For the past 18 months all eyes have been on the Securities Exchange Commission (SEC) as it aggressively pursues the cryptocurrency industry, purging bad actors and establishing its governance over nearly all token offerings. While the SEC has remained the industry’s focus, the Internal Revenue Service has been paying close attention and is preparing to assert itself in a major way.
The U.S. Department of Justice is joining the Internal Revenue Service to launch enforcement actions against cryptocurrency related tax crimes. On June 20, 2019 an agency official for the IRS publicly stated that it is beginning to launch audits against taxpayers with cryptocurrency assets, both in its Small Business/Self-Employed Division and Large Business and International Division. The IRS is also conducting work related to the Bank Secrecy Act which requires U.S. financial institutions to assist the U.S. government in instances of suspected money laundering and fraud.
In addition, the IRS has announced that it will issue new guidance shortly with respect to cryptocurrency in order to alleviate some of the confusion in the industry with respect to tax treatment of crypto.
This is just the beginning. Over the course of the next three years we will begin to see rigorous enforcement action by the IRS with respect to cryptocurrency. It is important to note that IRS guidance, while useful, is nonbinding. In addition, the Department of the Treasury’s March 5, 2019 Policy Statement on the Tax Regulatory Process underlines the limits of relying on such guidance. We have yet to witness new legislative initiatives or the establishment of precedent through caselaw.
The IRS is extremely concerned about large scale erosion of the tax base from cryptocurrency activities, and will initiate high profile audit activities to discourage noncompliance with U.S. tax reporting requirements. Cryptocurrency-based tax evasion is part of a larger picture of declining compliance, and the government will allocate resources as necessary to address the issue.
Below is an overview of some of the issues the IRS will be aggressively pursuing as well as what to expect in the event of an audit.
Cryptocurrency Audit Risks
Failure to Report Gains
Many cryptocurrency taxpayers will be subject to audits for failure to report capital gains incurred through the sale or conversion of cryptocurrencies, use of cryptocurrency to pay for goods and services, or receipt of free crypto via a fork or airdrop. Confusion abounds with respect to tax treatment of forks under various circumstances and calculation of cost basis – it is anticipated that new IRS guidance will help to clarify such concerns. In addition, amounts realized from a sale or exchange of property are subject to U.S. tax reporting, a rule frequently ignored by crypto traders. A provision known as Section 1031 exists with respect to exchanges of property which states that no gain or loss is recognized if property held for investment or in trade or business is exchanged solely for property of like kind. However, effective January 1, 2018, 1031 exchanges apply solely to real estate. Furthermore, in many circumstances the use of a qualified intermediary is required to successfully complete a 1031 exchange. Therefore, while it may be possible to invoke 1031 for exchanges through 2017, thereby deferring any gain, under all circumstances the exchange of one cryptocurrency for another is a reportable event as there is currently no de minimis exception.
Failure to Disclose Foreign Accounts
The Financial Crimes Enforcement Network (FinCEN) is a bureau of the U.S. Department of the Treasury that combats money laundering, terrorist financing, and other national and international financial crimes. FinCEN requires that any U.S. person with financial interest or signature authority over financial accounts must file a Foreign Bank Account Report (FBAR) if the aggregate value of the account exceeds $10,000 at any time in a calendar year.
Under the Foreign Account Tax Compliance Act (FATCA) the FBAR requires that foreign accounts, not property, be disclosed. In 2014, the IRS issued Notice 2014-14 stating that cryptocurrency is to be classified as property for tax purposes. This created some confusion among cryptocurrency holders as to whether they would be subject to FATCA compliance. It is very likely, however, that cryptocurrency ownership is subject to FATCA, as property held in foreign financial accounts (like stocks in a brokerage account) must be disclosed and cryptocurrency held in online wallets is analogous to online poker accounts which are also subject to disclosure requirements. In addition to the foregoing, some taxpayers may be required to file Form 8938 to disclose financial assets held overseas. Penalties for failure to file can be severe. The current penalty for non-willful failure to file the FATCA, for instance, is $10,000. Willful failure to file penalties are the greater of $100,000 or 50% of account balances and criminal penalties may also apply.
