Tax practitioners encounter a variety of challenges when handling cryptocurrency tax compliance for their clients. Cryptocurrency taxation is a complicated area, and there is little official guidance from regulators.
In this article, we share the most common issues that we encounter in crypto tax space. The goal is to help tax professionals who are new to cryptocurrency tax compliance.
In the article, we discuss the following five common issues:
1. Misunderstanding or lack of knowledge regarding cryptocurrency taxation
2. Skeptical cryptocurrency users—“anonymous” belief and mentality
3. Poor individual record keeping and missing data
4. Loss of access to transaction data
5. Issues related to the use of crypto tax software
Issue #1—Misunderstanding or Lack of Knowledge of Cryptocurrency Taxation
There is a lack of clarity in a number of areas of crypto taxation. Issues like the tax treatment of forks and their respective characterization, basis, recognition of income, etc. are certainly up for debate. Excellent diametrically opposing arguments can be made. These types of issues will exist unless and until there is definitive guidance.
However, underlying much of this is a fundamental misunderstanding of many individuals about the basics of taxation itself. For many people, it is not, or at least for some time, was not clear whether crypto would actually be taxable. Would there be de minimus exemptions like traditional “currency,” (the operative word when examining cryptocurrency…), or is everything to be taxable, as most of us believe now?
A large amount of questionable advice and information has also been shared by purported experts and amateurs alike. This has led many people to do things like taking tax code Section 1031 treatment for their crypto trading pre-2018. In virtually all, if not all cases, this does not apply and has never applied. Worse, many of these people failed to document and disclose, based upon the misconception that Section 1031 means no taxability, and therefore also no reporting requirements. In other cases, unconscionably aggressive positions often without disclosure have been taken on returns.
One could say that the first factor of lack of clarity in guidance can be solved, and based upon recent Internal Revenue Service pronouncements, will be addressed at some point in the near to mid-term future. Fundamental misunderstandings about taxability too can be addressed, though this is and should be a cohesive effort of both the professionals in the industry and the major players like exchanges. Two of the authors herein offer professional support through training classes and coaching to tax professionals looking to gain knowledge about crypto taxation and crypto tax practice overall.
In the interim, we must look to the closest parallels in other areas of taxation and existing guidance to make decisions on things like forks, airdrops, staking, and other new areas of finance which simply have no direct identical. Is a fork more like a split, a spin-off, or a dividend? Or do none of those apply? These are questions which need to be answered in the long-term.
Issue #2—People Don’t Want to Disclose All of Their Cryptocurrency Transactions
Adding to these previous issues with “misunderstandings” and “misinformation”, there is yet a third layer—what we refer to as the lingering “Silk Road Effect”—whereby many people falsely believe that crypto is so anonymous that compliance is not enforceable, and by proxy therefore not necessary.
This final factor is by far the most difficult. The remaining tendency for many players in crypto to believe that this is enough of a Wild-West not to have to report, or worse, a refusal to report completely and accurately leaves professionals in a position whereby disengagement for ethical reasons is a real concern.
What we often have to explain is that the records are not, for the most part, completely anonymous. Rather, one can trace many if not most crypto transactions, and therefore, the idea of anonymity is invalid. Conceptually, crypto is a common ledger, which everyone has limited access to. It is less that nobody has the data than that everyone has the data. The only question is access, but traceability does exist. Enforcement is not only possible but probable, and more than likely, long term, much easier than other areas.
Issue #3—Poor Individual Recording Keeping or Missing Data
In order to correctly calculate gain/loss and income/expenses etc. regarding cryptocurrency related activities, all transaction data from the very beginning of the client’s cryptocurrency usage needs to be accounted for. Unfortunately, many do not keep complete records for their cryptocurrency transactions. If the client had crypto transactions separate from exchanges, such as trading cryptocurrency directly with other individuals, gifting, receiving income in cryptocurrency, spending cryptocurrency in purchases, transferring cryptocurrency to a wallet or investing in an initial coin offering (ICO) or token sale etc., it is critical that the client keeps a detailed record for all of these transactions. Otherwise, they will not be able to correctly calculate the tax consequences for their tax return reporting.
If we encounter this kind of problem when handling a client’s crypto tax calculation, all that can be done is to ask the client to try and figure out what happened with each missing transaction. If the client indeed cannot remember, the tax professional will need to help them come up with some kind of reasonable estimation. A conservative approach is usually recommended, i.e., treating the transaction in question as a taxable event.
