The recent US Internal Revenue Service (IRS) memo that addresses cryptocurrency pre-2018 transactions has caused a lot of concern among many members of the cryptocurrency space.
While space is growing, the issue of taxation has always been and will always be a thorny one.
We reached to Wendy Walker, the Solutions Principal, Sovos to tell us more about it. Here is what she had to say.
Wendy Walker, Solutions Principal at Sovos
What exactly is the attitude or response of the US Internal Revenue Service (IRS) towards cryptocurrency transactions?
The Treasury and IRS have been slow to react to the swiftly changing cryptocurrency environment. Bitcoin has been actively traded since 2010, yet the first acknowledgement from the IRS to taxpayers that income tax obligations even existed related to crypto transactions wasn’t until 2014 (Notice 2014-21). That six-page document contained responses to 16 Frequently Asked Questions and left many more unanswered. Taxpayers didn’t receive more guidance from the IRS until five years later (Rev Rule 2019-24 and updated FAQs) when the market cap had grown by almost 300%. While that guidance provided more insight, it still left a lot unknown.
Simultaneously, the IRS began a campaign of education through enforcement. The IRS levied a John Doe Summons on Coinbase in 2017 for prior year tax information by its’ users and they followed up with those users by sending thousands of enforcement letters (Letters 6174, 6174-A, 6173) throughout the late summer of 2019 and 2020. Other taxpayers received Notice CP2000 from the IRS, indicating that the information they reported on their income tax returns did not match the information that had been reported on Forms 1099 by third-parties. And this cycle is only exacerbated by the recent John Doe Summonses levied on Circle and Kraken for prior tax years.
Despite all of this enforcement, there has been no follow-on guidance for taxpayers, tax preparers, nor industry tax professionals who are obligated to report income related to cryptocurrency transactions. As a result, third parties don’t report Forms 1099 for income they pay and taxpayers don’t report all of their earnings (or report it correctly) related to cryptocurrency transactions.
In April, the IRS Commissioner Rettig testified before the Senate Finance Committee that the $2T cryptocurrency market was a contributing factor in the growth of the estimated Tax Gap (the gap between income taxes owed versus what is actually paid/collected) and subsequently, the Treasury Greenbook has outlaid proposals for new information reporting requirements by third parties related to cryptocurrency transactions. Further, the hotly debated American Families Plan contains proposed regulations to require additional reporting by cryptocurrency exchanges (and other financial institutions) related to transactions by their users.
How exactly were cryptocurrency exchanges taxed before 2018?
I don’t think that there has ever been an ‘exact’ when it comes to tax reporting for crypto transactions – including now in 2021. As a taxpayer community, we have relied on existing tax law and the limited guidance the IRS has published through Notice 2014-21, Revenue Ruling 2019-24, and the virtual currency FAQ. In contrast, a taxpayer has a myriad of IRS resources available to them to describe how to calculate gains and losses related to securities and commodities transactions in Publication 550 or 551 and the Instructions for Schedule D of Form 1040 to name a few.
IRC section 1031 provides taxpayers an exception from recognizing gains or losses from exchanges of like-kind assets. Prior to 2018, many taxpayers took the position that exchanges of crypto for crypto were like-kind exchanges and thus deferred income tax on those earnings. Subsequently, effective January 1, 2018, the Tax Cuts & Jobs Act (TCJA) amended the language in IRC section 1031 to specify that tax treatment was only applicable to exchanges of ‘real property.
What are the implications of the new memo to the office of chief counsel on certain cryptocurrency transactions before 2018? Will there be back taxes to pay?
The implications in the General Counsel Memorandum are significant to taxpayers that treated exchanges of Bitcoin, Ether, and Litecoin as ‘like-kind for tax purposes for years prior to 2018. The Office of Chief Counsel articulated the detailed unique use-cases for which Ether and Bitcoin played in the market at that time and concluded that exchanges of Bitcoin for Litecoin or Ether for Litecoin would not qualify for like-kind exchange tax treatment.
Even more significant is that they also concluded that swaps of Bitcoin to Eth were not like-kind exchanges either, because although Ether and Bitcoin are both payment networks, the Etherium blockchain is also a platform for operating smart contracts. This characteristic difference sets Ether apart from Blockchain – at least for like-kind tax treatment purposes.
Taxpayers who took the like-kind position on these trades prior to 2018, will be exposed to back taxes, penalties, and interest. Generally, there is a 3-year statute of limitation from the date the income tax return was filed so crypto investors would need to go back and look at amending their 2017 income tax return and pay associated taxes, penalties, and interest.
However, there is also a special exception to note. There is a 6-year statute of limitation for people who fail to report at least 25% of their income. So crypto investors may need to look as far back as 2015 to determine whether their crypto investment earnings that were treated as like-kind exchanges represent 25% of their total income for those calendar years; and if so, they would need to amend returns and pay back taxes, penalties, and interest.
