As with any item of income or deduction, the recordkeeping responsibility to properly calculate gain or loss on trades of virtual currency is the taxpayer’s burden.
The Internal Revenue Service (IRS), through the use of data analytics and more likely through a summons issued to Coinbase, Inc. account holders (more on this later), is increasing its focus on the virtual currency industry by sending letters to taxpayers to ensure they are accurately reporting virtual currency/crypto transactions (think Bitcoin, among others). Even if you reported properly, you may still receive a letter, as some information reported to the IRS from the currency exchanges may contain inaccuracies. A letter from IRS is never a welcome surprise in the mail. The IRS reported that more than 10,000 letters were issued over the summer. Taxpayers receiving these letters have been targeted one way or another and may have failed to properly report income and pay the resulting tax from virtual currency transactions. By latest reports, the overall size of the crypto market is estimated at more than $150 billion, including value of blockchain companies, so it’s no surprise that the IRS has an interest.
Under current law, effective in 2014 when the IRS issued Notice 2014-21 (which is a concise FAQ providing guidance on how virtual currency transactions will be taxed in the U.S.), virtual currency is treated as “property,” with income generated by the trading of virtual currency taxed as a capital gain, at either short-term or long-term rates, for the taxpayer not in the trade or business of professional trading. If the taxpayer is a professional trader, the gain would be taxed at ordinary income rates as trade or business income. Pretty straightforward if you converted U.S. dollars to Bitcoin and then converted the virtual currency back to U.S. dollars for a profit. But what happens if instead, you use appreciated Bitcoins to purchase a new car, desk or HD television? In this instance, such transactions are treated as if the Bitcoin had been converted back to cash in a deemed sale, and the gain would be taxed as capital gain or ordinary income depending on the professional/nonprofessional status of the owner. Not many taxpayers are aware of this treatment and properly report the income. This is the win for the IRS.
Additionally, a taxpayer operating a business that receives payment for goods or services in the form of virtual currency must include in gross income the fair market value of the virtual currency, in U.S. dollars, at the time the virtual currency was received.
If the value of the currency at the time of sale, for accrual basis taxpayers, is different than at the time of collection, a gain or loss on sale must be recognized.
Furthermore, virtual currency received as payment for services constitutes wages for employees and self-employment income for independent contractors, and is subject to applicable withholding and information reporting requirements.
As with any item of income or deduction, the recordkeeping responsibility to properly calculate gain or loss on trades of virtual currency is the taxpayer’s burden. Unlike with most other investments, taxpayers are not provided a Form 1099 at year end displaying cost basis and selling price to determine gain or loss. Fortunately, several software packages have been developed to assist taxpayers in maintaining accurate records relating to their virtual currency transactions.
Since the use of virtual currency in everyday transactions is increasing and the concept is relatively new, the IRS is concerned that taxpayers trading or receiving virtual currency as a form of payment, as well as engaging in investment and trading activities, may be improperly reporting these transactions or not reporting them at all. According to IRS chief of criminal investigations Don Fort, virtual currencies pose a “significant threat” to collection efforts. As a result, the IRS is becoming more vigilant, with increasing focus on the development of new and heightened examination strategies surrounding virtual currency transactions. Fort also indicates that in the near future, the agency plans to announce criminal tax evasion cases centering around virtual currency.
Through increased use of data analytics and, we believe, information possibly collected from court-authorized John Doe summons (which does not identify the subject of the summons and is authorized by IRS, with approval from the court) to Coinbase account holders, IRS was able to target potential noncompliant taxpayers. IRS Commissioner Charles Rettig warns, “If you get a letter, and your name is on the letter, and it’s your home address or the address that matches your tax return, and it’s from IRS, and it’s encouraging you to maybe take a second look at your return, one might assume we had information.” Bottom line, if you get a letter, contact your tax adviser instead of attempting to reply to an IRS inquiry on your own.
What Letter Did You Receive?
Three different versions of the “education” letters were issued:
1. Letter 6173. Issued to taxpayers when, for one or more tax years between 2013 and 2017, IRS has not received either a federal income tax return (which may be an entirely separate and possibly a more serious issue) or an applicable form or schedule reporting the taxpayer’s virtual currency transactions, while the information provided to IRS from a virtual currency exchange reports transactions attributable to the taxpayer.
2. Letter 6174. Issued to taxpayers when IRS has information that the taxpayers have or had one or more accounts containing virtual currency but may not have known the requirements for reporting transactions involving virtual currency.
3. Letter 6174-A. Issued to taxpayers when IRS has information that the taxpayers have or had one or more accounts containing virtual currency but may not have properly reported the transactions.
Each version attempts to “educate” taxpayers of their filing. However, the letters have varying tones. Letter 6173 is the most demanding of the three. By a date specified in the letter, it requires either the submission of any unfiled tax return(s), filing of amended return(s) or for the taxpayer to certify under penalties of perjury that all tax reporting requirements relating to virtual currency were followed. If the taxpayer fails to respond by the date specified, the audit risk will increase. Letters 6174 and 6174-A are more informational in nature and do not require a response, however, if your virtual currency transactions were not reported properly, you should amend your tax returns as quickly as possible.
Despite Notice 2014-21 and the trend that virtual currency tax reporting is rapidly becoming a primary focus of current IRS compliance initiatives, there are many unanswered questions. For example, do the wash sale rules apply to loss transactions? Are virtual currency accounts required to be reported as foreign accounts on either IRS Form 8938, Statement of Specified Foreign Financial Assets, or FinCEN filings?
If you receive any type of correspondence from IRS, it is imprudent to ignore it. Do not respond directly. Comprehensive and thoughtful assessment is crucial. Whether investing, trading or purchasing goods and services, it is critical to maintain detailed records to ensure proper tax reporting and appropriate support in the event of an IRS inquiry. Don’t plan to rely on the traditional Form 1099 investment reports (as you will not receive one). However, you will receive a Form 1099-K from your third-party virtual currency network (Coinbase, etc.) if you received payments of $20,000 or more or if you engaged in more than 200 virtual currency transactions. As the world of virtual currency and related legislative activity continues to develop, as always, we are available to discuss the impact of a new or pending tax law on your personal or business situation.
For Further Information
If you would like more information about this topic or your own unique situation, please contact CPAs Philip Liotta, Michael A. Gillen or any of the practitioners in the Tax Accounting Group. For information about other pertinent tax topics, please visit our publications page.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.