An Update on Cryptocurrency and the IRS

There was a lot of movement from the IRS involving cryptocurrencies in 2019. Prior to 2019, the IRS had issued just one piece of guidance regarding cryptocurrencies. That was by issuance of Notice 2014-21 in which the IRS let us know it would treat cryptocurrencies as capital assets rather than as a currency. There are several implications of that outcome, perhaps most importantly that any transaction involving cryptocurrency will trigger gain or loss.1 Of course, many other consequences come from that determination. Beyond official guidance, the IRS took enforcement action in 2019 and took steps to increase future compliance.

2019 Enforcement Actions

In July 2019, the IRS began sending letters to taxpayers who potentially failed to report income from virtual currency transactions. Those letters were in the form of IRS Letter 6173, Letter 6174, or Letter 6174-A. From all appearances, the IRS sent these letters in a mass mailing campaign to more than 10,000 taxpayers.2 It appears these letters were sent to taxpayers the IRS merely knew held cryptocurrencies rather than taxpayers the IRS identified as having mistakenly reported any particular transaction.3 Nonetheless, this mass mailing is a clear indication that the IRS intends to prioritize enforcement action with respect to cryptocurrency transactions. In each of the letters, the IRS outlines the requirements to properly report cryptocurrency transactions in conformity with Notice 2014-21.

Following this round of letters, the IRS began sending Letter CP2000 to taxpayers they affirmatively believe to have misreported cryptocurrency transactions.4 As opposed to the previous round of letters, since these letters represent a mismatch between information on a taxpayer’s return and an information return filed with the IRS (usually, here, a Form 1099-K), anyone receiving this letter should take action. Otherwise, the IRS would be almost certain to open a formal audit.

Prior to 2019, the IRS was able to proceed on a John Doe summons issued to cryptocurrency exchange Coinbase, which operates as a retail website for the easy sale of certain cryptocurrencies and maintains its CoinbasePro exchange, to obtain information regarding trades.5  Then, in a case involving an individual taxpayer, the IRS issued a summons to another cryptocurrency exchange, Bitstamp which the court refused to enforce while giving the IRS time to issue a more narrow subpoena.6  These actions, in addition to the correspondence to taxpayers, indicate a very aggressive stance on the part of the IRS to catch cryptocurrency non-compliance. This aggressive stance is not limited to civil enforcement. Rather, the IRS intends to hire more investigators to assist in criminal investigations into crimes involving cryptocurrencies.7

2019 IRS Guidance and Charitable Planning Considerations

In the first official guidance since 2014, the IRS issued Rev. Rul. 2019-24 which addressed the tax consequences of “hard forks” and “airdrops.” We previously have written about this new guidance.8 As such, I will not go into detail here. In summary, this guidance defines a “hard fork” as “when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distribution ledger” which may “result in the creation of a new cryptocurrency.” A hard fork will result in a taxable accession to wealth when the new cryptocurrency is received. Often, the new cryptocurrency will be received in an “airdrop” which is “a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.” When a hard fork is coupled with an airdrop, there is immediate taxation since the taxpayer receives additional cryptocurrency through the hard fork and subsequent airdrop, therefore having an accession to wealth upon ability to sell or exchange the newly received cryptocurrency.

At the same time as issuing Rev. Rul. 2019-24, the IRS issued a new set of FAQ’s on its website.9 Largely, these FAQ’s are a product of the conclusion reached in Notice 2014-21 that a cryptocurrency will be treated as a capital asset. Once that conclusion was reached, the answer to several tax questions fell into place naturally as a result of that treatment. Although the results may have been expected, a change to the FAQ’s in December 2019 regarding charitable gifts of cryptocurrency got a lot of attention.10 The rules regarding charitable contributions of cryptocurrency are in-line with charitable donations of any capital asset. There is generally no gain or loss when a cryptocurrency is donated to charity and a deduction for cryptocurrency held more than one year will be equal to fair market value. Many planners hoped the IRS would provide some relief from substantiation requirements for donations of cryptocurrencies. That did not happen. Instead, the December 26, 2019 FAQ’s that were added made clear that a donation of over $250 requires contemporaneous written acknowledgement and a donation over $5,000 requires a completed IRS Form 8283.  The FAQ also confirmed the requirement for a charitable organization to file IRS Form 8282 if they sell, exchange, or otherwise dispose of the cryptocurrency within three years of the gift.

A big issue for donors of cryptocurrencies after confirmation of this treatment is the requirement for a qualified appraisal from a qualified appraiser for gifts over $5,000.11 First, there are exceptions to the strict substantiation requirements for publicly traded securities, including relief from the requirement to obtain a written appraisal.12 The definition of a publicly traded security includes a security which is traded on an exchange “in which quotations are published on a daily basis” or one which is “regularly traded in the national or regional over the counter market for which published quotations are available.”13 Many hoped the IRS guidance would find the major cryptocurrency exchanges met this definition. They did not, meaning the requirement for a qualified appraisal stands. Next, the definition of “qualified appraiser” is one who: (a) has earned an appraisal designation from a recognized organization or otherwise met minimum education or experience requirements, (b) regularly performs appraisals for compensation, and (c) meets any other requirements set forth in IRS regulations.14 Very few individuals likely meet these requirements for virtual currencies. In the end, donors of cryptocurrencies face major obstacles (and costs) to comply with the strict substantiation requirements for charitable donations of capital assets.

