Prepare for Pitfalls With Your Crypto Clients During Tax Season

Last year was brutal for cryptocurrencies, thanks to a series of interest rate increases and the catastrophic collapses of Terra Luna, Celsius, and FTX. While cryptocurrency investors have welcomed the bitcoin rally that has raised prices by 39% since the start of 2023, as tax time nears, the focus must be on 2022 losses to ensure taxpayers get all the tax benefits they can.

In theory, deducting crypto losses should be simple. But if you’re unprepared, those losses could cost you the most time and largest misstatements in any tax returns that you sign this tax season.

Client Acceptance

The moment you accept clients with a large amount of crypto, you have zero visibility into their investments or their activities in Web 3.0. Even if it’s unlikely that they’re involved in money laundering or other crypto criminal activity, there’s a high likelihood that they’ll fail to disclose something material to their taxes, such as a hardware wallet. And yet you’re the one signing the tax return.

You should do a risk analysis on any potential crypto clients and understand how they use every crypto platform—not only to ensure that you’re prepared to accept them, but also to ensure that you’ve considered how to best advise them on any legal or tax issues. You should first verify their identity and source of funds to avoid illegal activities. Then, assess their understanding of the tax implications behind any crypto transactions and their record-keeping practices. Check their financial situation, including any debt and ability to pay taxes on crypto holdings. Research the protocols and exchanges used to see if they have a good reputation and comply with regulations. Consider the volatility of the crypto’s value and its impact on the client’s ability to pay taxes.

Scope of Engagement

So you’ve accepted a crypto client who used 10 different exchanges, one of which was FTX.US and another of which was small and not supported by any crypto tax tools. The client uses trading bots for some of these, has 20 decentralized finance wallets and used several DeFi platforms to provide liquidity, earn yield, and even lend and borrow crypto assets.

Do you have a plan to help this client? If not, you might consider working with a crypto tax professional and outsourcing their assistance. Accountants wanting to do the work themselves have two choices: provide full service and help crypto clients calculate their gains and losses, or limit your role and have the client or another accountant do the crypto work. Each has its pros and cons.

Providing your clients with the full service will be a smoother process for them, but you must know the industry’s many protocols and issues, as the lack of guidance might force you to take a tax position. Your staff also needs to know how to use a crypto tax tool, connect the platforms correctly, and identify and communicate any issues.

Like any other service, you should have a defined preparation and review process while being efficient when gathering missing client information. A well-planned list and defined processes for dealing with missing data, missing guidance, and other issues can help you streamline matters. More than anything, have a well-defined process for reviewing the final report with your clients so you can catch anything big prior to filing.

Having clients do their own crypto tax report is an excellent choice, since no one will know how to complete their crypto tax puzzle better. Generating API keys from exchange accounts, listing all blockchain addresses used, and even knowing all wallets, exchanges, and platforms used (as well as identifying airdrops received) might take an accountant hours to unravel, while the client could do it quickly.

Keep in mind, however, that your crypto clients might unknowingly take tax positions while generating their own reports. For example, they may have lost funds on FTX and, in their mind, no longer have them, so they choose to dispose of these for $0 and reflect a capital loss in the tax reports. Deducting crypto funds lost to bankrupt exchanges is not something that taxpayers can deduct, and if you don’t ask the right questions, you unknowingly could sign a return showing a capital loss.

For this reason, it’s critical that you understand your clients’ involvement with crypto even when they handle their own crypto taxes. Due to the advantages of having clients do the work, some accountants choose a hybrid approach, such as having clients connect their wallets and exchanges, then getting into the nitty gritty of the gains and losses.

Tax Season Time … Extend!

Word of advice—extend the majority of your clients who are active in crypto. The recent collapse of FTX has only added pressure on regulators who were already examining the crypto industry, so it’s possible that the IRS might issue guidance in a year with so many collapses and bankruptcies.

While protecting consumers and stopping criminal activities—including tax evasion—are a top priority for the government, regulators are focusing on taxation as well. Digital asset tax reform bills have emerged as recently as last year, and the IRS will be issuing regulations soon about brokers reporting digital assets. While guidance on crypto’s many open questions isn’t guaranteed, it wouldn’t hurt to get an extension just in case things should change during the summer.

Crossing the Finish Line

No matter how you help your clients with crypto, come into it well-prepared. Agree on any billing arrangements over out-of-scope crypto work. Even if you ask about digital assets in your organizer, given the question on Form 1040, remember that many clients don’t read the organizers and you could miss key information if you don’t proactively talk to them.

If you choose to do the work yourself, have a clear process for gathering information, asking questions, and verifying that the crypto tax reports are accurate. If you choose to let your client do the work, understand what has gone into their tax report prior to signing the tax return and actively help the client complete the report.

Most importantly, take some time to get caught up with what has been happening with crypto (especially in 2022) and encourage your staff to watch out for any indications in workpapers that clients have unreported crypto holdings. Finding a surprise Coinbase transfer in a client’s bank statement would require a conversation.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

David Canedo, CPA, specializes in taxation of digital assets. He is the head of tax and compliance strategy at Accointing by Glassnode, a subsidiary of Glassnode that provides tracking, consolidation, tax and compliance solutions for crypto investors.