Cryptocurrency is a hot area in tax law. Whether it’s cryptocurrency or NFTs, these issues are more on the radar of the IRS now than ever, and additionally, there are more investors in these products now than ever.
From a tax perspective, it’s important to be mindful not just of how much money you’re making with these investments, but also of what you need to do in order to comply and avoid potentially significant penalties. The IRS is ramping up enforcement on a large scale, given the perceived under-reporting, and they are beginning to take more significant actions against those who are not in compliance.
Going back to the beginning, around 2009-2010, cryptocurrency gained popularity, and for several years there was a lack of enforcement generally by the IRS. With that in mind, the IRS in 2014 released Notice 2014-21, which, although not binding and not court precedent, states in particularity the IRS’s position on the topic and is more than likely to be accepted by a court in any subsequent litigation.
So what Notice 2014-21 basically says is that cryptocurrency, for tax purposes, is treated as property rather than cash or currency. This means that recognition from a tax perspective is going to be dependent on a sale, exchange, or other disposition of the property.
What that means for an everyday investor in cryptocurrency is that you are going to need to know the basis, or the amount that it was purchased for, as well as the sales price in terms of determining the taxable gain associated with that cryptocurrency. To the extent that individuals are not just investing in cryptocurrency but are paid for services rendered in cryptocurrency, there would be similar tax consequences to that of being paid in cash, such as being subject to income tax and possibly self-employment tax.
But focusing more on those that are investors in the product, there are some potential pitfalls that many have experienced in the past that should not be overlooked. In particular, with respect to establishing cost basis or the value of the purchase, many investors did not initially retain that information if it was held within a wallet. This has improved somewhat due to information available on the exchanges, but for day traders and casual investors, it is very important to retain that information. Otherwise, in the context of an audit, one might be subject to substantial changes or adjustments if they can’t prove that basis.
This even turns to specific situations for partial dispositions, people day trading, conducting a lot of transactions, conducting transactions that are very frequent within a 90-day period. For transactions involving things like hard forks—things particular to cryptocurrency—it’s even more necessary that you retain that information so that you can prove to the IRS, in the event of an audit or otherwise, that you should not be subject to more tax than is absolutely necessary.
With respect to investors that are trading frequently, specific identification is a must, or else the IRS may assume that there is a lack of information and can require taxpayers to report on another basis, which might be detrimental to those investors from a tax perspective.
So in sum, just in terms of making sure that you’re in current compliance, record retention is a must. Whether you retain that information from an exchange or a wallet or what have you, it’s important to bring that information to your tax preparer should you engage in any sales or exchanges.
Frequently, when people have cryptocurrency problems and they come to me, they think that there’s no way for the IRS ever figuring out about it, or they might blow me off and say, “Well, I understand that you’re requesting all this information, but what does it really matter?”
Well, the IRS over the last decade, in large part since the publication of that notice, has taken significant efforts to ramp up their information gathering. Some of that can be seen in their summonses issued to exchanges like Coinbase, Kraken, things like that. They’ve engaged third parties in order to gather more information from other sources, and they’re cross-referencing other sources of information in order to close the tax gap, which is significant.
So while there may have been the ability to hide from the tax man ten years ago through investments in cryptocurrency, that doesn’t hold in large part anymore. Given the substantial publications by the IRS on the subject, from their perspective, taxpayers are on notice, and a failure to report this information might be construed as negligent at best or intentional at worst, and could furthermore subject those taxpayers to significant penalties for failure to report those transactions.
In addition to gathering information from third parties, the IRS now specifically asks U.S. taxpayers about this issue on income tax returns, collection information statements, and other information that is required to be tendered to the IRS in different circumstances. So failure to answer those questions correctly can provide additional information on either negligent or intentional acts that can lead to additional penalties.
Aside from generally needing to report these transactions and the civil penalties that can accrue from failure to report these transactions accurately, there’s also significant criminal penalties that can attach to those that are intentionally failing to report gains and tax associated with cryptocurrency.
While five, ten years ago, many of these violations would not have been caught, and for those that were caught, maybe not subject to prosecution, in recent years the IRS and the Department of Justice have coordinated efforts to go after some of these would-be offenders. Much of that has focused on individuals who invested or used cryptocurrency in connection with other offenses such as money laundering, illicit activity, etc.
But there’s a significant government shortfall in funds, and as crypto gains popularity and there’s a perceived ability to collect more taxes from those investing in cryptocurrency, the prosecutions will shift from those engaged in illegal activity to those that are just investing in cryptocurrency alone and fail to report that income. You don’t want to be the first one to be prosecuted for failing to do that.
Like any tax offense, criminal conduct related to failure to report can potentially result in significant penalties—criminal penalties—but also incarceration.
So, in conclusion, while cryptocurrency is loved by investors for its secrecy and recently for the incredible gains that investors have been able to reap from investing, the secrecy is dwindling. The IRS is more on the up-and-up and willing, able, and desirous of enforcing the tax laws and finding those would-be offenders.
There are severe penalties that can result from a failure to report cryptocurrency correctly or failing to provide full information to the IRS. Notwithstanding prior non-compliance, even maintaining current compliance can require professional advice, as sometimes reporting is not as straightforward as a layperson might think.
All in all, if you have cryptocurrency, you’re well advised to contact a tax professional who can help you navigate, correctly address current compliance issues, as well as help you to resolve any prior non-compliance.
If you have any questions about this topic, contact Crepeau Mourges today, we’d be happy to help.
