Crypto Investors: Tax Declarations And Audit Risks

With the rise of cryptocurrencies, the IRS has been intensifying its focus on crypto holders. While the overall individual audit rates are low, the odds increase significantly as your income goes up. The IRS is getting more funding for audits, with a significant chunk of its extra funding over ten years dedicated to enforcement activities and collection measures. The IRS has also been working with contractors like Chainalysis to trace transactions and link 'anonymous' wallets to known investors. It has also issued John Doe Summons to exchanges like Coinbase and Kraken to request customer information. The agency has also launched Operation Hidden Treasure, an initiative to encourage people to voluntarily disclose offshore assets and income that they have not properly reported on their tax returns. Given these factors, declaring crypto investments may raise your odds of being audited.

Crypto investors who don't report their transactions are more likely to be audited

The Internal Revenue Service (IRS) is cracking down on cryptocurrency holders. The IRS has shifted its approach from education to enforcement, and is now taking a less lenient approach to non-disclosure of cryptocurrency assets and earnings. The tax laws surrounding crypto are constantly being revised, making it difficult to know the implications of investing in this space.

The IRS has invested heavily in tools to trace and prevent cryptocurrency tax fraud, and has worked with contractors like Chainalysis to trace transactions and link 'anonymous' wallets to known investors. Major exchanges like Coinbase and Kraken already report user information to the IRS, and all centralized exchanges will soon be required to send information on capital gains and losses to users and the IRS via Form 1099.

The odds of being audited for cryptocurrency taxes are still relatively low, but they are increasing as crypto usage grows. Overall, individual audit rates are around 0.6%–1% per year, according to IRS data. However, crypto holders are estimated to have an audit rate of around 2%–5%, which is higher than average.

The more activity or transactions with crypto, the higher the audit risk seems to be. Crypto tax non-compliance is estimated at over 50% by some experts, which drives greater IRS scrutiny. The new IRS question about virtual currency on Form 1040 also increases visibility into potential crypto tax issues.

If you fail to report your crypto transactions and gains, there is a larger chance of an audit. However, this doesn't mean that you will automatically get an IRS audit just because you have crypto investments. If you accurately report your gains and losses, you may be able to avoid an audit.

How to Avoid a Crypto Tax Audit

To avoid a crypto tax audit, it is important to accurately report your crypto earnings. This includes your complete cryptocurrency transaction history and the accounting method used to calculate capital gains. It is also important to explain steep rises or falls in income, double-check your tax return for any mathematical errors, and not over-report your home deductions.

The IRS is using contractors to trace blockchain transactions

The US Internal Revenue Service (IRS) is offering grants of up to $625,000 to contractors that can develop technologies to trace privacy-focused cryptocurrency transactions. The IRS Criminal Investigation department (IRS-CI) has played a role in the takedown of Dark Web marketplaces, money laundering programs, and trafficking rings. Cryptocurrencies such as Bitcoin, Ethereum, and Monero are often used for blackmail payments, stolen in hacks, or used to purchase illegal items on the Dark Web.

While cryptocurrencies have become a legitimate industry, the use of blockchain technologies and the emergence of privacy-focused coins that prevent transaction tracing is a concern for the IRS and law enforcement. The IRS has warned that Monero, in particular, is becoming popular with cybercriminal groups. The agency has also noted that "privacy coins are becoming more popular for general use and are also seeing an increase in use by illicit actors."

The IRS is seeking innovative solutions for tracing Monero transactions and off-chain transactions conducted using Layer 2 scaling networks. They have offered an initial payment of $500,000 to contractors Chainalysis and Integra FEC to develop their proposed tools, with an additional $125,000 to be paid upon successful deployment. These tools will include tracking capabilities for law enforcement and predictive analytics.

The IRS has also warned that owning or transacting in cryptocurrencies can heighten the chances of an audit. If crypto holders fail to report their transactions and gains accurately, they are more likely to be audited. However, simply owning or investing in cryptocurrencies does not automatically increase the risk of an audit. The overall odds of being audited are still relatively low, but they are increasing as crypto usage grows. The IRS estimates that crypto holders have an audit rate of around 2% to 5%, higher than the average individual audit rate of 0.6% to 1%.

To reduce the chances of an audit, crypto holders should accurately report their gains and earnings. Consulting a tax professional knowledgeable in crypto can help assess specific risks and ensure compliance with tax obligations.

