Own Cryptocurrency? Be Prepared for a Potential IRS Audit

At the risk of spreading a fear-mongering headline — theoretically, just about any U.S. taxpayer could be audited at any point by the Internal Revenue Service — it is true that cryptocurrency owners may now be at an increased risk of an audit. Recent actions by the IRS have given us clues that it is adding capacity to examine taxpayers who may not have complied with tax reporting requirements of cryptocurrency accounts

In May 2020, the IRS solicited help from contractors to assist in investigations of tax returns associated with cryptocurrency accounts. In the months since, the federal agency has made fresh requests for outside help. These requests have coincided with taxpayers’ receiving letters from the IRS advising them they may have not adhered to tax reporting requirements. The vast majority of cryptocurrency owners who received letters got at least one of the following three: 

  • Form 6174 Often referred to as a “soft notice,” this letter from the IRS informed taxpayers of potential discrepancies between their cryptocurrency transactions and what they reported on tax returns. The IRS indicated in this letter that it would not follow up on the matter and merely encouraged taxpayers to file an amended return (if necessary). 
  • Form 6174-A — Though this letter contains much of the same information in Form 6174, the IRS states in this letter that it might follow up with enforcement action. 
  • Form 6173 — This form specifically requests a response from the taxpayer about an alleged discrepancy between the tax return and cryptocurrency-involved transactions that actually occurred. Form 6173 provides instructions for responding to the IRS and indicates potential follow-up action.

What Would You Need to Provide in an IRS Audit? 

First, it’s worth going over what you need to maintain for tax-reporting purposes (remember, you must recognize a capital gain or loss when you cash out or give or receive cryptocurrency in exchange for services). The Internal Revenue Code mandates that you keep records like receipts and invoices if you engage in cryptocurrency transactions. If income is underreported by more than 25%, the IRS can audit tax returns for the previous six years, so you should keep records at least that long. 

In a cryptocurrency audit, you might be asked to produce: 

  • Any evidence of cryptocurrency transactions
  • Copies of communications with third parties who helped broker transactions
  • An explanation of your methodology for calculating your gain or loss on transactions

These are just a few examples of what the IRS might request from you. The more audits the IRS executes, the more information tax professionals will have on these examinations. 

A Note on Donating Cryptocurrency

The rise in popularity of cryptocurrency has also led to the rise of donations using cryptocurrency. A U.S. taxpayer may use cryptocurrency and use the charitable contribution deduction on his or her tax return. The deduction amount will typically be equal to the fair market value of the cryptocurrency at the time of the donation. Charitable organizations must recognize these donations as noncash charitable contributions. 

Conclusion

It’s taken the IRS a few years to get up to speed on cryptocurrency, but it appears the agency is getting its footing with regards to tax reporting obligations and audits. With the countless complexities and nuances involved in an IRS audit, it’s imperative for you to get professional legal counsel to represent you. 

Our firm would be honored to help you if you are facing a cryptocurrency audit; call our team at 206-984-3739 to set up a free consultation to discuss your options with us today.