IRS Warns Investors About Crypto Taxes Without Releasing Guidance

This blog was last updated on September 14, 2021

The IRS sent letters to more than 10,000 cryptocurrency holders last week, educating them about their income tax obligations associated with cryptocurrency transactions. The IRS also included information in that correspondence about applicable penalties for taxpayers who fail to report income and pay crypto taxes. 

The agency sent three letters to taxpayers:

1. Letter 6173 https://www.irs.gov/pub/notices/letter_6173.pdf notifies taxpayers that the IRS has information that the taxpayer should have included cryptocurrency income on income tax returns for the period from 2013-2017. The IRS requires a response to this notice by a specific date and suggests that the taxpayer file amended income tax returns to include the information or return a correspondence to the IRS that includes a statement of facts that explain specific points outlined in the letter as to why income tax is not owed related to virtual currency transactions. The letter also includes a “penalties of perjury” statement whereby the taxpayer is required to certify that the information provided in response to the letter is true, accurate and complete.
2. The second letter takes a little softer tone. Letter 6174-A https://www.irs.gov/pub/notices/letter_6174-a.pdf is aimed at taxpayers that reported virtual currency income but may have done so inaccurately. The letter asks the taxpayer to review a variety of resources and IRS publications and then indicates that the taxpayer should file an amended return if the taxpayer believes there was any inaccurate reporting. There is no mandated response due date as was seen in the first letter.
3. Finally, the informational Letter 6174 https://www.irs.gov/pub/notices/letter_6174.pdf acknowledges and provides a response to taxpayers who proactively inquired with the IRS for guidance related to the requirements for calculating their income taxes associated with cryptocurrency transactions and non-crypto virtual transactions. This letter contains the same educational information as is referenced in the other letters but again does not require a response by the taxpayer.

Enforcement rather than education

The IRS has a history of enforcement in this area rather than providing taxpayer guidance related to virtual currency transactions.

Bitcoin was established in 2008, but the first tax guidance related to virtual currency was not published until 2014. Two years later, the IRS clearly recognized that there was a sizeable amount of income not being reported related to virtual currency transactions. In fact, the agency publicly cited that very issue to the tax court in its defense of the John Doe summons United States v. Coinbase. Still, the IRS did not release updated guidance. 

Now, in 2019, we see additional enforcement activity with the letters that IRS began sending this month, requiring amended income tax returns to be filed or taxpayers to provide legal responses to proposed gaps in the reporting of their income over multiple tax years. But we still have no updated guidance from the IRS.

Two types of taxpayers affected by IRS lack of guidance

There are two types of taxpayers involved in this issue:

1. Individuals and businesses who need to claim income and deductions related to cryptocurrency transactions, and 
2. Payers of the income that gives rise to the tax (e.g., crypto trading exchanges).

At the IRS Nationwide Tax Forums in Chicago last week, there was much discussion about the issues of capital gains income versus ordinary income and how this lack of guidance impacts both business and individual income tax return preparation. While many of the participants at the Forum were focused on how individual taxpayers and companies can report income and deductions from a corporate or individual return perspective, we at Sovos are also worried about how the return filer of the 1099, the payer of these transactions, should report them. 

Both types of taxpayers are subject to penalties from the IRS for failure to report tax information when required. Individual and business taxpayers will be penalized if they failed to include income on their annual income tax return and will have to pay a penalty plus interest from the due date of the taxes that should have been paid. Payers are also subject to IRS penalties, but this is associated with withholding taxes and reporting tax information following a prescribed set of IRS rules. Payers also have to be concerned with creating tax liabilities for their clients when incorrect information is reported or other issues occur during the tax reporting process. 

Both types of taxpayers have little to no guidance from IRS related to virtual currency taxation. If there is one thing that was made clear by the IRS in Notice 2014-21, it was that income earned from crypto investments is expected to be included on the taxpayer’s annual income tax return. But, as part of that process, the first type of taxpayer, for example, needs to understand how the IRS expects them to record the value of an asset at the time of purchase. That’s because valuation of cryptocurrencies fluctuates across every exchange, and this can impact taxpayers’ individual basis calculation for that single virtual asset.

Sovos clients are the second type of taxpayer, and IRS Notice 2014-21 made it clear that cryptocurrencies are treated as property, for tax purposes, and that the corresponding tax rules apply. In the tax withholding and information reporting industry, this generally indicates Form 1099-B reporting is required by payers that pay proceeds related to the selling or trading of capital assets.  

However, the Form 1099-B is not required to be reported by exchanges. And, transactions in the cryptocurrency ecosystem don’t really correspond to the tax reporting processes described in the instructions for Form 1099-B reporting. In fact, there isn’t any Forms 1099 publication that contains any details around how to report 1099s related to virtual currency transactions.

Both taxpayers are penalized by IRS’s lack of guidance. As evidenced last weekt, the IRS is moving forward with assessing financial penalties to the first type of taxpayer – the ones who didn’t report their gains income nor pay the corresponding taxes. 

But payers can be penalized by the IRS for a variety of issues with virtual currency transactions too.  Payers can be penalized for not issuing a correct tax statement to the investor. Payers can be penalized for not issuing any tax statement to the investor. Payers can be penalized for not withholding taxes on applicable payments using virtual currency transactions. 

For example, IRS Notice 2014-21 made it clear that when cryptocurrency is used to pay for non-employee compensation, those transactions are subject to withholding and information return reporting.  When payers fail to withhold as required, there is significant liability and penalty associated. When payers fail to report or fail to report accurate 1099 statements to the recipient and to the IRS, there is significant penalty associated. There could also be state tax information reporting penalties that are applicable too.  

One can only speculate when the IRS will turn enforcement toward the payers in this community.

Guidance is imminent … maybe

The anticipation of the IRS releasing clarifying guidance has been building for months. More than 18 months ago, Congress became so frustrated that several members began writing letters to the IRS Commissioner, pleading for guidance to be released. After a long period of silence, the IRS finally wrote back to Rep. Tom Emmer in May and indicated that guidance was forthcoming.  

In late May, the commissioner indicated that the timing could be as soon as “within the next 30 days” implying an end-of June date. Many tax professionals in the industry speculated in blogs and articles about what that guidance might entail based on the tidbits from the commissioner.  The end of June came and went, still with no guidance.

But last week’s communication provided a glimmer of hope for the industry. The notable one-line sentence said: “The IRS anticipates issuing additional legal guidance in this area in the near future” sounds appropriately vague for the IRS in terms of a commitment on this topic. What is significant though, is that this is the first publicly written affirmation of forthcoming guidance by the IRS since that letter to Emmer that the commissioner wrote back in May.