Major exchanges like Coinbase and Kraken report user info to the IRS

Major exchanges like Coinbase and Kraken report user information to the IRS. Coinbase, for example, provides a Form 1099-K to some of its customers. The IRS has also issued John Doe Summons to these exchanges, requesting customer information.

In the future, all centralized exchanges will be required to send information on capital gains and losses to users and the IRS via Form 1099. This is part of the IRS's efforts to improve enforcement and increase tax compliance in the cryptocurrency space.

The IRS has been intensifying its focus on cryptocurrency holders due to historical under-reporting or omission of digital asset earnings. The agency has also launched Operation Hidden Treasure, an initiative to encourage people to voluntarily disclose offshore assets and income that were not properly reported on their tax returns.

While the overall odds of being audited are relatively low, taxpayers with crypto activities should take steps to comply with tax obligations and reduce their chances of being audited. This includes accurately reporting crypto earnings, explaining significant changes in income, double-checking tax returns for errors, and seeking professional tax advice when necessary.

The IRS has a team of crypto experts to guide auditors

The IRS has recently hired two private-sector experts, Sulolit "Raj" Mukherjee and Seth Wilks, as executive advisors. With their extensive experience in the tax and crypto industries, they will play a pivotal role in leading the IRS's efforts to build service, reporting, compliance, and enforcement programs focused on digital assets.

Mukherjee, a tax executive with over a decade of experience in tax compliance and tax information reporting, joins the IRS from a private blockchain software technology company, where he served as Global Head of Tax. Wilks, on the other hand, has worked in the digital asset tax policy space for the past six years, dealing with tax compliance and planning issues related to multinational corporations.

The addition of these crypto experts underscores the IRS's commitment to enhancing its capabilities in the digital asset arena. With their guidance, the IRS will be better equipped to address the unique challenges posed by cryptocurrencies and ensure fair and accurate tax enforcement in this complex and rapidly evolving sector.

The presence of crypto experts within the IRS also underscores the agency's increasing focus on cryptocurrency holders. The IRS is intensifying its efforts to clamp down on unreported income from cryptocurrency transactions, and the expertise of Mukherjee and Wilks will undoubtedly aid in this endeavour.

While the overall odds of being audited are relatively low, cryptocurrency holders do face higher audit risks than the average taxpayer. The IRS's crypto experts will be instrumental in scrutinising the tax filings of cryptocurrency users, identifying potential discrepancies, and guiding auditors through the complex web of blockchain transactions.

Crypto tax software can help you avoid an audit

The IRS is intensifying its focus on cryptocurrency holders, and the chances of being audited for crypto-related activities are increasing. However, crypto tax software can help you avoid an audit. Here's how:

Accurate Reporting of Crypto Earnings

Crypto tax software enables you to accurately report your crypto earnings, which is crucial in avoiding an audit. The software helps you gather and organise your complete crypto transaction history, the accounting methods used, and any relevant assumptions. This level of detail and accuracy is often challenging to achieve manually due to the complexity and decentralised nature of crypto transactions.

Double-Checking Your Tax Return

Crypto tax software also reduces the likelihood of mathematical errors in your tax returns. Simple calculation mistakes can increase your risk of an audit, especially if you've made a large number of transactions. The software automates these calculations, reducing the potential for human error.

Additional Documentation for Suspicious Activity

Sudden increases or decreases in income or expenses may raise red flags for the IRS. Crypto tax software can help you provide additional documentation to explain these fluctuations. By offering a comprehensive view of your crypto activities, the software enables you to address any suspicions and provide clarity to the IRS.

Caution with Deductions

While you can deduct business-related expenses for your crypto-based operations, such as mining, claiming unusually large deductions compared to your income may attract the scrutiny of the IRS. Crypto tax software helps you identify these potential red flags and ensures you stay within reasonable limits for deductions.

Compliance with Reporting Requirements

The IRS is increasing its efforts to enforce crypto tax compliance, and crypto tax software can help you stay on top of the evolving reporting requirements. For example, in the future, centralised exchanges will be mandated to send information on capital gains and losses to both users and the IRS via Form 1099. Crypto tax software can automatically integrate with these exchanges to ensure you have the necessary data for accurate reporting.

In summary, crypto tax software is a valuable tool for anyone looking to minimise their chances of a crypto-related audit by the IRS. The software improves the accuracy and compliance of your tax filings, reducing potential red flags that may trigger further scrutiny.

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