IRS to Cryptocurrency Owners: Come Clean, or Else!

Cryptocurrency News

The Internal Revenue Service is on the war path against Americans who haven’t reported income from cryptocurrencies like bitcoin.

In late July, the IRS said it had started to send warning letters to more than 10,000 people who may not have complied with tax rules on virtual currencies. Agency officials have said criminal tax indictments involving cryptocurrencies are expected soon, and other enforcement letters are going out.

Tax specialists are urging crypto users who aren’t in compliance to act quickly. While coming clean involves a maze of tricky decisions, ignoring the agency could cost a crypto holder dearly.

“I tell them, ‘It’s time to put your running shoes on.’ You must get to the IRS before they find you, especially if you got a letter,” says Bryan Skarlatos, a criminal tax lawyer with Kostelanetz & Fink in New York.

Dealing with the IRS disclosure maze is Mr. Skarlatos’s specialty: He guided nearly 2,000 U.S. taxpayers through it when they confessed secret offshore accounts between 2009 and 2018. He performed triage for more, telling those with cases that wouldn’t land them in prison about simpler solutions.

The IRS’s crypto crackdown has similarities with its offshore-account campaign. Mr. Skarlatos has handled about a dozen high-dollar cryptocurrency cases.

Mr. Skarlatos says people in possible violation of IRS rules should first look for signs of tax fraud. It must involve intentional disobedience of the law. One clear sign is a large amount of unpaid tax, say above $15,000, he adds.

Other signs of fraud can be efforts to disguise cryptocurrency ownership, as by using an assumed name; using a “tumbler” service that mixes some cryptocurrency with others to obscure the original source; and lying to a prior tax preparer—because the IRS will ask.

If there was fraud, the crypto owner will need a lawyer to provide attorney-client privilege. The owner should probably apply to the IRS’s Voluntary Disclosure program, which often levies large civil penalties but protects against criminal prosecution.

If the wrongdoing wasn’t fraudulent, the crypto owner can often file what is called a qualified amended return, typically through an accountant. This will avoid some penalties but not interest.

There is an important exception for crypto owners who weren’t fraudulent but are already known to the IRS. This category includes people who were outed when a federal court required Coinbase, the leading cryptocurrency exchange, to turn over information on about 14,000 customers to the agency.

When the IRS contacts wrongdoers about an audit before they come forward, Mr. Skarlatos says, they often face larger penalties than wrongdoers who weren’t known to the IRS.

The IRS is focusing on cryptocurrencies because their use is expanding, and enthusiasts often praise the anonymity virtual currencies offer. Many trades aren’t reportable to the IRS by third parties—unlike sales of securities such as stock shares, which generally must be reported to the IRS by brokerage firms.

An IRS analysis found that for 2013, 2014, and 2015, when more than 80% of returns were electronically filed, fewer than 1,000 e-filed returns each year reported transactions appearing to use virtual currencies. Coinbase said at the end of 2013 that it had 650,000 accounts. Now it has more than 30 million.

Cryptocurrency advocates are upset by the IRS’s campaign. They say the agency hasn’t yet released long-promised guidance, including how to pinpoint some fair market values; which cost-allocation methods to use; or whether the agency favors a small exemption for personal use. Recently, 60% of global bitcoin transactions were below $600, according to Coin Metrics, a cryptocurrency data provider.

“The scary IRS letters tell people to ‘accurately’ or ‘properly’ report their transactions, but what’s that? Maybe they would have filed if they had clear answers and hadn’t felt overwhelmed,” says James Foust, senior research fellow with Coin Center, an advocacy group.

Advocates also point out that tax reporting is onerous because the IRS classifies cryptocurrencies as property akin to stocks or a home. If someone uses bitcoin to buy a car or lunch, that is typically a taxable sale—as it would be if the person paid in shares of stock.

If the selling price of the bitcoin is higher than its purchase price, then the profit is typically taxable at capital-gains rates. If the selling price is lower, there may be a deductible capital loss. Frequent traders can have thousands of transactions to detail on IRS Form 8949, and cryptocurrencies’ volatility can yield both gains and losses within a short period.

The IRS will dismiss these arguments, says Jordan Bass, a certified public accountant in Los Angeles who says three-quarters of his tax-prep practice involves cryptocurrencies, a specialty he turned to after advising friends with bitcoin.

“The tax framework has been clear since 2014,” he says. “The IRS isn’t going to impose terrible penalties on good-faith efforts, but it will try to make an example of bad actors.”