How To Avoid A Crypto Tax Audit

In recent years, cryptocurrency and blockchain technology has grown in popularity and ubiquity. Bitcoin and other forms of cryptocurrency have experienced unprecedented growth in recent years, resulting in significant gains for many investors. 

The rise of cryptocurrency has also piqued the interest of the Internal Revenue Service (“IRS”). But what is a cryptocurrency, and why is the IRS becoming more interested in it? Take a deep dive below on the best IRS audit defense for cryptocurrency transactions.

What Is Cryptocurrency?

For record-keeping, cryptocurrency relies on blockchain technology. A blockchain is a digital system that organizes data that is added to ledgers in blocks or groups of data. 

Each block can only store a certain amount of data. As a result, new blocks are added to the ledger regularly. These blocks stack on top of each other, forming a chain. When a block is filled, then it’s considered complete. 

Afterwards, each block in the chain receives a precise timestamp as a digital signature.

Moreover, federal taxation in the United States treats cryptocurrency as a form of property and currency. 

Crypto exchange departs from the rest of the world, which regards it as fiat currency, or government-issued currency, not backed by a physical commodity. 

As a result, cryptocurrency gains and losses are observable and taxable. An actual business happens when cryptocurrency is sold or used to purchase goods or services.

Property sales or exchanges are taxed at long or short-term capital gain rates.

A cryptocurrency holder must know the basis of their cryptocurrency and the fair market value. Then, primarily when it is sold or transferred, calculate the amount of capital gain or loss on the sale or exchange of cryptocurrency. 

Short-Term Vs. Long-Term Capital Gain

To calculate the appropriate capital gain rate, the cryptocurrency trader must determine how long they’ve held the virtual currency, and this needs to be done before liquidating the amount.

Short-Term 

Short-term capital gain is an individual’s profit from the sale or exchange of virtual currency for less than one year. 

Currently, the government taxes short-term capital gains at up to 37%. This is on top of a 3.8% NIT in some cases.

Long-Term

On the other hand, a long-term capital gain is the profit gained from the sale or exchange of virtual currency held for more than a year and is currently taxed at up to 20%, plus a 3.8 per cent Net Investment Tax, also known as NIT in some instances. 

Currently, the government taxes short-term capital gains at up to 37%. This is on top of a 3.8% NIT in some cases.

As a result, the number of IRS audits of cryptocurrency transactions is growing. This article discusses how cryptocurrency owners can avoid an IRS audit.

What Is The Current Tax Landscape for Cryptocurrency?

The IRS has not actively enforced tax laws on cryptocurrency transactions in recent years. However, since 2014, the IRS has stated that virtual currency is a form of property subject to the same tax laws as stocks or other securities.

However, it has not taken a hardline stance in enforcing this policy. Recent developments indicate that this may be changing. 

Over the last few years, the IRS has steadily increased the number of audits it conducts on cryptocurrency transactions involving US taxpayers. Moreover, these audits will likely continue to rise significantly in the years ahead.

The IRS has been hiring outside contractors who are cryptocurrency experts since 2020. However, the IRS will only hire these experts if they intend to increase the volume and intensity of cryptocurrency audits.

Other indications are that the IRS is stepping up its enforcement of cryptocurrency transactions. For example, the IRS sued Coinbase, one of the largest virtual currency exchanges, in 2017 to obtain the names and account information of Coinbase account holders. 

The IRS noted that Coinbase had nearly six million customers between 2013 and 2015, but less than a thousand US taxpayers filed tax returns reporting cryptocurrency gains. As a result of the litigation, Coinbase turned over the information of approximately 13,000 account holders to the IRS in 2018. 

Unsurprisingly, the IRS sent approximately 10,000 letters to cryptocurrency account holders. The IRS used the letters to inform the account holders that cryptocurrency gains are taxable and that they should consider amending previously filed tax returns. 

Although not everyone who received a letter had a problem with their return, they reminded account holders that they must report their cryptocurrency transactions to the IRS or face an audit.

