Some cryptocurrency investors have started to receive notices from the Internal Revenue Service because what they reported on their tax returns doesn’t match information the agency is getting from third parties, such as exchanges.
But it is very likely that the many of these recipients actually paid the correct amount of taxes and the IRS’s forms are to blame, tax practitioners say.
“The information the IRS has comes from very unreliable data,” said Sean Ryan, chief technology officer at NODE40 LLC, a company that develops software to help people calculate their tax liabilities from cryptocurrency transactions.
The mismatch notices—called CP2000 notices—inform taxpayers that discrepancies have been detected and ask them to justify the positions they took on their returns.
For cryptocurrency investors, the mismatches often occur because a handful of virtual currency exchanges are providing information to the IRS that paints an inaccurate picture of what investors really owe in taxes, according to practitioners. This is due to a variety of factors, including that only gross amounts paid to customers are reported on the information returns, or Forms 1099-K. And it means that IRS efforts to enforce cryptocurrency compliance may instead be sowing confusion for taxpayers who are playing by the rules.
The Form 1099-K is used by third-party processors to report certain payment transactions to the IRS and to recipients of those payments in an effort to improve voluntary tax compliance. An individual should only receive a 1099-K if he or she had more than 200 transactions and received gross payments of more than $20,000 over the course of a year.
Most of the people who got 1099-Ks from their exchanges are probably going to get CP2000 notices, said Lisa M. Zarlenga, a partner at Steptoe & Johnson LLP, who advises clients on digital currency tax issues. “That doesn’t necessarily mean that they owe additional taxes, they just owe additional information to the IRS,” she said.
The IRS said it didn’t have an immediate comment.
CP2000 notices aren’t a new type of form or unique to cryptocurrencies, but many individuals with digital assets have been receiving them lately because of the 1099-K issues. The notices coincide with a separate batch of letters the IRS started sending to more than 10,000 cryptocurrency users in July warning of potential civil and criminal enforcement action if they don’t report their digital assets.
Both efforts demonstrate the IRS’s increased focus on ensuring cryptocurrency investors are paying their fair share in taxes.
The amounts reported on the 1099-K for cryptocurrency transactions are “almost always” going to differ with the information a taxpayer puts on his or her tax return, Ryan said.
The biggest problem is that 1099-Ks don’t account for basis—the amount that someone paid for an asset, he said.
So if an investor withdrew $100,000 in bitcoin from an exchange, the form will show the $100,000 payment but won’t take into account the purchase price of the digital assets. The investor may have actually bought the bitcoin for $105,000 and in reality has a $5,000 loss.
A tax return, however, would take into account basis and require the individual to calculate gain or loss, Zarlenga said.
Also, only some exchanges, like Coinbase Inc., submit 1099-Ks to the IRS. So the forms will only reflect transactions on those select few exchanges when in reality a taxpayer may use many different exchanges—some of which don’t issue the forms, Ryan said.
Coinbase didn’t immediately return a request for comment but pointed to a variety of tools the company offers on its website to help customers figure out what they owe in taxes.
Requiring exchanges to instead fill out Form 1099-B, used by brokers and in barter exchanges, might paint a more accurate picture of the taxes that customers owe, Ryan said. The form lists gains and losses from transactions.
“But that would be a big burden on the exchanges,” he said. And “it would probably hinder the experience of digital currency.” It also still wouldn’t be 100% accurate, he said.
Avoidable with Help
Taxpayers could avoid hearing from the IRS by using creative reporting and planning tactics—but for most this means going to an accountant or tax adviser for help.
For example, if a 1099-K is showing gross proceeds of $100,000 but the taxpayer actually had a gain of just $5,000 for the year, he or she could report $95,000 in basis on the tax return, said Evan Fox, practice leader in the Digital Asset Advisory Services group at Berdon LLP in New York.
This would ensure both the $5,000 gain is reflected and that the information on the return aligns with what’s reported on the 1099-K, he said.
But taxpayers may not always know when to go to an adviser or be aware of tools that are at their disposal.
There is an education problem in the industry, Ryan said. Taxpayers, for example, may not know some software can help them avoid matching issues.
And “most people—the overwhelming majority—have no idea what the IRS considers an appropriate approach to taxing in digital currency,” Ryan said.