A recent report (the “Report”) of the IRS Commissioner’s Information Reporting Advisory Committee (“IRPAC”) has identified the need for additional guidance on cryptocurrency transactions to enforce compliance on cryptocurrency transactions. The Report heavily relies on the recent experience the IRS had in enforcing the Coinbase summons, as recently reported in On the Chain. The IRS explained the problem earlier this year: because transactions in virtual currencies can be difficult to trace and have an inherently “pseudo-anonymous” aspect, some taxpayers may be tempted to hide taxable income from the IRS. IRS News Release, IR-2018-71, March 23, 2018. Taxpayers in this situation are at risk, given that, as recently reported in On the Chain, there is no voluntary disclosure program for taxpayers that have failed to report crypto related income.
In the Report, the IRS estimates that potentially unreported cryptocurrency tax liabilities represent approximately 2.5% of the estimated $458 billion tax gap. The calculation relies upon a recent article by Fundstrat Global Advisers, which sets cryptocurrency-related labilities at $25 billion, based on taxable gains of approximately $92 billon and a noncompliance rate of 50%. The Fundstrat Report estimates that approximately 30% of the investors in cryptocurrency are in the U.S., which is more than $500 billion at the end of December 2017 (up from about $19 billion at the start of January 2017!), according to data from CoinMarketCap.
While the IRS previously addressed certain issues in Notice 2014-21, there remain significant open issues that will need additional analysis and further guidance to refine the reporting of these transactions. For example, the reports cites the following:
- whether virtual currency held for investment is a capital asset;
- whether the virtual currency ought to be treated as a security, subject or not subject to the wash sale rules, or affected by mark-to-market implications under section 475 of the Code;
- whether a taxpayer may use LIFO or FIFO to determine the basis of virtual currency sold;
- how to track basis through activities in the blockchain;
- whether broker reporting is required under section 6045 of the Code for transactions using virtual currency;
- whether a taxpayer may contribute virtual currency to an IRA; and
- whether virtual currency is a commodity.
Also, while an initial reading would suggest that virtual currency would not be considered a financial account for FATCA purposes, various guidance notes issued by foreign jurisdictions for purposes of implementing the Common Reporting Standard (CRS) have indicated virtual currency does represent a financial account. This inconsistency, the Report notes, between regimes that purportedly try to maintain a high level of consistency will be confusing to withholding agents and subject to inherent error.
Citing the recent Coinbase summons and the failures to report income identified in that case, the Report opines that many, if not most, taxpayers will report their virtual currency activities correctly if they are able to determine their tax implications. Some taxpayers will be tempted to do otherwise, however, because anonymity is inherent in the structure of the block chain activities. In light of Coinbase, these taxpayers are likely to use exchanges outside the jurisdiction of the U.S. The Report notes that it is unclear at present whether the U.S. may obtain information from foreign exchange activities (determining the exact nature of residence of the virtual activities of an exchange is itself vexing under existing source and jurisdiction rules, and leads to issues of whether the activities are sourced to any jurisdiction or are stateless income).
The Report concludes with IRPAC stating that it would be very interested in helping develop information reporting and withholding guidance on these important issues.