It is each taxpayer’s responsibility to keep a complete record of all their crypto activities. As a tax service provider, we stress the importance of record keeping to our clients and help them understand that taxpayers always bear the burden of proof if their tax return gets an IRS audit.
Issue #4—Loss of Access to Transaction Data
It is not uncommon for a client to have lost access to their crypto transaction data and even coins due to reasons like exchange shutdowns, scams, unrecoverable loss of password/private key to their online account or wallet, or the permanent loss of their hardware wallet.
Exchange shutdowns have been a problem since the early period of cryptocurrency trading. Shutdowns of exchanges like Mt. Gox, BitGrail, and recently Cryptopia have caused clients to lose access to their cryptocurrency. Those who lose coins from a shutdown are entitled to claim a loss deduction. However, no accurate calculation of the loss can be performed if no transaction data is available.
The same problem occurs for loss of transaction data and coins due to reasons other than exchange shutdowns, such as crypto investment scams, loss of private keys to an online wallet, loss of a hardware wallets etc. There is very little you can do if your client has lost access to their exchange or wallet account(s) and they don’t have a record of the historical transactions. We usually suggest that our clients attempt to put all the pieces together as accurately as possible, then at the end, post a manual adjusting entry to zero out the ending balances for each “lost” account. In order to do this, all the ending balances for each existing account that the client still has access to must be reconciled first.
Issue #5—Issues Related to the Use of Crypto Tax Software
Cryptocurrency tax software can be used to automatically associate historical cost basis and fair market value to crypto transactions. Tax preparers generally use these tools to import their clients historical trade data from cryptocurrency exchanges like Coinbase to then generate the reports that contain the necessary information for forms like the 8949.
Not all tax software is built equally, and common issues are seen across the board. One of the biggest challenges lies with the vast amount of exchanges and other platforms that are available for crypto users to trade or exchange tokens on. There are dozens of such platforms today. If the tax software you are using does not directly support one of these platforms, getting the historical data into the program can be incredibly tedious and require a significant amount of spreadsheet gymnastics. Manipulating data and trying to get it into the right format can chew up hours of a tax preparers time which cuts into the profitability of that client. Many platforms also limit the amount of data that can actually be imported. If a client has thousands or tens of thousands of trades, the software can get expensive.
Other issues deal with the actual functionality of these software platforms. Certain platforms offer select costing methods like FIFO or LIFO. If you or your client want to take a different approach outside one of the offered methods, the software will be less useful. Other functionality like margin trading is not commonly seen as an option on the majority of platforms today. If your client has traded crypto on margin from an exchange like Kraken or Poloniex, you need to be aware that these types of trades will be more difficult to deal with if they can’t be calculated within your crypto tax software.
As the industry continues to grow, the software tools will continue to get better and better. Before taking on clients, you should be aware of the functionalities and limitations of your software.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
David Kemmerer is the Co-Founder and CEO of CryptoTrader.Tax, a tax reporting platform built for cryptocurrency traders and tax professionals. David and his company are focused on solving the challenges that come with tax compliance in the cryptocurrency world. With its corporate partnership with tax giant Intuit TurboTax, CryptoTrader.Tax is helping bring cryptocurrency tax reporting to the mainstream.
Sharon Yip is a CPA with 20 years of tax experience. She is the founder of Crypto Tax Advisors, LLC, a tax practice specialized in cryptocurrency taxation compliance and consulting. Sharon has extensive personal experience in cryptocurrency investment. In addition to serving crypto tax clients, Sharon is also an expert coach to other tax practitioners. She is the author of A Quick Start Guide to Cryptocurrency Taxation eBook and the creator of Mastering Cryptocurrency Taxation online course.
Joshua Azran CPA/ABV/CFF, CMA, CGMA, CFE is a multi-credentialed expert with nearly two decades of experience in accounting, tax, and finance. He is the founder of Azran Financial, one of the nation’s leading firms focused on cryptocurrency tax and blockchain accounting. Joshua’s clients include some of the top names in blockchain technology ranging from the exchanges to blockchain technology startups. Joshua also teaches one of the most comprehensive courses on crypto taxation for professionals, Crypto Tax Verified.