In January 2018, an individual investor visited my office and asked me to prepare income tax returns based on his cryptocurrency trading gains. This individual used U.S. dollars to buy Bitcoins. He proceeded to trade in and out of other cryptocurrencies (“altcoins”) on a major trading exchange. When he first called my office, Bitcoin had recently reached its peak exchange rate of about $19,000 USD per Bitcoin unit on December 17, 2017. My client had multiplied his money tenfold. Unfortunately, the volatility in the cryptocurrency market wiped out more than half of his unrealized gains in just over a month. Eventually he decided that he was not ready to come into tax compliance, and we parted ways with mutual best wishes.
IRS Enforcement Efforts
My former client had planned to come forward voluntarily to comply with the IRS reporting requirements under IRS Notice 2014-21, which states that the IRS will treat Bitcoin as property for recognition of gains and losses. However, the IRS faces a significant challenge in its quest to encourage voluntary compliance. Many taxpayers will only comply voluntarily if they reasonably expect that noncompliance could lead to adverse consequences. The IRS has assigned a team of 10 investigators to begin enforcement action against tax cheats who use the anonymity of cryptocurrency to hide income and assets from the government. See: “IRS Cops Are Scouring Crypto Accounts to Build Tax Evasion Cases” by David Voreacos, Bloomberg News, February 8, 2018. For a current analytical perspective on the difficulty IRS may have in enforcing tax laws on cryptocurrency investors, see: “Tax Compliance in a Decentralizing Economy” by Manoj Viswanathan, The Georgia State Law Review (February 21, 2018).
Four Suggestions for Cryptocurrency Investors
I offer four key suggestions to cryptocurrency investors and their professional advisers:
First, I predict that the IRS and other government regulatory agencies will catch up to the enforcement challenges posed by the anonymity of cryptocurrency ownership. Just as the IRS managed to obtain information on U.S. account holders at foreign banks such as UBS, so too the IRS will obtain records from major Bitcoin trading platforms. Already in November 2017, the IRS won a significant victory when a U.S. District Court judge in San Francisco upheld an IRS subpoena seeking records of selected U.S. account holders in Coinbase.
Second, it is possible that when IRS enforcement catches up with non-compliant Bitcoin investors, the IRS may offer a voluntary disclosure program similar to the one currently available for holders of offshore bank accounts. Under the current OVDP program, taxpayers who come forward voluntarily are not criminally prosecuted. The penalty rates, however, differ significantly. The penalty for intentional tax violators varies between 27.5 and 50 percent of the value of undisclosed assets. The penalty for unintentional violators is reduced to 5 percent of the value of undisclosed assets. Thus, Bitcoin investors cannot expect that they can participate in a possible voluntary disclosure program without experiencing some financial pain.
Third, Bitcoin investors and traders should keep good records for tax accounting purposes. My former client (see above) used a trading platform that kept records of his transactions readily available only for the preceding six months or so. My tax accounting work was made more complicated by the lack of complete records.
If IRS offers a voluntary disclosure program, it will provide a limited look-back period—for example, the filing of tax returns for three to six years preceding the disclosure date. Since some Bitcoin exchanges do not retain customer data going back that far in a readily accessible format, those customers should diligently retain their own records. The retention of full records, however, may suggest that the failure to comply was intentional, thereby preventing taxpayers from enjoying the lower penalty rates discussed above.
Finally, I urge all Bitcoin investors to comply with the law. Many taxpayers with offshore accounts lived to regret their non-compliance with the bank disclosure laws. Over 56,000 taxpayers paid more than $11 billion in penalties, according to an IRS press release dated March 13, 2018. Many individuals also suffered intense anxiety, and some paid significant legal fees. A few people went to jail for criminal tax evasion. Therefore, tax honesty remains the best policy.
For more information on IRS taxation of Bitcoin, please see our prior blog post: “The United States Taxation of Bitcoins and Transactions Denominated in Bitcoins” by Attorney Morris N. Robinson, The Massachusetts Tax Alert (January 6, 2016).