It is tax season in the United States and the Internal Revenue Service (IRS) has made it clear that it will be keeping an eye on crypto tax reporting compliance in 2020. Since late 2019, the IRS has moved towards making virtual currencies a major part of its tax compliance drive for the 2020 tax season.
IRS Keen on Robust Crypto Tax Reporting Compliance
Cryptocurrencies have grown in popularity throughout the last 10 years with the entire market capitalization currently standing at $284 billion. Despite the increase in trading activity and crypto ownership, the IRS has constantly highlighted the low tax reportage from U.S. cryptocurrency owners and traders.
In previous years, the IRS has issued information requests to major U.S. crypto trading platforms like Coinbase and Bitstamp. In a series of “John Doe” summons, the IRS demanded detailed customer information covering the period between 2013 and 2015.
The courts would eventually restrict the IRS probe to customers whose total transaction volume exceeded $20,000 during the period as the previous summons were deemed too broad, bordering on an intrusion into user privacy. By 2019, the IRS was sending warning letters to crypto holders advocating the need for accurate crypto tax reporting.
For IRS, the purpose of sending these letters was to draw the attention of crypto owners to their tax filing obligations. This move by IRS also signaled the agency’s intention to step up its enforcement of cryptocurrency tax compliance.
For the 2020 tax season, the IRS is taking steps to prevent anyone from claiming ignorance as a defense against improper crypto tax filing, by including a question that over 150m US taxpayers will face when completing their Form 1040. On the first page of Schedule 1, the IRS directly asks the question:
“At any time in 2019, did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency.”
A Framework for Establishing Willful Violation
By including a crypto-related question as part of the tax filing process for virtual currencies, the IRS is setting a legal framework to go after any instances of “willful failure” to declare cryptocurrency income. Take the Foreign Bank and Financial Accounts (FBAR) reporting, for instance, failure to check the “YES” box in Part III of Form 1040 constitutes a “willful” FBAR violation.
Going by this precedent, the IRS can go after crypto owners who fail to disclose virtual currency incomes when filing tax returns. Perhaps 2020 may be a watershed year in the fight against crypto tax evasion with potentially 150 million taxpayers having to honestly answer whether they hold any crypto investment positions. Failure to disclose crypto holdings could see crypto owners having to pay fines of up to $250,000 or even spend five years in prison.
The portion of the IRS crypto question that references sending and exchanging of cryptocurrencies has also caused some confusion as to the tax implications of simply moving crypto funds across wallets held by the same owner. The IRS, however, clarified the matter via its FAQ page saying:
“If you transfer virtual currency from a wallet, address, or account belonging to you, to another wallet, address, or account that also belongs to you, then the transfer is a non-taxable event.”
1099-K and What to do with it
U.S. exchanges like Coinbase have already been sending out 1099-Ks to customers that meet the stipulated transactional thresholds — gross payment above $20,000 from more than 200 transactions. These 1099-Ks contain information about the trading activity of a customer which includes deposits, withdrawals, and cross-exchange transactions to mention a few.
However, this form will not provide accurate data for a trader that trades across multiple exchanges. When cryptocurrency is sent from one exchange to another, the two exchanges involved do not maintain a record of the date and the original price (Cost Basis) for when the cryptocurrency was acquired.
For example, let’s say you have acquired 1 Bitcoin on Coinbase and then sent that Bitcoin to Binance. On Binance, 1 BTC was traded for ETH. Now your data is spread across two exchanges, one having your cost basis information and the other the Fair Market Value information and as this is not shared between each other, reporting becomes challenging, making the 1099-K unsuitable for determining actual crypto tax obligations. With the IRS classifying virtual currency as property, tax considerations center around capital gains and losses, as well as income tax if the ‘coins’ are received or paid as wages.
The 1099-K also doesn’t provide a first-in-first-out (FIFO) matching of trades so there is no way of determining cost basis. The gross reportable payment data contained in the 1099-K also presents an inaccurate picture of the crypto trader’s tax obligation as the usually high amount shown in the document is often nowhere near the actual taxable figure.
Information Deficit Still Persists for Crypto Taxes
While the IRS moves towards strict crypto tax reporting compliance, there still exists information gaps about certain matters relating to cryptocurrency tax filing. Even with the updated guidelines and FAQs, crypto traders still have to navigate through uncertainties when it comes to virtual currency taxes.
One of the major issues is the proper way to determine the cost basis for taxable cryptocurrency transactions. Obtaining cost basis requires the correct identification of the crypto transaction in question.
For cost basis calculation, it might be helpful to categorize crypto transactions along the lines of trade and income. Each of these two categories has specific cost basis considerations.
Trade covers crypto-to-crypto, crypto-to-fiat, and payments. In this paradigm, the purchase price of the crypto less the cost basis gives the capital gain or loss. The cost basis in this scenario is the purchase price of the crypto including exchange fees, divided by the number of the trader’s holdings in that particular cryptocurrency.
Income covers paying or receiving wages in crypto, mining, airdrops, and hard forks followed by an airdrop of new tokens. The cost basis for cryptocurrencies under this paradigm is the fair market value at the time of earning the digital tokens. Tax payment on crypto wages or cryptocurrencies acquired via mining or airdrops fall under Federal income tax rules.
Given the complexities involved in crypto tax reporting, commentators say the IRS is looking to people to take the initiative and self-report their crypto involvement even if there are inaccuracies in the actual figures. Meanwhile, some U.S. lawmakers and blockchain advocacy groups are pushing for the establishment of a ‘de minimis’ exemption for crypto taxes.
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