The Internal Revenue Service (IRS) has had an interest in virtual currencies, including cryptocurrencies like Bitcoin, for several years. The IRS is looking closely at these transactions. Taxpayers should ensure that they are properly reporting these transactions now, before they get audited by the IRS or face a potential criminal investigation.
IRS Position on Taxation of Virtual Currencies
In a 2014 notice (Notice 2014-21), the IRS determined that virtual currencies are capital assets and result in gain or loss when they are sold or exchanged. In addition, virtual currencies may be taxed as income when they are received.
For example, assume that an individual has their own sole proprietorship (Schedule C) business and provides services to another business. For these services, the individual is paid BTC 1 (one Bitcoin) at a time when this BTC 1 was worth $20,000. Later in the same year, the individual buys a new vehicle with BTC 1 at a time when the vehicle was worth $45,000.
In this example, the individual has $20,000 of income when they receive the BTC 1 in exchange for the services provided. This income should be reported as gross receipts on Schedule C.
In addition, when the individual exchanges BTC 1 for a new vehicle, the individual has additional income equal to $45,000 minus $20,000, or $25,000 of income. This income is a short-term capital gain that would be reported on Form 8949 and Schedule D. In total, the individual has $45,000 of income from the two Bitcoin transactions, even though the individual has not received any U.S. Dollars to pay the tax on these two transactions.
IRS Past Enforcement of Virtual Currency Transactions
Since 2014, the IRS’s interest in virtual currencies has had three main phases.
In the first phase, the IRS began educating taxpayers about its position on virtual currencies. The IRS did this through a webpage devoted to virtual currencies, a webpage with frequently asked questions, and by issuing press releases to remind taxpayers about their obligation to report transactions.
In the second phase, the IRS began actively gathering information about taxpayers who engage in virtual currency transactions. This started through John Doe Summonses against businesses that facilitate cryptocurrency transactions like Coinbase in 2016, as well as Circle and Kraken in 2021. The IRS uses a John Doe Summons when it does not know the names of taxpayers. For example, the John Doe Summons issued to Kraken requests the names and transaction information for U.S. taxpayers who conducted at least $20,000 in transactions between 2016 and 2020.
For the taxpayers identified in the John Doe Summons responses, the IRS then sent 10,000 letters to taxpayers instructing them to properly report the virtual currency transactions. These letters included IRS Letter 6173, IRS Letter 6174, and IRS Letter 6174-A. Some of these letters (for example, Letter 6173) require a response by a certain date. Other letters may not require a response if the transactions were properly reported.
The second phase also included increased visibility for virtual currency transactions on IRS forms. For example, the most prominent question on the Form 1040 is now, “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” In addition, the IRS’s collection information statement (Form 433-A) includes a section where taxpayers can report their interests in virtual currencies. The Report of Foreign Bank and Financial Accounts (FBAR) rules will be revised to require individuals to report virtual currencies held in accounts located outside the United States. Lastly, the Infrastructure Investment and Jobs Act contained additional reporting requirements for virtual currencies.
In the third phase, the IRS and Department of Justice are now beginning to use this information to bring civil and criminal charges against individuals. For example, in February 2022, two individuals were arrested for allegedly laundering $4.5 billion in cryptocurrency, and as part of this, the government seized $3.6 billion in cryptocurrency. Later in February 2022, the Department of Justice also named the first Director of National Cryptocurrency Enforcement Team.
What to Do If You Are Investing in Virtual Currencies
Going forward, the IRS will increase the number of IRS audits (examinations) and criminal investigations related to virtual currencies. It is important that taxpayers correct any unreported virtual currency transactions before the IRS contacts them, so that taxpayers may potentially avoid penalties or criminal charges.
Are you concerned that you have not properly reported virtual currency transactions? Do you have potential criminal exposure? The Former IRS Attorneys of Holtz, Slavett & Drabkin, APLC can review your situation from an IRS perspective and advise on how to fix these tax problems before the IRS contacts you. We can be reached at 310-550-6200 to schedule a consultation.
David J. Warner is a former IRS senior trial attorney and a Principal and Shareholder at Holtz, Slavett & Drabkin, APLC. While at the IRS, David advised IRS revenue agents (auditors) on complex international and domestic audits and handled over 500 cases in U.S. Tax Court. David also taught tax practice and procedure, as well as tax courses on partnership and S corporation taxation, to IRS attorneys and to law students at Loyola Law School, UCI School of Law, and Chapman University Fowler School of Law. David regularly lectures about tax matters, including virtual currencies, to groups of attorneys and accountants. Please contact David at (949) 999-6606 to schedule a consultation.