Reading Between the Lines of the IRS Cryptocurrency Warning Letters
A couple weeks ago, the IRS began sending letters to more than 10,000 taxpayers, warning them to report income and pay taxes on cryptocurrency transactions. This is probably the opening shot in what promises to be a long battle to encourage taxpayers to voluntarily report cryptocurrency gains. Why does the IRS care? And why send these letters?
“Encouraging” Voluntary Compliance
With the total cryptocurrency market cap pushing $300 billion, the IRS clearly believes there is a lot of tax revenue at stake. And the IRS simply cannot audit everyone. Cryptocurrency audits are costly and time-consuming, for taxpayers and (importantly) for the IRS itself.
Because of this, the IRS needs taxpayers to come forward on their own and report their gains. The IRS can make an example of a few bad apples, and surely they will, but they really need cryptocurrency holders to voluntarily come forward, and to do so en masse.
This is where the IRS letters (Letter 6173, Letter 6174, and Letter 6174-A) come in. They let taxpayers know that they are in the IRS’s cross-hairs, and thereby encourage them to comply. The letters also are designed to put these taxpayers “on notice.” Anyone who receives a letter and doesn’t take action might face increased penalties by the IRS down the road.
If it Worked in Switzerland
The IRS is likely drawing on its recent success in Swiss Bank enforcement to guide its efforts here. Over the past decade, the IRS has collected billions of dollars from American taxpayers who had not reported offshore bank accounts. The IRS views this program as a huge success, and is surely adapting this model to increase cryptocurrency compliance.
So how did the IRS get taxpayers to come forward and report their Swiss accounts without auditing everyone? The IRS used a combination of tactics. First, the IRS went after the foreign banks, demanding records of US account holders, and also requiring the banks to pay substantial criminal fines. But the IRS didn’t stop there, they also went to FedEx, DHL, and UPS to see who in the United States was receiving mail from certain offshore banks.
In the crypto context, we should expect to see the IRS go after foreign and domestic exchanges for customer information, as well as mainstream financial institutions and technology providers who may have details on who is trading cryptocurrencies. Indeed, the IRS is probably already taking these steps, and gathering as much data as it can.
Yet the IRS also offered a carrot to taxpayers who came forward and disclosed their Swiss accounts. In the Swiss Bank cases, taxpayers who came forward sooner received lower penalties and more favorable treatment than taxpayers who waited. Penalties started at 20%, and increased to 25%, then 27.5%. The taxpayers who waited the longest to come forward faced 50% penalties on their foreign account balances. A costly mistake, to be sure!
The IRS has said that it won’t offer a crypto “amnesty” program. But even if the structure is not exactly the same, we should assume the IRS is planning to use similar tools. Taxpayers who receive these warning letters and promptly and carefully correct any necessary filings will likely receive more lenient treatment. Taxpayers who do nothing will probably be at a greater risk of civil (and, in extreme cases) criminal penalties. These letters are just the first wave of IRS activity. More is certainly coming.
One problem the IRS faces with crypto (that it did not face with Swiss Bank accounts), is that the tax reporting rules for crypto are not at all clear. The IRS issued limited guidance five years ago, in Notice 2014–21. But it left a number of big questions unanswered, and this was before crypto markets exploded in 2017. The IRS has promised more guidance, but cryptocurrency investors are still waiting for the details.
Without clear guidance, how can the IRS expect taxpayers to accurately report their gains? It’s a real problem, and it will only get worse until the IRS provides some clarification.
Yesterday, James Foust at Coincenter published an insightful piece suggesting that the recent letters actually contain “hidden tax guidance” on two critical issues. Foust notes that the letters require taxpayers to “report the virtual currency received at its fair market value, measured in U.S. dollars, as of the date and time of the transaction.” Previously the IRS had only said that taxpayers must use fair market value as of the “date of payment.”
Foust also picks up on another subtlety in the letters, where the IRS notes that exchanges of one virtual currency for another virtual currency must be reported. He suggests the IRS may be signaling that it will not allow taxpayers to claim “like-kind” and defer gains “crypto-to-crypto” transactions for pre-2018 transactions.
Could the IRS be issuing guidance under cover of these letters? Maybe, but maybe not. For one, the letters’ language on crypto-to-crypto exchanges might simply mean that taxpayers must report these trades, not that they have to pay tax on them for pre-2018 trades (there is no question that such trades are taxable after Congress changed the rules for 2018).
Also, the IRS typically does not make policy statements by sending letters to individual taxpayers. If the IRS is announcing a position, it will usually publish its stance so that everyone can see and adjust their reporting accordingly. The IRS may indeed be trying to kill two birds with one stone, issuing guidance while also warning taxpayers to report. But it is too early to tell.
The Letters Tell a Story
Whether or not the letters contain hidden guidance, one thing is clear. The IRS is gearing up to assess and collect tax from cryptocurrency investors. Both the IRS and taxpayers who received the letters should proceed carefully and thoughtfully. The IRS should not be issuing guidance by stealth, and it certainly should not expect taxpayers to have complied with rules that it never articulated.
At the same time, taxpayers who receive the letters, or who have cryptocurrency gains to report, should also be mindful. Panicking and firing off a half-baked response to these letters can easily do more harm than good. A number of taxpayers have landed themselves in hot water (including one Tax Court judge!), not for their original filings, but for how they responded to IRS requests for information. Taxpayers should proceed deliberately, and obtain counsel from an experienced CPA or tax attorney.