The IRS is actively working to resolve cryptocurrency transaction-related non-compliance. More than 10,000 tax notifications were delivered by the IRS to people who might not be in compliance in 2019. It handed out another round of tax letters to suspect taxpayers in the middle of 2020. The IRS didn’t send any letters in 2021, however this absence was more likely because of the IRS moving to remote work and dealing with stimulus-related concerns than it was due to a lack of attention.
These investigations focused largely on finding cryptocurrency traders and investors who were underreporting gains. However, because of the market downturn this year, the IRS will probably also pay attention to traders who overreport losses in an effort to reduce their tax liability.
In addition, with the Inflation Reduction Act (IRAadoption )’s in August, the IRS auditing activities are anticipated to intensify. The law set up $45 billion for “digital asset monitoring and compliance efforts,” which are specifically included in the list of enforcement activities. The agency will utilise these monies to purchase equipment and hire employees for audits and tax collection over the following ten years.
Taxpayers may be concerned about their exposure to IRS audits when dealing with cryptocurrencies in light of these developments. Some of the concerns might be reduced by learning the ins and outs of IRS audits and how to avoid them.
Key Ideas:
IRS Audit Types
IRS audits might be of one of four varieties.
Audits of correspondence
The IRS most frequently performs correspondence audits. These make up around 75% of the service’s tax investigations, and as of now, they are the only kind of crypto audit that the IRS has started based on the most recent data. These audits are carried out by the mail, as the name would imply. In mail inquiries, specific amounts indicated on your tax return are typically verified with further documentation.
For instance, the IRS sent letter 6173 in 2019 to select taxpayers who were made aware of the Coinbase subpoena and asked them to submit the precise gain and loss calculations for the reported bitcoin gains and losses. Following Coinbase’s subpoena, over 10,000 taxpayers received tax letters (Letter 6173, Letter 6174 & 6174-A).
IRS Office Audits
Face-to-face meetings held at an Internal Revenue Service office are IRS Office audits. You must appear in person at a designated IRS office during these audits and provide any documentation the examination officer requests.
IRS Field Audits
Compared to office and correspondence audits, field audits are more serious. To acquire thorough documentation, they are conducted at your house (or place of business). Business organisations frequently undergo these audits (as opposed to individuals).
Program for Measuring Taxpayer Compliance (TCMP) Audits
The most thorough sort of audits are TCMP audits, which can be a frustrating experience for taxpayers. Instead of just looking at a certain section of information, the IRS now examines every aspect of a taxpayer’s return and verifies the information with sources.
How To Avoid Audits For Crypto Taxes
The following situations may lead to an IRS audit of cryptocurrency owners.
Mismatches: 1099
You may receive three tax forms from cryptocurrency exchanges: Forms 1099-K, 1099-B, and 1099-MISCs. You will receive a CP2000 letter and be the target of a correspondence audit if you fail to include the amounts reported on these forms on your tax return.
For instance, let’s imagine you received a Form 1099-MISC stating that you made $1,000 by staking on an exchange. If you don’t mention it on your tax return, the IRS’s computer system (Automated Underreporter, or AUR) will automatically mark it as underreporting taxes by $1,000. The same rules apply if you obtain a Form 1099-B or Form 1099-K and fail to report them appropriately.
Because the IRS already has a copy of any tax forms you receive through exchanges, you should definitely disclose them to prevent a correspondence audit.
Information Obtained by Issuing Subpoenas to Exchanges
The IRS also conducts audits of cryptocurrency owners using data obtained through subpoenas. For instance, in 2018 Coinbase was compelled by a John Doe subpoena to reveal information about roughly 13,000 user accounts, including taxpayer identification number, name, birthdate, address, records of account activity, transaction logs, and all periodic statements of account or invoices (or the equivalent).
The IRS served Kraken, a San Francisco-based cryptocurrency exchange, with a John Doe summons in 2021, asking for information pertaining to the “investigation of an ascertainable group or class of persons” that it has a good faith belief “may have failed to comply with internal revenue laws.” Another Los Angeles-based exchange, SFOX, was ordered to provide information about specific cryptocurrency users in 2022.
Random Choice
You might be arbitrarily chosen for an audit in addition to 1099 reporting mistakes and subpoenas.
According to the IRS, sometimes, returns are selected solely based on a statistical algorithm. Your tax return is compared to “norms” for returns that are comparable to yours. We create these “norms” as part of the IRS’s National Research Program by auditing a statistically reliable random sample of returns.
Consider the scenario where you’ve been declaring an annual income of $50,000. However, you disclosed $2 million in cryptocurrency gains in 2021 since one of the coins you acquired in very early saw a significant rise. Even if you fully state the facts in this situation, you can still be chosen for an audit since your tax return is unusual compared to the return of the average taxpayer, who earns $50,000 year.
The same rules can be used to deduct excessive losses incurred during bad markets. Because they result in lower total taxable income and bigger tax refunds, reported losses are scrutinised more than profits. The IRS might be looking for tax filings that overstate the amount of losses because the market has recently swung downward.
By selling your submerged digital assets, you can use tax loss harvesting to deduct your income by claiming a capital loss. Investors in the cryptocurrency and stock markets both adhere to this ethical standard. As long as assets are sold to an unaffiliated entity subject to untainted market circumstances, their losses are legal.
However, in really bearish situations, dishonest individuals can be persuaded to use fraudulent tax loss harvesting to generate fictitious losses. They could, for instance, sell themselves underwater assets at steep discounts to feign losses. Pseudo-anonymity in the cryptographic field makes this quite simple to do.
Sam, for instance, has a $1 million NFT in Wallet A. Sam also has a wallet that goes by the name of Wallet B. Sam can deceitfully declare a loss of $900,000 ($100,000 – $1,000,0000) by “selling” the NFT to Wallet B for $100,000. Under random selection, these kinds of exorbitant and illegitimate losses could be recognized.
How to Reduce Audit Exposure
How to Reduce Audit Exposure Audits using 1099s are the simplest to prevent. By appropriately reporting amounts from 1099s on your tax return, you can fully avoid them. Unfortunately, there is little you can do about audits that are prompted by subpoenas because you have no influence over them. Keep thorough records of your bitcoin transactions and gain & loss computations in case you are chosen for an audit through subpoenas so that you may effectively defend yourself. Finally, to lessen the possibility of arbitrary audits, you can consult with an expert tax advisor and have your tax return completed professionally.
Next Steps
- Assemble every 1099 form, then appropriately report each one on your tax return.
- If you have a tax year with significant gains, see a seasoned tax advisor (or losses).
