New Virtual Currency Tax Reporting and Compliance Measures Imminent
Despite explosive growth in the popularity of virtual currency, the Treasury Inspector General for Tax Administration (TIGTA) has determined that the IRS and Treasury have been slow to enforce tax compliance measures. Since 2014, the IRS has issued limited guidance on the matter, and only recently announced plans to question individual taxpayers on their virtual currency transactions through Form 1040 for 2020 returns.
Nonetheless, the IRS and Treasury have made clear that virtual currency transactions are taxable and that they intend to enforce compliance.
How can they enforce compliance without the proper guidance and avenues for reporting?
That’s exactly what the TIGTA aimed to assess when they performed an audit of the IRS’s efforts to facilitate and enforce virtual currency transaction reporting.
The results of the audit published on September 24, 2020, confirmed that the IRS still has work to do in improving taxpayer compliance and thus proposed two key recommendations for how the IRS can improve crypto transaction reporting:
- Develop proper guidance for taxpayers and third-party virtual currency transaction services.
- Create the proper internal processes to identify virtual currency noncompliance during audits.
What does tax compliance for virtual currency look like?
Before we dive into TIGTA’s recommendations, it’s important to understand tax compliance as it relates to virtual currency transactions.
According to the IRS, there are two types of noncompliance: willful and non-willful. The former includes activities that appear to use virtual currency to evade taxes, while the latter primarily results from a lack of understanding about virtual currency taxability. However, non-willful noncompliance could also stem from improper calculation of gains and losses from a virtual currency transaction, a mischaracterization of the taxpayer’s income, and/or the lack of fulfilling reporting requirements on the part of third-party virtual currency transaction service providers.
With no rigorous guidance or processes in place from the IRS, these contributing factors for non-willful noncompliance are a common occurrence. Third-party platforms facilitating virtual currency transactions, such as exchanges, debit and credit card companies, Bitcoin ATM (BTM) operators, and payment processors, either have no reporting obligations or report transactions inconsistently, if at all. Additionally, there is a significant information gap in how taxpayers should be reporting their virtual currency transactions. Many reported transactions are unspecified as virtual currency transactions since the standard information returns don’t provide a clear avenue for identifying transactions as related to virtual currency.
How will TIGTA’s recommendations change virtual currency transaction reporting?
TIGTA recommends that the IRS first prioritize issuing proper guidance on virtual currency transactions, with the goal of closing the information reporting gap and reducing taxpayer noncompliance. The IRS agreed with the recommendation, stating that they are currently collaborating with the Treasury (as they have before) to develop specific guidance on third-party reporting for virtual currency transactions. Improving third-party reporting will vastly reduce an individual taxpayer’s burden in reporting their virtual currency transactions, and it will also eliminate an individual’s ability to conceal gains or losses from these transactions.
To envision enhanced third-party reporting in the virtual currency world, picture the new reporting obligations that changed the brokerage world. Consider a virtual currency exchange to have the same obligation as brokerage houses to report gains and losses. For example, each time you spend a virtual currency using a credit card connected to your bitcoin wallet, you would report that you sold a quantity of a virtual currency, thus reporting both the sale and the cost of that coin. Similarly, each time you go to a BTM to cash out ethereum, the BTM operator would have the obligation to report your gains and losses on the transaction.
However, the matter of reporting the cost basis of the asset still leaves the burden on the taxpayer, in both brokerage and the virtual currency. When brokerage accounts were first required to report transactions occurring on their platforms, they only had to report sales. It took the IRS decades following the codified rules to also report the related cost basis.
The challenge that exists in the brokerage world today is that taxpayers who transfer assets between brokerage houses have to submit to the platform the cost basis of assets transferred in. This still puts the onus on owners of digital assets to track as they move assets between exchanges, wallets, BTM providers, and credit and debit card providers. Although this first recommendation from TIGTA will help make significant progress in improving reporting and reducing taxpayers’ burden, the IRS will still have work to do to define the most optimal reporting processes.
TIGTA’s second recommendation calls for the IRS to develop a more formalized process for sharing information and identifying noncompliance internally, specifically between the departments performing Title 26 and Title 31 examinations. By sharing information between these examinations, the IRS can more effectively monitor compliance. The IRS agreed with this recommendation as well, noting that they have published interim guidance on this matter, but it is likely they will implement a more permanent process in the future.
Individual taxpayers may feel less of an impact, but third-party companies dealing with virtual currency transactions should expect changes to their reporting obligations and can expect a likely Title 31 examination in their future.
The Bottom Line
Tax compliance for virtual currency is a moving target as the IRS continuously issues new guidance and seeks means to improve reporting. This impedes taxpayers’ ability to stay ahead of the curve of avoiding potential penalties, but help is available.
Aprio is constantly monitoring updates from the IRS to make sure our clients are always informed and compliant. We have been pioneers at the intersection of virtual currencies and tax liability since 2013, and are equipped to help exchanges, BTM, wallet companies, virtual currency processors, and any taxpayer with virtual currencies understand their related tax burdens. Contact Mitchell Kopelman, Partner-in-Charge Technology & Blockchain Practice, for more information.