How do individuals or companies that buy and sell cryptocurrencies report the profits or losses resulting from such activities?
Overview
The IRS is constantly sending letters to US taxpayers who may have inaccurately reported or failed to report their crypto transactions. The agency has established a special task force within its Criminal Investigation Division for the sole purpose of investigating and prosecuting US taxpayers who evade taxes by inaccurately reporting or failing to report the income they make from cryptocurrencies.
The IRS treats supplying false information more seriously than failing to report. Since the agency has many avenues that it utilizes to get information on crypto transactions (i.e., requesting such information directly from cryptocurrency exchanges), it's very risky to submit false or inaccurate information.
The IRS has used court orders to demand cryptocurrency transaction information from exchanges. Coinbase was subject to such court orders that saw the exchange surrender crypto transaction data belonging to over 13,000 of its US customers.
To avoid facing serious criminal charges and hefty penalties like tax evasion, contempt, and possible jail time, you should never submit false returns. Retaining an experienced tax lawyer is the best defense as such a lawyer understands tax compliance and up-to-date IRS guidance on cryptocurrency transactions and cryptocurrency-related federal agency investigations.
IRS' Take on Virtual Currencies or Cryptocurrencies
As per the IRS Notice 2014-21, virtual currencies are digital representations of something of value that performs the functions of currency or money (i.e., stores value, is a unit of account, and a medium of exchange). As per the notice, the IRS views virtual currencies as property for federal income tax reasons.
Since 2014, the IRS has released other information relating to virtual currencies. In 2018, for instance, the agency issued a reminder on the importance of reporting virtual currency transactions and consequences (IRS audits, penalties, and interest charges). The agency issued severe consequences like criminal charges in extreme cases.
In 2019, the agency sent 10,000+ letters to US taxpayers guilty of failing to report their virtual currency income entirely or correctly. The letters (6173, 6174-A, or 6174) demanded that the taxpayers in question file amended returns or settle back taxes.
How to Report Crypto Transactions to the IRS
Cryptocurrency losses, gains, disposition, or income-triggering events need to be reported when filing returns. The events are reported on Form 8949 or Form 1040 Schedule-B/C or D.
Step 1: Establish the Existence of Crypto Transactions
First, you need to establish if your crypto dealings qualify as transactions – selling, exchanging, receiving, or acquiring, mining coins, launching or participating in ICOs (Initial Coin Offers, receiving airdrops, etc.).
As of 2019, the IRS' FORM 1040 was amended to include a question on whether you have received, sold, exchanged, or acquired financial interest in a virtual currency in the taxable year in question. Answering this question is mandatory. Most importantly, it must be answered correctly since the IRS may have information on your crypto dealings. A dishonest answer can result in criminal penalties, tax evasion charges, interest charges, jail time, and protracted criminal prosecution.
Step 2: Establish the Form of the Transaction
If you've had crypto dealings in the taxable year in question, the next step is establishing if those dealings are capital or ordinary, as different transaction forms attract different tax rates. The form of the cryptocurrency transaction depends on factors like the purpose of the transaction, nature of transaction, holding period, etc.
For instance, crypto trades, dispositions, and exchanges held for over a year can result in capital losses or gains. Such dealings – i.e., selling airdrops or exchanging digital tokens – are capital dealings. Ordinary dealings include those that have ordinary income – i.e., receiving airdrops, mining coins, or receiving payment from an ICO.
Step 3: Determine Capital Gains/Losses for that Year
Every time a US taxpayer disposes crypto, they incur capital losses or gains that must be recognized as per the IRS. The payable tax amount in question depends on factors such as the holding period (how long a cryptocurrency is held) as well as a taxpayer's annual income. If you hold crypto for a year or less, this results in a short-term capital gain/loss. Holding periods longer than a year attracts a long-term capital gain/loss.
Once the transactions are grouped in regard to the holding period, they are netted. Short-term capital gains attract an income tax rate that can amount to 37%, while long-term capital gains attract lower tax rates such as 20%, 15%, or even 0%, depending on income. If you make a capital loss, you can offset the capital gains made on other assets up to $3,000 (of ordinary income).
Step 4: Fill out IRS Form 8949
The next step is completing Form 8949 used to report capital asset dispositions and sale. The form was originally used for bonds and stocks but included cryptocurrency capital assets. You should include short-term and long-term gains and losses as well as the amounts reported in Forms 1099-B/1099-S.
Step 5: Transfer Net Amount
The net amount gained or lost calculated and recorded on Form 8949 should also be included in Schedule D which allows US taxpayers to report capital gains/losses from cryptocurrency activity and all other sources.
Step 6: Calculate Cryptocurrency Ordinary Income, If Any
Crypto can be made/earned from many activities ranging from mining to staking, employment, receiving airdrops, etc. This income must be taxed and needs to be recognized by filling out different forms depending on how income was received.
Schedule 1 form is used for reporting crypto income earned as a hobby or from forks, wages, and airdrops. Schedule B is used for reporting interest from crypto staking, while Schedule C is used for reporting crypto earned through business operations – i.e., receiving crypto as payment from crypto mining. The report entered in Schedule 1, Schedule B, and Schedule C is recorded as other income, interest, and self-employment income, respectively.
Step 7: Complete Other Tax Return Sections
Reporting taxable events involving cryptocurrency is a challenge. Once you are done, completing the other tax return sections is easy.
What Happens If I Fail to Report Crypto Transactions to the IRS?
As mentioned above, inaccurately reporting crypto transactions or failing to report them can attract serious consequences ranging from civil to criminal penalties and jail time for filing false returns and evading taxes.
Tax evasion can attract fines not exceeding $100,000 and prison time (up to 5 years). Filing an inaccurate tax return can result in fines up to $100,000 and a 3-year prison sentence.
The IRS usually asks cryptocurrency exchanges about crypto transactions, investments, trades, and other dealing involving US taxpayers. The agency can also use subpoenas to force exchanges to provide such information. Considering IRS audits have increased dramatically and are likely to continue rising in the future, US taxpayers and entities with crypto interest and dealings must be proactive about retaining law firms with experience in tax law as well as the ever-evolving cryptocurrency landscape.
“US taxpayers must take the IRS very seriously on its cryptocurrency mandate and do whatever it takes to be compliant. The IRS has expanded its analytic and investigative tools on taxpayers using virtual currency legitimately and otherwise. The agency is willing to prosecute taxpayers with illegal crypto dealings for offenses such as tax evasion, contempt, and perjury. If you receive correspondence from the IRS relating to your cryptocurrency transactions, get taxation and legal advice immediately to reduce your exposure." – Dr. Nick Oberheiden (Founding Attorney, Blockchain Lawyers)
Summary
The IRS started investigating virtual currency transactions by US taxpayers several years ago and is more aggressively investigating such matters. The agency is now using a multitude of tools ranging from sending letters to conducting audits and launching criminal investigations.
IRS Criminal Investigations are increasingly targeted at virtual currency transactions and the individual US taxpayers and entities behind them. The IRS pursues cryptocurrency exchanges like Coinbase for crypto transaction information. Hiding or omitting important details about your crypto dealings can be uncovered easily and result in serious problems like tax evasion charges and jail time.
If you perform crypto transactions and haven't reported all transactions, get legal help now. Contact our knowledgeable tax and crypto attorneys today.
