Tax experts see audits, enforcement on the horizon as IRS highlights crypto question

The U.S. Internal Revenue Service is closing the gap of plausible deniability for crypto reporting by placing the subject front-and-center on the draft of their new tax form.

Before taxpayers even begin the first part of the IRS’s 1040, Schedule 1 form, they’ll be asked if they’re crypto holders. An early draft released in October reads: “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” with a simple yes or no checkbox to its right.

This is the first time the words “virtual currency” appear together on a tax form, according to Roger Brown, a former IRS counsel and current head of tax and regulatory affairs at crypto accounting software firm Lukka. 

However, that doesn’t mean the IRS wasn’t addressing income on crypto holdings before this point. CEO and co-founder of Lukka, Jake Benson, explained that IRS guidance instructed taxpayers to report gain and loss transactions on the 8949, a subset of the Schedule D form.

Still, that form didn’t contain the words “virtual currency,” “cryptocurrency” or “digital asset.” Rather, it dealt with “the sale or exchange of a capital asset not reported on another form or schedule,” using 1099 forms issued by exchanges. 

The language of the crypto question bears resemblance to one on the Schedule B form, according to Stephen Turanchik of Paul Hastings LLP’s tax practice.

That form asks if taxpayers have a financial interest or a signatory authority or a financial account such as a bank account, security account or both account located in a sovereign country. Historically, Turanchik said, the IRS has taken action against those who fail to check that box, but many argued that they’d never even filled out a Schedule B or didn’t understand the question. 

Sending a message

By placing the crypto question at the top of the 1040, Schedule 1, Turanchik said the message is clear: taxpayers can no longer claim ignorance of their tax burdens in relation to crypto.

“The only real difference here is they've moved the question regarding foreign financial assets here about a virtual currency to the front of the form,” said Turanchik. “And under the current IRS guidance, the IRS has said publicly we consider virtual currency property.”

Ultimately, Turanchik said the move indicates a commitment to enforcement. Between the thousands of letters sent out to crypto holders earlier this year and the criminal investigation background of the new head of the Small Business/Self Employed division of the IRS, the agency is likely signaling that taxpayers can expect closer scrutiny – and potential action – from the IRS going forward. 

With this in mind, the crypto question could lead to more audits, according to Turanchik and Benson.

“The IRS will will certainly be auditing more more crypto holders this season,” said Benson. “No doubt about it.”

“Crypto holders are more likely to get audited, but there’s nothing wrong with holding crypto as long as you report the gains and losses from it,” said Turanchik. 

That’s within the purview of the IRS, according to Turanchik, Benson and Brown. They all pointed to the IRS’s broad powers of investigation. In fact, a question need not be exclusively for the purpose of taxation. Turanchik pointed out that the FBAR form is primarily focused on checking for nefarious activity like money laundering or terrorism. 

Brown also said that some questions on IRS forms may be asked for the purpose of statistical analysis rather than looking deeper into a single taxpayer’s transactions, especially since the IRS doesn’t have the resources to audit every crypto holder. 

Still, many could face audits, meaning that if they have not reported crypto holdings in past years, they will have to retroactively submit – the same procedure for any asset class. 

“Even though the question just appears on the tax forms this year, the IRS is very clear that if you did not file your transactions and your gains and losses in prior years, that you do need to go back and amend those previous year's returns,” said Benson. “That’s not special for cryptocurrency.”

Tools of the trade

Ahead of the coming shift, Lukka has rolled out software to help the average holder, retooling its institutional software for CPAs and the individual. He said the crackdown on reporting will likely affect a range of taxpayers, and the type of reporting crypto holders will be required to do will be complicated, according to Benson. 

“If you had trades on different exchanges or different venues, you have to somehow figure out how to get your trading history aggregated and you have to somehow figure out how to price all of those trades,” he said. “You have to figure out how to supply cost basis. You have to figure out fair market value. So if you're to do this by hand or manually, I mean, it can take hours. If not, it's just literally impossible."

Additionally, some taxpayers may be unclear on what exactly to report due to the inclusion of the words “otherwise acquire any financial interest.” “Acquisition” or buying something, isn’t a taxable event in itself since it doesn’t necessarily mean a taxpayer has received income, according to Brown.

Turanchik also said that there is room for confusion on what it means to acquire, such as if an investor has stake in a hedge fund with some crypto exposure. Brown said he expects the IRS to further clarify this wording during the comment period.

More information is likely still to come from the IRS, given that the new 1040 is only in draft form. The final version may differ from the initial draft.

However, the crypto question is likely to remain at the forefront of the IRS’s concerns this tax season, according the those interviewed for this story.