Taxpayers, the IRS and Cryptocurrency

Tesla made waves when it announced in an SEC filing on February 8, 2021 that it purchased $1.5 billion worth of bitcoin. Tesla also announced that it will start accepting bitcoin as payment for its products, which makes it the first major automotive manufacturer to do so.

The price of bitcoin has risen over 600% in the past year. Following Tesla’s lead in capitalizing on bitcoin’s boom, Goldman Sachs announced that it will restart its cryptocurrency trading desk.

The popularity of bitcoin has risen with its value. This rise in popularity has piqued the interest of the IRS. All of this, combined with the fact that the IRS is likely to buff-up enforcement in 2021 as a way to recoup COVID-19 loses without raising taxes has taxpayers asking: is the cryptocurrency that I own taxable? 

If interested in the basics of cryptocurrency, the tax status of virtual currency, and why contacting legal experts in the field is a taxpayer’s best bet moving forward, the following information will help you understand more about this digital economy.

Cryptocurrency Basics

Cryptocurrency can be, and largely is, a complicated topic. Moving forward with the topic of its taxability, I will first introduce some basics.

Virtual currency, often called cryptocurrency, or “crypto” for short, has been around since 2009. Bitcoin was created to be a peer-to-peer direct payment system that allowed users to transfer funds to each other without using a bank. “Instead of using a check that needs to clear through a bank and the banking system, individuals can pay each other in bitcoin, directly.” This helps keep the transfers easy and anonymous.

Bitcoin, like other forms of currency, derives its value from what people are willing to pay for it, or by what people will accept bitcoin for. As discussed above, Tesla is now accepting it as a payment method.

However, it is unlike other forms of currency because “it is not backed by any government and it is entirely intangible. You can’t hold a bitcoin or any other virtual currency in your hand.” 

Bitcoin was the first publicly traded cryptocurrency. It started trading in 2010 at less than $0.01 per Bitcoin and eventually rose to its all time high, as of writing this article in early March 2021, of $58,332.36.

Today, there are now thousands of different cryptocurrencies, popular ones include Ethereum and Litecoin (which acts as silver to bitcoin’s gold).

Despite the hype and price fluctuation, taxpayers are still left wondering what this means to their cryptocurrency wallets. 

Operation Hidden Treasure

Damon Rowe, the Director of the Office of Fraud Enforcement at the IRS announced on March 5, 2021 during a presentation on fraud enforcement priorities that the IRS has added a dedicated team of IRS Criminal Investigation professionals who are working on “Operation Hidden Treasure.”

Operation Hidden Treasure will focus on taxpayers who omit cryptocurrency income from their tax returns.

According to Forbes, “Operation Hidden Treasure is a partnership between the civil office of fraud enforcement and the criminal investigation unit to root out tax evasion from cryptocurrency owners.” To achieve this, the IRS will be looking for various tax evasion signatures. 

One such signature the IRS will be looking for is called, “‘structuring,’ which literally means structuring transactions in increments of less than $10,000 to avoid certain reporting requirements.

Because the use of bitcoin is inherently anonymous on the blockchain (a public ledger used by bitcoin to decentralize and verify transactions on the peer-to-peer network), the IRS will work “with sophisticated vendors to identify and investigate these tax evasion signatures.”

The IRS will be prosecuting these cases under Internal Revenue Code § 7201, which says that, “any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.”

The IRS & the Digital Economy 

If this sounds intimidating, it’s meant to. Carolyn Schneck, who is the National Fraud Counsel & Assistance Division Counsel for the Office of Chief Counsel, IRS “had a message for crypto traders who are would-be tax evaders: ‘We see you.’” 

The IRS’s Fraud Enforcement Office will be “training with the European Union Agency for Law Enforcement Cooperation, better known as Europol. The IRS has also been working with private contractors to identify key signatures of fraudulent activity, said Carolyn Schenck, who added that the transactions are not anonymous.

Operation Hidden Treasure has been a long time coming. “Back in 2020, the IRS started hiring outside contractors who are experts in cryptocurrency to help them identify cryptocurrency investors whose tax returns either omit or contain incorrect data regarding cryptocurrency transactions.” 

On March 2, the IRS updated the Frequently Asked Questions (FAQs) on Virtual Currency Transactions. “The new FAQ provides that taxpayers whose only crypto transactions include the purchase of virtual currency with real currency need not answer yes to the question on the front page of the 2020 IRS Form 1040,” which states that a taxpayer who engaged in any transaction involving virtual currency must check the “yes” box next to the question on page 1. 

This seems like a contradiction, “but the 1040 instructions provide a little more color, explaining that ‘a transaction involving virtual currency does not include the holding of virtual currency in a wallet or account, or the transfer of virtual currency from one wallet or account you own or control to another that you own or control.” Is your head spinning yet? 

The author of this article argues that taxpayers should answer “yes” even if they only bought virtual currency, and nothing more, because of two grounds: 

• First, the informal IRS guidances and FAQs only “assist” taxpayers, and there is caselaw that says taxpayers do not have “rights” based on them.
• Second, the IRS could potentially use the answer of “no” as a way to show intent to deceive if the taxpayer later on fails to disclose, or report, crypto should that duty arise in the future. 

Attorney-Client Privilege is Worth Quite a Bit 

If you are a taxpayer who owns cryptocurrency, you may be wondering what to do at this point. To begin with, it's highly advisable to talk to an attorney who is an expert in dealing with the IRS. A CPA may be able to help organize a portfolio or report taxes, but the big distinction between CPAs and attorneys is privilege.

Attorney-client privilege keeps confidential communications between an attorney and his or her client secret. CPAs do not have this privilege and can be forced to testify in court. Based on the aggressive language of the IRS, paying taxes on cryptocurrency can quickly turn into a criminal or civil prosecution case. 

“The tax defense bar has been asking the IRS to announce some type of voluntary disclosure program, similar to the foreign bank disclosure program, designed for virtual currency holders to ‘come clean’ for years, to no avail.”

Although the IRS has not started a formal voluntary disclosure program, an experienced tax counsel can help navigate these murky waters.

With the growing need of revenue to cover COVID-19 losses, one of the worst things a taxpayer could do right now is bury their head in the sand. 

If you own cryptocurrency, contact our team of tax professionals and we will help you through the IRS’s ever-changing tax regime.