By: Nick J. Richards, Esq.
Digital currency owners have the attention of the IRS and Congress. The Inflation Reduction Act (IRA) allocates an additional $45 billion to the IRS for monitoring and enforcing compliance in digital asset reporting. IRS studies show that a large percentage of digital asset owners are not in compliance with their tax reporting (and payment) obligations. Targeted audits and compliance letters have begun and will likely increase in 2024 as the IRS audit program ramps up.
Early on, there was uncertainty as to whether Bitcoin and other cryptocurrencies would be treated and taxed like currency or stock. It was largely a theoretical question until cryptocurrencies started to increase in value and taxpayers recognized real wealth. In 2014, the IRS ruled that digital currencies were assets (like stock) that were taxed upon their sale and sellers were thus subject to capital gains tax. Capital gains tax rates depend on the taxpayer’s holding period – assets owned for more than a year on sale are subject to lower long-term tax rates and assets held for less than a year are subject to short-term capital gain (equivalent to income tax) on sale.
As with other areas of tax non-compliance, misunderstanding the tax requirements together with the belief that the IRS couldn’t find out, led to widespread non-compliance and IRS focus.
In 2019, the IRS issued a John Doe Summons on Coinbase and obtained digital asset account holder names, identification numbers, addresses, account records, and other information. The IRS then sent Letter 6173 to over 10,000 cryptocurrency owners in 2019 and followed with audit letters to suspicious cryptocurrency taxpayers in 2020. In 2021, the IRS served a John Doe Summons on Kraken, and on SFOX in 2022. These fishing expeditions – as they are often called – are likely to produce taxpayer information that the IRS will use to issue Letters 6173 alerting taxpayers to a discrepancy in their records and tax returns. Correspondence, office, and field audits are also likely and some of these audits could turn into criminal investigations, prosecution, and jail time.
The IRS has different operating divisions that conduct audits. LB&I (Large Business & International) is the IRS division that audits large companies and international issues. SB/SE is the IRS division that audits small businesses and self-employed individuals. LB&I audits often involve teams of revenue agents and they are governed by strict rules as to how the audit progresses and information is provided. SB/SE conducts different types of audits depending on the taxpayer and issue.
Correspondence Audits are the most common and simple type of examination the IRS conducts. The audits are conducted through the mail by an IRS Service Center, and they are generally limited to a single issue based on reporting information (1099, W2, etc.). The IRS computer can easily track reporting information and match it to tax information it has on file for specific taxpayers. If the IRS shows a 1099 wasn’t reported on a tax return, the taxpayer may receive a CP2000 (or Letter 6173 for crypto) proposing additional tax for the unreported item. The taxpayer can then accept the determination or provide further information for IRS review.
Office Audits require taxpayers to gather their records and meet with an examiner at the local IRS office. They are generally limited in scope and involve small schedule-c businesses and personal tax issues. They are not handled by full IRS Revenue Agents.
Field Audits are conducted by revenue agents at the taxpayer or taxpayer representative’s business. They generally involve a comprehensive examination of multiple tax years, and the revenue agent has discretion to expand (or limit) the scope. The determination to expand is based on the likely existence of non-compliance in other areas and the taxpayer’s cooperation with the examiner. Expansion can include additional years, businesses, and severity of the audit. Of particular concern are field audits conducted by Special Enforcement Program (SEP) revenue agents. These audits appear like any other field audit, but SEP agents are specially trained to conduct civil audits of taxpayers who may have criminal exposure. The SEP agent and SEP manager are trained to conduct the audits so to enable an efficient hand-off to a criminal investigator if warranted.
Finally, Taxpayer Compliance Measurement Program (TCMP) Audits are detailed line-by-line audits that can be very intrusive and complicated. The IRS reports that taxpayers under TCMP audits are selected at random and that the detailed audits are used to determine further areas of IRS enforcement and allocation of resources.
With special enforcement programs like crypto, the IRS trains a special cadre of revenue agents to conduct the specific program audits. The agents are empowered with standardized document requests and taxpayer interview questions. The program and agents are supported by IRS attorneys and management, and IRS collections may also be involved and assigned early to collect. It is often the objective of revenue agents to contact taxpayers and ask the difficult questions before they are able to hire a tax attorney to represent them.
Taxes are complex and taxpayers often fail to understand the severity of their situation. We have years of experience successfully handling IRS and State tax audits and we can help with your crypto/virtual currency compliance. If you have not been contacted by the IRS, you have the opportunity to voluntarily comply and if you received Letter 6173 you know the IRS is watching. It may take time, but they will likely take some action against taxpayers who receive the compliance letter but fail to report their digital currency transactions.
Meanwhile, digital currency holders who receive audit letters are well advised to speak to an experienced tax attorney before they talk to anyone else. There is no privilege for taxpayer communications with CPAs and tax preparers – and accountants are often key IRS witnesses in criminal tax cases. If you have a digital currency tax issue, we are available – call us today.