What Could Result In An Irs Audit? 

To identify specific tax returns for auditing, the IRS employs advanced data mining techniques, powerful computing hardware, and automated systems to detect income underreporting. 

For example, the IRS Automated Under Reporter system compares income reported on a tax return to income reported on W-2, 1099, 1098, and 1096 forms. 

The individual’s return is flagged for audit if it fails to address the income identified on one of these forms. This type of audit is computer-driven and is typically resolved by calculating the new tax plus penalties and interest due to unreported income.

In reality, many cryptocurrency traders are audited. Why? Because they failed to report a 1099-K or 1099-B from a cryptocurrency exchange on their tax return.

What Should You Do If You Believe You Have Underreported Your Cryptocurrency Income In Previous Years? 

First, you should be aware that the IRS has the authority to audit your finances and determine whether or not you have underreported your cryptocurrency income. Therefore, if an IRS audit occurs and underreporting is discovered, you will be required to pay the taxes you would have paid if you had reported your income correctly. 

Furthermore, the IRS will seek interest on any unpaid balance and may levy a civil penalty. In some civil cases, the IRS will often seek a penalty of 20% of the understatement of the owed tax if a taxpayer’s negligence caused the understatement.

However, if fraud is proven to be involved, the IRS may demand up to 75% of the tax owed. If the return is more recent, you may be able to file an amended tax return to correct any underreporting. However, for older returns, you will require the assistance of a professional. 

Either way, you should seek the advice of a tax and cryptocurrency attorney to guide you through the process. An experienced attorney can help you avoid a criminal charge by showing you through a civil disclosure to the IRS or presenting you with other options.

Under-reporting is generally treated as a civil matter by the IRS. Failure to report something because you did not fully understand your reporting obligations is not usually considered a criminal offence. 

Nonetheless, it is critical to understand that knowingly or willfully evading taxes can result in criminal charges. 

In short, if you were aware that you were required to report your cryptocurrency income but failed to do so, you may be held criminally liable for tax evasion. If you believe you may face criminal charges for failing to report your cryptocurrency income, you should immediately consult a criminal tax defense attorney about tax audit defense.

Discussing the matter with your accountant is not advisable because your conversations with your accountant are not as confidential as your communications with an attorney are. 

The IRS may request an accountant to testify against you and be forced to share information about you with investigators. Keeping track of your transactions cannot be easy if you trade cryptocurrencies regularly. 

Some exchanges will provide you with a tax form detailing your cryptocurrency gains. However, many deals will not offer you this information. 

Suppose you are or plan to trade in cryptocurrency. In that case, it is recommended that you use cryptocurrency management software with audit support to track your transactions and accurately record any gains from your trades. 

Having accurate and complete documentation will be highly beneficial if you become the subject of an IRS audit.

What To Do If The IRS Has Contacted You?

If you have already been contacted by the IRS or believe you will be, you should contact an experienced tax attorney immediately to discuss tax audit defence. 

An attorney with experience in cryptocurrency transactions can assist you in navigating the audit and preventing your case from escalating into a criminal investigation. 

The content of audit requests can vary, but generally, it will require you to disclose all your account details, including any wallet IDs, blockchain addresses, digital currency exchange accounts, and details on any transactions you made.

Sometimes, you would need to provide documents—for example, all correspondence with all counterparties to a virtual currency transaction. 

Having an experienced attorney assist you with this process will ensure that you do not make any mistakes and will help you resolve the audit as quickly as possible.

Final Thoughts

Cryptocurrency tax audits by the IRS are on the rise. If you own cryptocurrency, you should plan for an IRS audit ahead of time. Maintain records of your cryptocurrency transactions and have them converted into US dollars. 

It would be best to track how you determine your cryptocurrency’s value, and you must keep these records for as long as possible. Although the IRS has been slow to audit returns in recent years, it has increased its enforcement of cryptocurrency transactions. 

You can reduce your exposure to the following by using this article to remind you to minimize the risk of an IRS audit.

• costly tax adjustments
• penalties
• interest