Understanding Voluntary Compliance
To answer the above question conclusively, it is important to understand how the IRS works. Generally, the IRS relies on voluntary compliance. It is usually expected that taxpayers voluntarily comply on tax matters by reporting all their taxable transactions yearly.
Enforcement actions support voluntary compliance, so taxpayers who don't comply voluntarily can expect some form of action, i.e., hefty penalties. However, many taxpayers still fail to report cryptocurrency transactions voluntarily.
Why Do Many US Taxpayers Fail to Report Cryptocurrency Transactions Voluntarily?
Some taxpayers genuinely don't know if they should report crypto transactions to the IRS. Others don't know the exact elements of a cryptocurrency transaction that should be reported. There are also those who think the IRS has no way of tracking cryptocurrency transactions.
Can the IRS Track Cryptocurrency Transactions?
Yes. The IRS doesn't rely heavily on voluntary compliance on cryptocurrency matters. It has several methods it uses to track cryptocurrency and prosecute those who are found guilty of tax evasion.
Brief Background on IRS Cryptocurrency Tracking
Since 2014, the IRS has treated cryptocurrency as property subject to federal income taxes. However, less than 1,000 taxpayers reported cryptocurrency transactions between 2013 and 2015.
Since then, the IRS has attempted to enforce tax laws on cryptocurrency. In 2019, the revenue service sent 10,000+ letters to persons it believed failed to comply with virtual income reporting requirements.
The same year, the IRS adjusted the Schedule 1 Form, adding a question asking US taxpayers explicitly whether they'd profited from cryptocurrency that year. This new question required taxpayers to state if they had sent, received, sold, exchanged, or acquired a financial interest in a cryptocurrency.
In 2020, the question was moved to Form 1040, which is used by all US taxpayers to file annual income tax returns.
How Does the IRS Track Cryptocurrency?
There are two main methods the IRS uses to track crypto if a taxpayer fails to disclose transactions voluntarily. They include:
I. The IRS Gets Information from Cryptocurrency Exchanges
The IRS can compel many cryptocurrency exchanges doing business with US taxpayers to provide cryptocurrency transaction information about such persons. Cryptocurrency exchanges that provide their US clients with Forms 1099-K or 1099-B report transactions to the IRS. If your exchange has ever required you to fill out these forms, the IRS probably knows about your crypto transactions.
Individuals who make 200 or more crypto transactions every year valued over $20,000 should receive Form 1099-K, showing monthly proceeds. Crypto exchanges doing business with American taxpayers must generate these forms for all users who meet the set criteria. What's more, copies of these forms must be submitted to the IRS.
As a result, if you file your tax return but omit your cryptocurrency activity, the IRS can automatically flag the return. Persons who receive Form 1099-B but fail to report the same on their returns are also bound to have their returns flagged.
Which exchanges comply with the IRS cryptocurrency reporting?
Coinbase, Binance.us, Kraken, Uphold, and Gemini are well-known cryptocurrency exchanges that report transaction activities of US taxpayers directly to the revenue service. Any tax forms you get from these exchanges usually end up with the IRS.
The IRS also issues subpoenas in its efforts to track virtual currency transactions. In the past, the IRS has issued many crypto exchanges with subpoenas to force them to disclose specific cryptocurrency user account information.
In 2018, for instance, the IRS used a subpoena to force Coinbase to disclose user account information belonging to 13,000+ users. The information included names, birth dates, taxpayer-identification numbers, transaction logs, periodic account statements, etc. While the scope of the original subpoena was challenged (reduced from approximately 480,000 to 13,000 users), Coinbase was still compelled to provide information and went further to notify its affected users of the IRS' request.
Besides Coinbase, the IRS has issued subpoenas to other exchanges like Circle, Kraken, and Bitstamp. In a nutshell, the IRS can find out whatever it requires concerning US taxpayers and their transactions in respective exchanges. Using subpoenas, the revenue service can discover which US taxpayers trade via specific exchanges, how often they transact, what cryptocurrencies they transact, the scope of cryptocurrency transactions they report to the IRS, and more.
While subpoenas can be cumbersome when issued to exchanges, they have proven to be effective in catching non-compliant taxpayers in the US.
III. Other IRS Efforts to Enforce Cryptocurrency Reporting
Besides relying on voluntary reporting from exchanges or using subpoenas, the IRS consults blockchain companies to stay ahead of the cryptocurrency ecosystem. Through these companies, the IRS utilizes advanced technologies like machine learning and advanced data analysis to flag suspicious cryptocurrency activity in various exchanges. The IRS can monitor billions of crypto transactions with ease and pursue American taxpayers who under-report their crypto activities.
What Should You Do about Your Cryptocurrency Transactions?
It's advisable to voluntarily comply with the IRS' requirements on cryptocurrency transactions and other tax matters. If you have a cryptocurrency account with exchanges that do business with American taxpayers, you can rest assured that the IRS could already have your information. Being proactive about your crypto dealings eliminates financial penalties and other unfavorable tax liabilities, such as being charged for criminal tax evasion.
There is an increased interest and enforcement of crypto tax laws currently and a huge incentive for the IRS to track virtual currency transactions. If you buy, sell, send, receive, exchange, or have acquired financial interest in any cryptocurrency, plan to report all your transactions to the revenue service.
Individuals who get Forms 1099-K or 1099-B can comply easily. However, even if your exchange hasn't provided these forms, you are obligated to maintain your own records to enable you to compute your tax liability accurately.
If your cryptocurrency tax matters are complex, you can consult a cryptocurrency tax expert or other advisors to assist you with proper crypto transaction reporting to the IRS.