Also in 2019, the IRS released new Schedule 1 to the Form 1040. That schedule requires taxpayers to answer Yes or No to the question “at any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” The breadth of this question likely requires anyone who held any “financial interest” in a cryptocurrency during the year to check “Yes.” There is no definition of “financial interest” for this purpose. For example, does owning interests in a business entity (such as membership interests in an LLC) which owns cryptocurrency constitute holding a “financial interest” in a virtual currency? What about trading on an exchange such as Robinhood where the investor does not actually hold the cryptocurrency?15Cautious taxpayers likely should answer in the affirmative. There is reason for being conservative here. This question looks very similar to the question on Schedule B involving foreign financial accounts. The IRS has used that question as a tool in criminal tax evasion cases. Negligent or inadvertent omission of information from a tax return is one thing; filing an affirmatively false return is quite another. The inclusion of this question raises the stakes like what we have seen for foreign accounts.

Conclusion

2019 was a big year for the IRS cryptocurrency teams. The IRS undertook a number of enforcement actions, issued new published guidance, and updated the Form 1040 to include a question involving cryptocurrencies. Clearly, there is a big push towards compliance and information gathering. As time passes, we will see whether the IRS becomes more forgiving in some areas (such as relaxing charitable substantiation requirements) as well as whether the IRS uses this new information to aggressively pursue taxpayers (similar to foreign financial accounts). In any event, any taxpayer who holds cryptocurrency either directly or indirectly needs to be sure they are carefully tracking all transactions and properly reporting to the IRS. The consequences failing to do so could be high.16 The IRS is watching.

S. Gray Edmondson, J.D., LL.M.

Gray practices in the areas of tax, business, and estate planning. View Full Profile.

Footnotes

  1. Note that, after the 2017 Tax Cuts and Jobs Act, there can be no possibility of a like-kind exchange of cryptocurrencies since a like-kind exchange can now only apply to real property.
  2. https://www.irs.gov/newsroom/irs-has-begun-sending-letters-to-virtual-currency-owners-advising-them-to-pay-back-taxes-file-amended-returns-part-of-agencys-larger-efforts.
  3. Cross, Tyson, Crypto Investors Don’t Need to Panic About IRS Letter 6174-A, Here’s Why, Forbes, July 26, 2019, https://www.forbes.com/sites/tysoncross/2019/07/26/crypto-investors-receiving-irs-letter-6174-a-dont-need-to-panic-heres-why/#50c78a8a2111.
  4. De, Nikhilesh, New IRS Warning Letters Target Crypto Investors Who Misreported Trades, Coindesk.com, August 14, 2019, https://www.coindesk.com/new-irs-warning-letters-target-crypto-investors-who-misreported-trades, and Cohen, Lokay, IRS Sends New Round of Letters to Bitcoin and Crypto Holders, Cointellegraph.com, August 25, 2019, https://cointelegraph.com/news/internal-revenue-service-sends-new-round-of-letters-to-crypto-holders.
  5. Aquilio, Mark, Court Grants IRS Summons of Coinbase Records, Journal of Accountancy, March 1, 2018, https://www.journalofaccountancy.com/issues/2018/mar/irs-summons-of-coinbase-records.html.
  6. Versprille, Allyson, Judge Tells IRS to Narrow Summons on Cryptocurrency Exchange, Bloomberg Tax, November 26, 2019, https://news.bloombergtax.com/daily-tax-report/judge-tells-irs-to-narrow-summons-on-cryptocurrency-exchange.
  7. Lee, Danielle, IRS Criminal Investigation Expects to Hire More Agents, Pursue More Crypto Cases, Accounting Today, December 5, 2019, https://www.accountingtoday.com/news/irs-criminal-investigation-expects-to-hire-more-agents-pursue-more-cryptocurrency-cases-in-coming-year.
  8. Sage, Joshua W., Tales from the Crypto: Rev. Rul. 2019-24 and New FAQs Released by IRS, October 15, 2019, https://www.esapllc.com/rev-rul-2019-24/.
  9. https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions
  10. FAQ’s 33-36.
  11. IRC § 170(f)(11)(C).
  12. IRC § 170(f)(11)(A)(ii)(I) and Treas. Reg. § 1.170-16(d)(2)(i).
  13. Treas. Reg. § 1.170A-13(c)(7)(xi).
  14. See Treas. Reg. § 1.170A-17(b).
  15. See Cryptocurrency Transfers and Deposits, https://robinhood.com/us/en/support/articles/360001284443/cryptocurrency-transfers-and-deposits/ (Accessed February 2, 2020).
  16. For example, taxpayers bear the burden of proving cost basis. Therefore, failure to keep track of cost basis could result in negative tax results.