Digital assets are becoming increasingly prevalent in financial markets. It is now estimated that over 40 million Americans, or 16% of the adult population, invest in, trade or otherwise transact using cryptocurrencies. Accordingly, the IRS is expanding its digital asset examination and enforcement efforts.
Underreporting of digital asset transactions
Currently, there is a considerable risk of tax evasion related to digital asset transactions. The decentralized and anonymous nature of digital assets, coupled with the absence of broker reporting requirements and limited understand of how the principles of taxation apply to digital assets among investors, has led to significant underreporting of taxable income.
The size of the tax gap created by the underreporting of digital asset transactions is hard to calculate. In 2020, only 2.3 million taxpayers answered that they received, sold, sent, exchanged or acquired any financial interest in a virtual currency. This represents less than 10% of the projected number of taxpayers who engaged in digital asset transactions in that year. A recent Barclays analysis found that investors are likely paying less than half of the taxes they owe on virtual currency trades. And, in 2021, former IRS Commissioner Chuck Rettig estimated tax evasion has reached $1 trillion annually, citing cryptocurrency transactions as a driving factor.
The 2021 Infrastructure Investment and Jobs Act created a new reporting requirement for digital assets, including cryptocurrencies. The legislation will require brokers to report digital asset transactions on a Form 1099. The law was set to go into effect Jan. 1, 2023; however, the implementation is currently delayed indefinitely, until the IRS is able to issue a set of final regulations.
2022 question on digital assets
This year, individual income tax filers must answer the following question on their return:
“At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”
While this question is not new, the scope is significantly broader than in prior years, capturing a myriad of transactions and expanding to include all digital assets, not just virtual currency.
Taxpayers who meet any of the following criteria must answer “yes”:
Taxpayers may answer “no” if they did not transact using digital assets or their activity was limited to:
Individuals should answer this question honestly. Answering incorrectly will not prevent the IRS from discovering a taxpayer’s digital asset transactions.
IRS focus and enforcement efforts
The IRS is aggressively pursuing digital asset transaction enforcement efforts. In 2021, the IRS unveiled Operation Hidden Treasure, a joint effort between the Office of Fraud Enforcement and the Criminal Investigation Unit, focused on taxpayers who omit cryptocurrency income from their tax filings. This joint venture will pursue both civil and criminal cases. Civil cases are subject to a civil fraud penalty of up to 75% of the understatement of tax as well as interest charges.
The IRS has also been using John Doe summonses to gather information on taxpayers who use cryptocurrency. In recent years, federal district courts have granted the IRS authority to investigate several cryptocurrency exchanges, allowing the IRS to obtain tax-related information on unknown taxpayers who fit the criteria in the summons. Information acquired is used by the IRS to assess taxes and penalties on unreported or underreported taxable income of noncompliant taxpayers.
Taxpayers should consider utilizing one of the many digital asset tax reporting software platforms on the market in order to accurately capture all of the activity in a tax year. Note that the reports provided by the software platforms require clean up and identification of more complex transactions. This process can be time-consuming if one is working with a new vendor and having to sort through a mountain of transactions, so this step should not wait until the last minute. Individuals should also analyze whether the outputs have picked up all their activity for the tax year.
Items that should also be brought to the accountant’s attention, but may not have been captured in tax reporting software platforms:
Finally, if individuals have experienced any significant gains, they may be required to make quarterly estimated tax payments during the year to minimize or prevent penalties and interest on unpaid taxes. So, it is crucial that taxpayers discuss their digital asset activity with their Baker Tilly advisor.
For more information, please visit Digital Assets at Baker Tilly.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.