IRS Adds Coinbase Software to Cryptocurrency Enforcement Tools – Taxpayers Beware
July 22, 2020 by Joshua Smeltzer
The IRS continues to update its resources to close a significant gap in unreported cryptocurrency investing. The IRS issued its first official guidance on cryptocurrency in 2014 and not again until 2019. Despite this guidance, and several informal FAQs, many questions still remain. However, enforcement is not slowing down. In 2018 the IRS announced a virtual currency compliance campaign using both outreach and examinations. In August 2019 more than 10,000 taxpayers received letters indicating that they may have failed to report cryptocurrency and urging them to pay the required taxes. And, of course, there is always the ever-present threat of criminal investigations.
Coinbase, one of the most prominent cryptocurrency exchanges, was the subject of a high-profile John Doe summons by the IRS for customer information. A John Doe summons, as the name implies, involves taxpayers in a group the IRS cannot identify by name—yet. The IRS and the Justice Department Tax Division have received several victories in John Doe summons cases because of the relatively low burden of proof required. The John Doe summons issued to Coinbase resulted in the release of information for 13,000 customers after lengthy litigation. Many taxpayers are still handling reporting issues following receipt of letters from Coinbase that their names were disclosed to the IRS. As more data is received by the IRS more taxpayers will receive letters indicating examination or criminal investigation.
If you have invested, or are thinking of investing, in cryptocurrency there are several things to consider regarding tax reporting. You may think you won’t get caught, but failure to report is a risky course of action involving potential civil penalties and criminal action. Here are the top things to consider:
- New IRS checkbox. The 2019 Form 1040 added a question targeting cryptocurrency. A checkbox on Schedule 1 requires taxpayers to answer whether at any time during 2019 they sold, sent, exchanged, or otherwise acquired any financial interest in cryptocurrency. When in doubt, taxpayers should check the box. The Justice Department Tax Division has successfully argued that failure to check a box, in the FBAR reporting context, is per se willful failure to report. The same arguments can be expected for cryptocurrency and willful, as opposed to non-willful actions, usually carry higher penalties and a greater threat of criminal investigation.
- Cryptocurrency is NOT currency for tax purposes. The IRS guidance in 2014 states that cryptocurrency is property, not currency, for tax purposes. Because cryptocurrency is treated as property (like stocks and real estate) taxpayers pay and realize gain or loss at disposition. This requires taxpayers to know when they bought cryptocurrency, how much they paid, and what they received for it. This can be difficult if the cryptocurrency is not on a recognized exchange or recordkeeping for older transactions were not well maintained. Regardless, taxpayers must determine their basis using the fair market value when the virtual currency is received. There are several software companies offering tools to help with the reporting process but any questions should be answered by a qualified tax advisor.
- Mining cryptocurrency may cause issues. An investor may have trouble identifying exactly when they received mined cryptocurrency for purposes of determining value. Mining is performed by high-powered computers solving complex math problems that produces new cryptocurrency and further securing the network by verifying its transaction information. As compensation, miners are awarded virtual currency whenever they add a new block of transactions to the blockchain. The IRS requires a reasonable method (e.g. first in, first out method) to determine fair market value but does not specifically define what method to use. With the volatility of cryptocurrency prices throughout the day it may be difficult to determine the exact price when the virtual currency is awarded.
- FAQ guidance from the IRS is NOT binding. There is very little official guidance on cryptocurrency reporting and taxpayers and their advisors may need to use FAQs published by the IRS. However, these FAQs are not legal authority on which taxpayers can rely and they can be changed or removed by the IRS at any time. If a situation doesn’t fit squarely into the official guidance issued in 2014, or more recent guidance in airdrops and hard forks in 2019, then a taxpayer must make their best decision on available information and advice from qualified tax advisors.
- Fix past reporting problems quickly. For the time being, the safest course appears to be careful reporting with amending or providing quiet disclosures as further guidance is issued. In some instances formal voluntary disclosures may be appropriate. Regardless, if you believe past reporting is insufficient or inaccurate it is important to seek help from a qualified tax advisor on the proper way to fix those errors. Fixing errors voluntarily is always better than after the IRS sends an examination notice or notice of criminal investigation.
As the IRS continues to gather information and data, increases in cryptocurrency examinations and criminal investigations can be expected. If you have questions regarding your specific situation, please contact a Brown Fox attorney.