07 Feb 2021 Virtual Currency – Reporting & Enforcement Update
2020 has been a year we would all like to forget in many ways. But it has been a banner year for the virtual currency world. After a slow and painful decline from a high price point near the end of 2017, Bitcoin (BTC) and most other alternative coins have been setting all-time highs in late 2020 and early 2021. Numerous factors have contributed to this resurgence. Factors include stronger interest from large institutional investors and greater availability to retail investors through exchanges and mobile applications.
The IRS is aware of this trend and has continued to develop its position and guidance in this area since 2014. While initial efforts focused on establishing that virtual currency is taxable property and determining exactly how to report taxable gains, recent announcements reflect a stronger technical understanding. For example, Revenue Ruling 2019-24 goes into detail regarding how to apply the gross revenue constructive receipt principle in situations where there are “hard forks” of existing currencies and “airdrops” of additional currency amounts for existing holders. This improved awareness has revealed the magnitude of a related underreporting issue, which is now attracting the attention of several leading enforcement officials including Commissioner Rettig and Treasury Secretary Mnuchin.
Consider the broad language used by the IRS in this 2020 question that all taxpayers are expected to answer on Form 1040: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” The positioning implies that the previous version of the question on Schedule 1, the expanded online FAQ section, and specific sale reporting instructions on the topic have not been enough. Taxpayers are rarely asked to assert this type of involvement in an asset class so directly.
It is worth comparing this situation to another one the IRS has recently placed under heavy scrutiny – foreign bank account reporting. On the one hand, there is no informational return reporting component to simply holding virtual currency in an account, unlike the FBAR requirement that kicks in for foreign accounts over a certain value. Additionally, the U.S. criminal code outlines several penalties for negligent and willful misstatements of foreign account information and would not apply to virtual currencies. The major virtual currency misstatement deterrent emphasized by the IRS in recent news bulletins is the tax evasion law carrying a max prison term of 5 years and a max fine of $250,000. But, the threshold for this level of enforcement is much higher than the average taxpayer would meet. For the average taxpayer, who maybe decides to not answer the Yes/No question or forgot to report a taxable virtual currency transaction for some reason, this leaves a lot of ambiguity. The IRS appears to be working to resolve this.
For several years now, the Department of the Treasury has been interacting with the largest coin exchanges in the marketplace to discuss effective tax reporting and pressure them into compliance with federal investigations. Simultaneously, it has issued thousands of letters to taxpayers identified in transaction sweeps informing them of delinquent tax liabilities and offering options for voluntary disclosure to potentially reduced penalties. In contrast with the foreign bank account world, the IRS has made it clear that a specialized disclosure program specifically for virtual currency scenarios will not be available.
In place of a program designed to encourage disclosure, the IRS is putting taxpayers at the mercy of the general voluntary disclosure process initiated through Form 14457. Despite marketplace resistance to the idea of a 1099 equivalent for income reporting, there is a clear trend toward greater compliance. This began with a lawsuit initiated by the SEC against the Ripple (XRP) cryptocurrency platform for illegally selling unregistered securities worth $1.3 billion. This was a hard reversal from a more lenient position previously taken for initial coin offerings, and the case introduces the imminent presence of federal public securities regulation over virtual currencies.
With all the ominous tax warnings and discussion of money laundering, this regulatory situation looks a lot like the foreign bank account world in the mid-2000s. As much as the decentralized currency crowd will hate to hear it, the logical next step for the federal government is to require annual income reporting and informational account detail reporting in the same manner that we are accustomed to with foreign accounts. We may also see more targeted legislation or code additions that mirror the foreign bank account penalties. In the meantime, it is important to recognize that the fantasy of avoiding taxes or stashing away wealth in virtual currency formats has come to a screeching halt. It was never really a reasonable choice to begin with.
Before Filing Your 2020 Taxes
Ensure that all 2020 wage and capital transactions involving virtual currencies are accurately reported, disclose any errors from prior tax years through the applicable program (especially if you received a letter), and do not forget to consider the new 1040 question in its new position. Contact Haynie & Company if you have any questions regarding your tax situation.