The Treasury Inspector General for Tax Administration (TIGTA) recently conducted an audit that found that the IRS is struggling to identify taxpayers with virtual currency. The primary reason? Limited information reporting from cryptocurrency exchanges. As cryptocurrency continues to grow in popularity, the amount of non-compliance in the crypto tax space is increasing, and the administration has asked the IRS to reduce this information gap by enforcing more stricter rules on crypto exchanges.
Third-Party Information Reporting
Third-party information reporting is one of the mechanisms the IRS uses to ensure tax compliance. These are rules that require your employer to send you a W-2 or your stock exchange to send you a 1099. A copy of each statement also goes to the IRS. When you file your tax return, the IRS system matches what’s been reported to them by the issuers with what you have reported on your tax forms. If there’s a mismatch, the IRS automatically sends you a tax notice inquiring about the discrepancy.
This information reporting system is very effective. As the audit report points out, the IRS estimates that tax compliance is approximately 95% when there is substantial information reporting. This increases to 99% when information reporting is combined with withholding (e.g. W-2). However, tax compliance drops to a staggering 45% when there is little or no information reporting or withholding.
Problem With Crypto Exchanges
Unfortunately, US crypto tax compliance is very poor, in large part due to lack of information reporting from crypto exchanges. Tax rules around information reporting related to crypto are murky and written well before the invention of cryptocurrency. Therefore, exchanges are interpreting rules in many different ways and issuing different forms from one platform to the next. Some prominent crypto exchanges issue Form 1099-Ks when users have more than 200 transactions and $20,000 in volume.
Other exchanges file other 1099 forms such as 1099-B and 1099-MISC. The TIGTA audit report points out that these forms are not consistent nor effective because they don’t tell the IRS that the amounts being reported are virtual currency related. It urges the IRS to modify the information reporting system in a way so that the IRS knows information being reported are virtual currency related.
The TIGTA believes that exchanges should issue Form 1099-Bs similar to brokerages. Although this is proven in the stock and securities world, this is practically impossible to do in the crypto world. Form 1099-B requires exchanges to report the cost basis of each sale. In many cases, crypto exchanges do not have access to cost basis information if the user is transferring funds from another exchange or their local hardware or paper wallet. Self custody is quite common in the crypto world, unlike the stock world. Moreover, users could transfer funds out of exchange to another location and the exchange won’t know if it’s a disposition or a transfer. These factors coupled with other unique intricacies associated with cryptocurrencies make it nearly impossible to generate accurate and complete Form 1099-B at the exchange level.
Overall, the TIGTA report and the recently issued GAO report show that the IRS is facing increasing pressure to enforce much stricter rules on both crypto taxpayers and crypto exchanges. In this environment, crypto users should do everything they can to be as compliant as possible to avoid any trouble. An easy way to get started is by using crypto tax filing software like CoinTracker to get your crypto taxes done accurately.
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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.