3-1. What are the implications of tighter taxation policies by the US IRS on cryptocurrency transactions and overall adoption?
Tighter policies only work when people actually understand the policies.
The enforcement approach to taxation of crypto assets rather than providing clear requirements to taxpayers of what to report is a waste of IRS resources and an unnecessary burden on taxpayers. As it stands, we have vague guidance for how crypto investors should report gains and losses related to cryptocurrency transactions and there is no guidance for how to report income from a variety of other crypto transactions including sales of NFT assets, staking rewards, lending income, and more.
To exacerbate matters, we also do not have any IRS guidance for third-party payers of the income who are required to report Forms 1099. The IRS uses third-party information return reporting as its’ primary enforcement mechanism, matching information reported by the third-party payer to the information that the crypto investor reported on their annual income tax return. With so many exchanges not reporting Forms 1099 and others reporting incomplete Forms 1099 information, neither the IRS nor the crypto investor is receiving accurate and reliable information.
Without clear tax reporting requirements for investors, third-party payers, and the IRS this cycle of education through enforcement hampers adoption of crypto by Wall Street investors at least, and at the same time will contribute to the growth of the Tax Gap.
Does the IRS have tools to detect tax avoidance or evasion in the case of cryptocurrency exchanges? How exactly would they be able to determine tax avoidance or evasion?
The IRS has a variety of document matching systems that they use to detect mismatches between income reported on third-party returns such as Forms 1099 and income reported on corresponding income tax returns by taxpayers.
As mentioned, there is no clear requirement for third-party reporting of crypto transactions and as a result, some exchanges do not report Forms 1099, others report incomplete Forms 1099 and this creates problems for taxpayers.
When an exchange doesn’t issue Form 1099, we’ve seen the IRS issue John Doe Summonses for prior-year tax information. This results in IRS enforcement letters and audits of taxpayers for which those exchanges turn over the requested information.
When an exchange issues an incorrect Form 1099, we’ve seen the IRS issue Notice CP2000 to taxpayers to identify the mismatches and propose taxes and penalties associated with the amounts that were not matched.
When it comes to criminal enforcement, the Criminal Investigations teams have contracted with third-party tax and accounting professionals to provide them with access to the blockchain data so that they can verify income amounts reported by certain taxpayers. In the FY22 budget, the IRS asks for funding to ‘improve the IRS’s ability to trace virtual currency transactions in financial investigations and utilize emerging tools and technology to combat cyber-enabled financial crimes” so I anticipate we will see other technology-enabled to better combat criminal cases.
Do you think we are seeing a shift from the various kinds of cryptocurrency taxation regimes to a singular window where all cryptocurrency transactions fall under similar kinds of tax? What are your thoughts on this?
In the US, we are already operating in a singular window and that is that convertible cryptocurrencies are treated as ‘property for tax purposes’ (Notice 2014-21) – and so that means that all of the applicable rules for taxing property transactions already apply. For example, sales or other dispositions of property held for investment purposes are already subject to capital gains tax in the U.S. whether the property that was sold or exchanged is gold, automobiles or cryptocurrency assets. Similarly, the United Kingdom, France, Switzerland, Australia – all treat cryptocurrency as ‘property’ and apply existing capital gains tax requirements to transactions.
As regulators come to understand the different use cases of blockchain technology and cryptocurrencies, I believe we will see the taxation principles evolve. The Treasury and IRS have formally prioritized cryptocurrency taxation initiatives for the Fiscal Year 2022 and with that will come a deeper understanding of things like stablecoins and NFTs and how those are different cryptocurrencies from Bitcoin, for example.
Do you think the Biden administration will use the IRS as its favorite tool against cryptocurrencies and their underlying technologies?
I think the Biden Administration is relying on recommendations made by the IRS in the last several Tax Gap reports along with findings in recent Treasury Inspector General for Tax Administration (TIGTA) and Government Accountability Office (GAO) reports related to taxpayer compliance with reporting and paying taxes associated with cryptocurrency transactions.
The analysis and conclusions in those reports indicate not only the sizable growth in the crypto market but also noncompliance by taxpayers engaging in cryptocurrency transactions. More importantly, they provide statistical evidence that when a taxpayer does not receive a third-party information return, such as a Form 1099 or W-2, they will likely not report that income and pay the associated taxes.
So rather than using John Doe Summonses and fishing for cryptocurrency investors by sifting through affirmative responses to the virtual currency question on page 1 of 1040, I think the Biden Administration is planning to arm the IRS with more efficient and reliable methods of enforcing tax compliance through third-party information reporting of transactions.