silent, so you do not have to speak to the IRS, but the fifth does not give you any rights to refuse the IRS demands for records.  When they demand that you provide bank statements and documents, you have to comply even if it does incriminate you.

 

Is It Wise To Handle The IRS Alone?

It is so much the wiser to hire professional help when the IRS starts prodding and sending you notices. When the IRS visits you, hire an attorney or a CPA. It’s that simple. As mentioned above, you have no obligation to talk to the IRS albeit the civil or the criminal division.  Politely decline the interview and inform that that your attorney or CPA will contact them. Then ask them for a business card. Usually, the IRS will not push you to talk after this, but if they do – decline – politely; even if they tell you that they are merely talking to you as a witness, still refuse. Witness today, target tomorrow – IRS investigations are fluid in nature.

 

If the IRS contacted you in writing rather than in person, still refer it to an attorney or CPA.  If you feel secure enough to respond to a query by the IRS in person rather than using a lawyer, be very mindful of your response. It is often better to involve your tax lawyer early on. Often failure to engage your lawyer early on leads to very high expenses later on.

 

You have to have a lawyer present when you deal with the IRS, partly because you need to distance yourself to some degree from the IRS when they start asking questions and because it is very awkward not to answer questions when you are handling it personally.  This is a very dangerous disposition for you.  When you have representation, you will have the opportunity to prepare the appropriate responses beforehand.

 

Check These IRS Filing Rules For Crypto Investors

 

Important Clarification On Cryptocurrency Reporting Rules

During the AICPA National Tax Conference in Washington, DC, IRS and FinCEN officials provided more clarity on cryptocurrency reporting requirements.

 

Like-Kind Exchanges

 

The panel clarified:

⇒ That the crypto FAQs of 9 October 2019 were clarifications of the original crypto tax guidance and that it applies retroactively. What this means is that taxpayers should have been following the ‘new guidance,’ since the publication of original notice in 2014.

⇒ Although like-kind exchanges were for the first time explicitly disallowed for crypto after January 1^st 2018, it was, in fact, never allowed at all.

⇒ Hence, the IRS can take retroactive action on tax returns, which assumed like-kind exchange treatment for crypto before January 1^st,

⇒ Those who did the same can use Coin Tracker to calculate their capital gains on their cryptocurrency without like-kind treatment to amend their returns.

 

Specific Identification

 

The panel clarified:

⇒ FIFO (First-in first-out) is the default method to account for cryptocurrency disposals.

⇒ Specific Identification can be allowed if you can document the particular digital identifier and show:

⇒ The date and time of acquisition of every unit.

⇒ Your basis and the fair market value of every unit at the time of purchase.

⇒ The date and time of disposal of each unit.

⇒ The fair market value of each unit upon disposal.

⇒ The amount of property or money received for each unit.

⇒ As long as taxpayers meet the conditions in (2) above, it allows for HIFO (highest-in first-out), LIFO (last-in-first-out), and any other type of specific identification accounting, including fungible assets from exchanges.

⇒ This applies retroactively to historically disposed assets.

⇒ The new FAQs are merely a clarification of previously released crypto guidance.

 

Foreign Reporting (FBAR)

⇒ Crypto held in international exchanges are NOT required to be reported under FBAR (FinCEN 114).

⇒ FACTA (foreign reporting on IRS Form 8938) has not been confirmed for crypto yet.

⇒ Until it is confirmed or denied, it is advisable that those who fall under FACTA thresholds to file on their crypto.

 

Airdrops

⇒ IRS FAQs about airdrops only cover new coins after a hard fork.

⇒ It remains unclear whether true airdrops are taxable income or not.

 

The IRS Refunds Compliant Crypto Taxpayers

The US has no crypto regulations at all.  There is no indication that this state of affairs will change soon.  Those crypto owners and traders that cooperate with the IRS will see benefits. Tax reductions and even refunds are in the cards if you comply.

 

Rewarding Compliance

Crypto users who complied with recent letters the IRS sent out in which they requested proof of trades and transactions in support of tax reports submitted, already received tax refunds.  The main goal of the IRS is not punishment.  One crypto investor received notice from the IRS that he owed $3,900 in taxes. The investor paid up, and to his surprise, the IRS rewarded his compliance with a full refund. The IRS sent out 10,000 letters to crypto investors. How many of the investors received refunds remains a closely guarded secret.

 

Big Brother Is Watching

The strategy is to educate crypto users as to the reach of the IRS in the world of crypto.  By showing crypto users that the IRS knew all about their additional crypto accounts, which they failed to disclose in their reporting of trades and transactions, the IRS hopes for extensive compliance.

 

The IRS does not always have accurate information. In cases where the investor exchanges one currency for another without making any profits on the transaction, the IRS may not understand what happened. To be sure, they will know about the transaction, but nothing more.   Nevertheless, if the agency made errors, it rewarded those who complied with their request for clarification with refunds.

 

Crypto Donations to Charity are The Next Frontier For IRS Regulations

 

IRS Confirms Crypto Donations Above $5000 Require Formal Appraisal

⇒ Charitable organizations that receive digital asset donations greater than $5,000 now require a formal appraisal.

⇒ A qualified appraiser must verify the amounts of these donations.

⇒ This poses challenges :

⇒ It is a challenge to find a qualified appraiser that will meet the IRS’s criteria.

⇒ These appraisals might be very costly.

⇒ Expensive appraisals might discourage donations.

 

This requirement adds an unnecessary level of complexity that will deter people from making donations. This will hurt the non-profits, they say.

 

More Like Than Painting

Tax practitioners expected this after the IRS guidance in 2014 defined cryptocurrency as property for tax purposes.  Traders hoped that the lack of specific instructions meant that the IRS did not require appraisals since the value of digital assets – especially the most prominent types like Bitcoin – are readily available on the trading exchanges.

 

Some advocates are upset over this ruling and say that digital assets share similarities with stocks and not paintings – they believe this ruling will harm the industry. The IRS had been requested to treat cryptocurrencies that are traded on significant exchanges the same as stocks and other publicly traded securities that are free from the qualified appraisal rule. Detractors say that there is a substantial difference between stock exchanges and cryptocurrency exchanges, whereas stock exchanges trade on a single exchange that trades for a finite period per day, cryptocurrency trade 24-hours per day on many exchanges.  This makes it easier to inflate the value of donations by using foreign exchanges, particularly those in Asia.

 

Qualified Appraiser?

It is tough to meet the IRS definition of a qualified appraiser.  The IRS requires an appraiser:

⇒ To have a recognized appraiser designation or, to meet minimum educational requirements, have two or more years experience in valuing digital assets must regularly prepare appraisals for which they are paid.

 

The problem is, no one in the world qualifies in respect of these requirements. No degree or appraisal designation applies specifically to cryptocurrency.  There is almost no one that has the experience required because cryptocurrency is just too new.

 

Cost Involved

Appraisers are expensive and an appraisal will cost hundreds of dollars. This will detract some donors.  Also, appraisers will quickly check the price of the digital asset on a cryptocurrency exchange, and then charge $500 or more for a job that takes 30-seconds to complete.

 

Some appraisers disagree with this simplistic view. According to some, it takes between two and two and a half hours to account for around-the-clock trades on multiple exchanges.

 

The IRS will have to define the term “major” exchange.

 

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.