Virtual Currency Transactions and the Audit Process
The IRS will ask for your wallet ID and blockchain addresses to gather detailed information about any virtual currency transactions.
If you fail to adequately respond to the IRS’ letters or fail to amend improperly filed virtual currency earnings, it is likely that the IRS will initiate an audit.
Although audits may be conducted both via mail and in-person, it is likely that the IRS will conduct your virtual currency audit via mail. The audit process “officially” begins when the IRS issues you an audit request.
While audit requests can vary in content, there are several preliminary questions the IRS will ask about your virtual currency income. You can expect that they will ask you to disclose all accounts, including:
- Wallet ID and blockchain addresses; and
- any digital currency exchanges utilized, along with their respective user IDs, email addresses, IP addresses, and account numbers relating to those platforms.
In addition, the IRS will most likely require detailed information about any virtual currency transactions, including:
- The date and time each unit of virtual currency was acquired.
- The basis and FMV of each unit at time of acquisition.
- The date and time each unit was sold, exchanged, of otherwise disposed.
- The FMV of each unit at the time of sale, exchange, or disposition, and the amount of money or the FMV of property received for each unit, and;
- An explanation of the method used to compute basis relating to the sale or other disposition of virtual currency.
If you are unable to provide the IRS with specifics of when your cryptocurrency or NFTs were purchased or sold, the IRS will assume that you disposed of your virtual currency in chronological order, beginning with the earliest unit of cryptocurrency or NFTs purchased or acquired.
This default method is known as the first in, first out (“FIFO”) basis. See Internal Revenue Service Notice 2014-21. The FIFO method has several drawbacks, especially if you’re a high-volume cryptocurrency user.
The FIFO method isn’t recommended during times of inflation or fluctuation, as it does not accurately reflect production costs.
While the IRS will assume you sold your cryptocurrency or NFTs at an inflated rate, it will not take the same consideration into account when calculating your production costs.
The result? FIFO makes it appear as though you earned more than you actually did. For this reason, you will most likely incur larger tax liabilities- which is why the IRS prefers to utilize this particular method.
It is imperative that you maintain organized transaction records at all times. Organized records are the key to ensuring that you’re accurately reporting your virtual currency earnings.
It is also important that you respond by the date stated on your audit notification letter. Failure to do so may result in the IRS issuing you a tax penalty by default.
Generally, the IRS can include returns filed within the last three years in an audit.
However, it is highly unlikely that the IRS will review three years of records, especially since the IRS has only recently begun sending letters and issuing virtual currency tax directives.
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What Happens When I Send My Response to the IRS?
Once the IRS receives your response to its audit request, an IRS Audit Officer will review your documents. An IRS audit can be resolved in one of three ways:
- No change: the audit has substantiated all the items being reviewed and results in no changes. This generally means that the IRS will not demand you pay additional taxes and fees.
- Agreed: an audit where the IRS proposed changes, you agree to the changes, and agree to be assessed a tax liability (if applicable).
- Disagreed: an audit where the IRS has proposed changes and you disagree with the changes.
The length of time it takes to complete an audit may vary greatly. No two timelines are alike. However, once the IRS has rendered its decision, you will receive a “Decision Letter” in the mail with one of the three outcomes listed above.
The Appeals Process
If you are deemed to be liable for taxes owed, it’s important to remember that you do have options.
In fact, some would argue that the audit itself is the most difficult part of the process. Once an audit has been completed, you may choose to file an appeal with the IRS by mailing them a “Notice of Protest”.
The IRS advises taxpayers to appeal if they believe one of the following has occurred:
- The IRS made an incorrect decision based on a misinterpretation of the law.
- The IRS didn’t properly apply the law due to a misunderstanding of the facts.
- The facts used by the IRS to reach their conclusion are incorrect.
A Notice of Protest must be mailed to the IRS within 30 days of the decision letter being issued. See “Opportunities Exist to Improve Monitoring and Transparency of Appeal Resolution Timeliness”, September 2018.
The IRS is then required to forward your file to the Office of Appeals. The assigned Appeals Officer will try to settle your proposed tax liability in a manner that is amiable to both you and the IRS.
The Appeals Officer may attempt to schedule an Appeals Conference, an informal meeting in which the taxpayer and Appeals Officer meet to discuss issues at dispute.
Appeals Officers are directed to resolve cases in an efficient manner and are willing to “work with” the taxpayer to settle outstanding liabilities.
This is an indication that once your case reaches the appeals phase, the IRS is committed to resolution and cooperation every step of the way, to avoid costly and lengthy litigation in tax court.
The Office of Appeals has broad discretion to consider any arguments under the law in favor of the taxpayer barring arguments made based on religious, moral, or political beliefs.
The Office of Appeals is dedicated to resolving tax controversies without litigation, on a basis which is fair and impartial to both the government and the taxpayer.
This is done in a manner that will enhance voluntary compliance and public confidence in the integrity and efficiency of the IRS.
Keep in mind that the Appeals Officer may not immediately decide. They can request that further documentation be provided.
If this happens, don’t worry. Take diligent notes and promptly provide the officer with the paperwork they are requesting.
There are several factors that must be weighed prior to the filing of an appeal. On the upside, an appeal costs nothing to file (unless you choose to hire a professional) and most cases result in a reduced tax liability.
Appealing an audit decision also delays your tax audit bill for several months, as you are not required to pay your outstanding taxes while the matter is pending.
Appealing also provides you with time to gather previously unavailable documents and information.
For example, if you were unable to obtain a spreadsheet or transaction record during the audit process due to technological difficulties (or any other reason), filing an appeal will allow you to delay paying your taxes AND will provide you with time to obtain those spreadsheets or transaction records.
When the Office of Appeals receives new information or documents that were either not included or unavailable during the audit process, your case will be “remanded” or sent back to the Audit Office for reconsideration. See Internal Revenue Service Publication 5, Rev. 4-2021.
If your overall tax liability (fees and penalty) is less than $25,000, you may submit a Small Case Request.
Although small case requests are processed in a similar manner to appeals with greater tax liability, they are generally much faster to resolve than their larger counterparts.
Thank you in advance for reading “The Ultimate Guide to Bitcoin, NFTs and Virtual Currency Taxation.” It was a labor of love and our law firm welcomes all questions, comments, concerns, and feedback that you may have about this free resource.