2019 was a very eventful year for cryptocurrency taxation.
After five years from the issuance of the original crypto guidance in 2014 (IRS Notice 2014-21), in 2019, the Internal Revenue Service came up with several initiatives to police crypto tax compliance.
- August 2019—the IRS sent out tax notices (Letter 6173, Letter 6174, and Letter 6174-A) to 10,000 taxpayers with cryptocurrency transactions.
- Oct. 9, 2019—the IRS issued 43 Q&As elaborating on the originally issued Notice 2014-21
- Oct. 9, 2019—the IRS issued Revenue Ruling 2019-24 addressing forks and airdrops
- Oct. 10, 2019—the IRS released a draft 2019 Schedule 1 which asks taxpayers, “At any time during 2019, did you receive, sell, exchange, otherwise hold any financial interest in any virtual currency?”
The above initiatives are due to extremely poor compliance rates. According to the IRS Chief Counsel, Michael Desmond, the IRS receives approximately 150 million tax returns annually. Various sources report that there are about 7-11% of adults in the U.S. with some sort of economic affiliation with virtual currencies. This means that the service should receive roughly 12 million tax returns with some sort of cryptocurrency transactions. However, the amount of returns received with such transactions is far fewer than that. As a matter of fact, due to this high degree of non-compliance IRS’s immediate goal is not to achieve perfect compliance or come up with more detailed guidance, but to move taxpayers from reporting absolutely nothing to report something on tax returns.
This article will analyze why cryptocurrency tax compliance is extremely low among U.S. taxpayers and what to expect from the IRS in the coming years. Poor compliance is primarily due to three reasons: Poor to no information reporting, reconciliation challenges, and crypto holders’ ideology coupled with lack of education.
Poor to No Information Reporting
Third party information reporting directly enhances taxpayer compliance. For example, under the current information reporting regime, a copy of Form 1099-B (Proceeds From Broker and Barter Exchange Transactions) prepared by a brokerage service goes to the IRS and the taxpayer. If the taxpayer does not report what’s reported on Form 1099-B, the agency will generate an automatic CP2000 notice to rectify the omission. This so-called matching mechanism also works as a great deterrence and encourages taxpayers to report accurate amounts.
Interestingly, under the current interpretation of the law, cryptocurrency exchanges are not required to issue Form 1099-Bs to their users. This is because most of the exchanges are not registered as brokerages under the U.S. laws and dealing with “stocks and securities.” Currently, they treat themselves as third-party payments settlement organizations (TPSOs). As a result, they are only required to produce Form 1099-Ks if the user exceeds $20,000 in transaction amount and has more than 200 transactions in a calendar year. Taxpayers who meet these criteria is far fewer than the actual number of crypto holders in the U.S. Those who do not receive a Form 1099-K believe that they do not have any tax reporting obligation.
Reconciliation Burden For the Taxpayer
Being compliant is not easy for those who receive Form 1099-Ks either. The Form 1099-K only reports the gross proceeds and does not provide any meaningful numbers to the taxpayers to prepare their tax returns. The burden of tracking the cost basis of crypto assets, determining the holding period (short-term vs. long-term), identifying the proper disposition method (FIFO, LIFO, HIFO, etc), valuing crypto to crypto trades, etc. fall with the taxpayer. If you are not a sophisticated taxpayer, you will ignore reporting these transactions merely due to the administrative burden and compliance cost. Even for the seasoned tax practitioners, due to the technological nature of crypto transactions, in many cases, it is virtually impossible to calculate gains and losses for tax purposes manually.
One may think that the potential solution is to mandate crypto exchanges to issue Form 1099-Bs like traditional brokerages. However, this is an impossible task in the crypto world. Typically, a crypto exchange only has access to cost basis information for the transactions occurring in their exchange. For example, if a taxpayer transfers coins from another exchange and/or an offline wallet, the reporting exchange will not have any data on the U.S. dollar cost basis of those transferred coins. Further, some foreign exchanges do not even collect taxpayer information or keep good transaction data useful for U.S. tax purposes; these exchanges do not participate in any type of tax reporting.
Luckily, there is a solution to this problem. There are third party data aggregator tools like, CoinTracker.io. Taxpayers can link multiple exchanges and wallets to a CoinTracker.io account and the software reconciles all the transactions and generate a taxpayer friendly capital gain/loss report to be included in the tax return. Since the traditional matching mechanism is not functional in the crypto space, these software are essential to calculate cryptocurrency gains and losses for taxpayers, tax practitioners, and the IRS.
Ideology and Lack of Education
In addition to poor information reporting and administrative burden, liberal ideologies of crypto users lead to a great deal of intentional non-compliance. Cryptocurrencies run on blockchain technology, which is based on the premise of decentralization. In a decentralized world, there are no central authorities like banks, tax collectors, and governments. Therefore, strong crypto enthusiasts are against paying taxes on cryptocurrency trading gains. Furthermore, technologies such as blockchain and cryptocurrencies are often incorrectly associated with 100% anonymity. By relying on this premise, many strong crypto users believe that the IRS cannot find them.
What Is the IRS Doing?
On Oct. 10, 2019, the IRS released draft 2019 Schedule 1, which asks taxpayers the question, “At any time during 2019, did you receive, sell, exchange, otherwise hold any financial interest in any virtual currency?” This is a yes/no question. By adding such a broad question, the IRS expects to gather more data directly from the U.S. taxpayers (as opposed to exchanges or other sources) about their cryptocurrency affiliations. The agency likely expects that a question like this will alert the taxpayers and improve voluntary compliance. Faced with a limited budget and technological challenges, a question like this seems to be a smart and cost effective way to improve compliance and generate tax dollars. The IRS will continue to generate CP2000 notices when applicable. Similar to the past, the IRS internal system will automatically generate these notices when it detects mismatches between 1099-K reported amounts and what has been reported on the tax returns. Finally, the service will highly rely on tax practitioners in advising taxpayers and helping them navigate through complicated crypto taxes.
Cryptocurrency taxation, which was once a niche subject, is rapidly becoming a mainstream topic among tax practitioners, especially with the addition of the new question on 2019 Schedule 1. The compliance rate in this space has been poor for a long time due to lack of information reporting from exchanges, reconciliation burden, and the unique ideology of crypto users. The IRS is actively working on initiatives to police this space and improve compliance.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Shehan is one of the handful of CPAs in the country who is an operator and conceptual subject matter expert on cryptocurrency taxes. Prior to CoinTracker, Shehan co-founded and worked for several regional and national public accounting firms for several years.