Failure to Report ICO Income
Another interesting issue that will inevitably arise is the tax classification of tokens sold in Initial Currency Offerings (ICOs). Keenly aware of the SEC, many token offerings in late 2017 and 2018 were conducted as Reg D 506(c) private placement offerings in compliance with U.S. securities regulations. What about the tax consequences? In a traditional securities offering of equity or debt, the proceeds of the offering are nontaxable to the offeror. Think of a classic Series A raise for a startup company. The company issues shares in exchange for investment and realizes no gain on the transaction. Many of the token offerings of 2017-2018 did not treat the issuance as a realization event and thus did not recognize income from the offering, and conducting an offering in accordance with U.S. securities laws has no bearing on tax classification or IRS policies. It is likely that many issuers failed to report realized income from ICOs for the reason stated above or, in some instances, out of sheer willfulness.
Civil Prosecution-Offers in Compromise, Tax Court
The IRS generally has three years to audit a tax return. If a taxpayer recognized cryptocurrency gains in 2017 and failed to report them in 2018, it could be 2021 before the IRS sends a letter. In addition, the IRS has the right to look back at the past six years of returns if it suspects further substantial errors.
In the event of an audit, a taxpayer has the right to obtain authorized representation. An audit may be concluded in three ways: the taxpayer may substantiate all of the items being reviewed, which results in no changes; the IRS may propose changes and the taxpayer agrees; or the IRS may propose changes and the taxpayer disagrees with the audit findings.
If a taxpayer agrees with the audit findings there are a number of options available with respect to payment for underreported taxes. Publication 594, The IRS Collection Process, explains in detail the various options. Options include installment payments and settlement known as an Offer in Compromise, as well as paying the debt immediately and in full.
If the taxpayer disagrees with the audit the next step is to agree to mediation, file an appeal with the Office of Appeals, an independent organization within the IRS that assists taxpayers through an informal administrative process, or file a petition for Tax Court. The United States provides for two types of procedures to resolve claims in Tax Court, small (S case) and regular. S case trials are less formal and are appropriate for deficiency cases that are $50,000 or less in total for each year in dispute. S case trials are often an efficient option for taxpayers. It is important to note, however, that there is no right of appeal to a U.S. Court of Appeals from a decision in an S Case. Neither the taxpayer nor the IRS has the right to appeal. A regular Tax Court case, on the other hand, preserves such rights and maintains adherence to formality and the Federal Rules of Evidence. A taxpayer has the right to representation by an attorney (or, in some instances, a CPA or Enrolled Agent) licensed before U.S. Tax Court in Tax Court cases.
Criminal Prosecution-The IRS Investigation Process
A criminal investigation by the IRS is a very serious matter and differs substantially from an audit. In a criminal investigation, IRS Special Agents conduct a very thorough investigation that may last years in order to acquire sufficient evidence to mount a case against a taxpayer. A criminal tax violation conviction can result in severe fines as well as significant jail time (up to five years in jail for each count). In criminal prosecutions, the IRS plays to win. A taxpayer often will not know that he or she is subject to a criminal investigation until very late stages. It is absolutely critical that a taxpayer obtain competent legal counsel at the first sign of a potential investigation. It is also important to remember that conversations with a taxpayer’s accountant are not protected and statements made to an accountant can be used against the taxpayer during a trial. In contrast, conversations with one’s attorney are subject to attorney-client privilege. Under certain circumstances an attorney may be able to hire an accountant to assist with audit preparation and extend the attorney-client privilege under what is known as a Kovel Arrangement, in which a law firm retains an accountant to counsel the firm on specific accounting and tax issues.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
By Katya Fisher, Esq. and James Mann, Esq. of Greenspoon Marder LLP.
Fisher is a Partner and Leader of the Blockchain, Digital Assets and Technology Transactions Practice at Greenspoon Marder and has represented clients in tax disputes before the New York State Department of Taxation and Finance, the Internal Revenue Service and the United States Tax Court. Mannis a Partner with the Tax practice group at Greenspoon Marder and advises financial institutions regarding international tax, structuring renewable energy asset-based bank loans and securitizations, cross-border tax-advantaged partnerships and securitizations, project finance, and renewable energy deals.