Cryptocurrency that has a value in dollars is a virtual currency that has been around for several years now. Like cash, people can use cryptocurrency to pay for goods and services. However, unlike cash (where a dollar is always a dollar, even if it is subjected to inflation), the value of cryptocurrency may increase or decrease at any given point in time.
There are many taxpayers who have not listed their cryptocurrency on their tax returns and have not paid the appropriate amount of tax to the IRS. Taxpayers may feel confused regarding how to treat cryptocurrency for tax purposes or may be simply unaware that it may need to be listed on their tax return.
In 2014, the IRS released virtual currency-specific guidance with regards to tax purposes. This was a good start towards helping the taxpayer correctly report and pay taxes. Taxpayers (and tax return preparers) have had questions regarding how concepts, that are unique to cryptocurrency, fit into our established tax system. In 2019, after multiple requests for guidance, the IRS addressed some questions regarding cryptocurrency “hard forks” and “airdropping” which have answered some questions regarding the taxation of cryptocurrency.
Cryptocurrency creates another problem for the IRS as it is more difficult to trace than other forms of income. When an employee receives income from an employer, the law requires the employer to take certain actions which may include withholding taxes and notifying the IRS of the income. Accordingly, the IRS should be aware that the taxpayer received this income even if it is not disclosed to the IRS by the taxpayer. Although the Financial Crimes Enforcement Network (FinCEN) may require businesses or individuals to register as a money services business, it is still harder for the IRS to trace.
In August of 2019, the IRS sent out approximately 10,000 letters to holders of cryptocurrency. Some of these letters merely informed the individual that the IRS is aware that they have cryptocurrency, while other letters informed the individual of a discrepancy regarding cryptocurrency on their tax return. More recently, a source from within the IRS announced that the IRS will audit many cryptocurrency holders. The early release of income tax forms for 2019 specifically asks whether the taxpayer received, sold, sent, exchanged or otherwise acquired any financial interest in virtual currency.
While there may still be questions regarding how cryptocurrency should be treated for tax purposes, one thing is clear, if you fail to report or pay tax on the income from associated cryptocurrency, you may be facing steep penalties and even criminal prosecution.