insight magazine

IRS Makes Major Change to Cryptocurrency Taxation

The agency’s guidance remains cryptic, but crypto-to-crypto exchanges are now definitely classed as taxable events. By Sean Ryan | Digital Exclusive - 2019


News that the IRS will have sent out more than 10,000 warning letters to taxpayers in pursuit of cryptocurrency transaction taxes by the end of August 2019 comes as no surprise to those of us that have followed the agency’s approach to enforcement over the last few years. But that doesn’t mean your clients won’t be shocked or even panicked when the IRS singles them out, claiming they owe back taxes and must file amended returns—or not.

The IRS’ attempts to identify and tax cryptocurrency users are growing more prevalent, which means CPAs need to be more vigilant in advising clients who make transactions with cryptocurrencies or invest in them.

Consider the recent CP2000 letters, which indicate for the first time that the IRS has information provided by specific cryptocurrency exchanges and exactly how much a taxpayer underpaid. The thing is, this information is likely to be inaccurate: exchanges like Coinbase issue 1099-K forms to users that meet certain conditions, but these do not accurately paint a picture of a trader’s activity or taxes owed. After all, there are more than 240 cryptocurrency exchanges operating globally, and traders rarely limit themselves to a single platform.

We have been seeing governments steadily catching up with those they perceive to be in violation of the law when it comes to trading cryptocurrencies. Identifying users has continued to be a challenge for them, chiefly because the infrastructure of the emerging space is founded on technology designed to operate independently of the existing financial system.

The initial round of IRS letters came in three forms: Letter 6173, Letter 6174, and Letter 6174-A. The 6174 versions notified recipients that the IRS believes taxes or additional taxes may be owed based on their insight into the taxpayer’s activity, while letter 6173 claimed that additional taxes are probably owed. These letters may represent a type of informal safe harbor period where, if returns are amended and penalties paid, no further (criminal) action will be taken. Although the IRS considers these letters educational in nature, the education is woefully incomplete and at least one letter—6173—demands a response within 30 days consisting of an amended return, back taxes, and penalties with interest.

The latest CP2000 letter is similar in its urgency: the taxpayer has 30 days to either accept the IRS’ assessment of the taxes owed—or to refute it. Remember, however, that the burden of proof lands entirely on the taxpayer. Though guidance was only proffered in 2014, cryptocurrency exchange users will be responsible for accurately reporting on their activities prior, even on wallets to which they no longer have access, or on exchanges which no longer exist.

Perhaps the most significant policy change the IRS snuck in is the fact that all three letters in the first round contained a statement making clear that an exchange of one cryptocurrency for another is taxable. Up to now, there has been much debate among accountants and tax attorneys as to whether this was already the case or not, with valid arguments on both sides. These letters mark the first occasion in which the IRS has clearly stated that a crypto-to-crypto exchange is taxable, but it still doesn’t make clear if that position includes pre-2018 trades, or if it applies exclusively to post-2018 trades. Now the debate will move to how crypto-to-crypto exchanges that took place before 2018 may apply Section 1031 of the IRS code.

The guidance available to taxpayers is sparse as is, and a number of stakeholders (including members of Congress) have urged the agency to revise its stance and to issue a more comprehensive framework. Looking at the situation optimistically, perhaps the statement made in the letters is taken from a draft of said framework, but no one knows for sure.

The reality, however, is that the IRS has promised answers imminently (hinting that they would arrive in late June), but we have yet to see any. Identifying tax evaders is an important component of the IRS’ responsibilities but its new strategy is alarming. It’s heavy on the punitive side but light on the educational side. The agency must shirk its image as a fearsome, Orweillian organization and make it an utmost priority to provide taxpayers with the know-how to correctly report.

Until clearer guidance is issued, taxpayers must be proactive in ensuring a meticulous audit trail is maintained, ideally by using software to track every transaction made with every specific unit of cryptocurrency. This can become unwieldy for frequent traders or businesses, in which case it’s of paramount importance that they adopt tailored accounting solutions for their crypto activities.

It’s an uncomfortable position to be in for individuals dealing with cryptocurrencies. No matter which way the regulations fall, users must save detailed records and strive to organize them in a manner where they can be most flexibly manipulated in the future when the IRS’ desired methodology is better understood. Crypto-specific accounting software exists today to manage this activity and allows users to irrefutably account for income, gains, and losses. Following this simple advice will leave taxpayers well-positioned to explain self-reported tax liabilities.

Further, taxpayers and practitioners can get involved by contacting their members of Congress to press the need for answers from the IRS on how to report cryptocurrency activity.

The more pressure they feel from constituents, the more likely we will all get answers. If you are a member of professional organizations like the Illinois CPA Society or AICPA, use those resources to help develop a cryptocurrency tax methodology that aligns well with taxpayer needs and tax practitioner recommendations. There is strength in numbers; failing any meaningful regulations, a unified front is a comfortable fallback.
Sean Ryan is co-founder of NODE40, a robust cryptocurrency reporting software that integrates directly with major cryptocurrency exchanges.

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