Tales from the Crypto: Why Tax Reporting for Cryptocurrencies Is So Scary

 

The evolution of cryptocurrencies isn’t necessarily going as planned. The virtual “coins,” which aren’t really coins at all, were supposed to disrupt the very concept of money itself. With no central bank, no governmental oversight and no physical manifestation, cryptocurrencies provided a perfect method for some investors to skirt regulation and dodge tax authorities. And for a while, they have.

 

That narrative is changing. In 2016, the IRS successfully served a summons to popular trading exchange Coinbase in search of information about its customers. Two years prior to serving the summons, the IRS had issued Notice 2014-21, which detailed regulations for how taxpayers should report cryptocurrency transactions.

 

A legal battle between the IRS and Coinbase ensued, but by November 2017, a court had ordered the exchange to hand over a list of users, which it did. Then, a real tipping point occurred: The Tax Cuts and Jobs Act, passed in early 2018, removed a loophole and effectively enforced a tax on crypto assets. The battle to regulate cryptocurrency began in earnest. It continues today.  

 

Crypto supporters and government regulators have been at odds as the SEC and IRS have sought to rein in crypto exchanges and derive tax revenue from transactions. However, regulation is inevitable and will continue to evolve, and this will weigh heavily on the future of cryptocurrency.

 

What’s not obvious yet is the impact regulation will have. While crypto advocates worry that too much government oversight will damage the appeal and value of cryptocurrencies, regulation could also play a role in legitimizing a form of payment often associated with shady “dark web” purchases and money laundering.

 

What’s more, many investors who want to comply with the IRS will demand that exchanges provide tax information reporting since keeping up with transactions is nearly impossible for individual investors. In any case, exchanges—and investors—are ramping up tax information reporting efforts, and with tax reporting comes complexity and risk for all parties involved.

Cryptocurrencies and the air of lawlessness

It’s no secret that cryptocurrencies are the de facto currency of the dark web, the mostly unseen but enormous part of the Internet where (often illegal) pornography, weapons and gambling are readily available. While Bitcoin, the most popular cryptocurrency in general, used to rule the dark web, so-called “privacy coins” such as Monero and Zcash have become popular there recently.

 

Difficult to track because of their decentralized nature, cryptocurrencies leave little to no paper trail. And given their unique blockchain structures, Monero and Zcash are even harder to track than more popular currencies. As reported in The Economist, Europol, the European policing agency, says only 3-4 percent of Europe’s criminal proceeds are laundered using cryptocurrencies. However, that number will likely grow as crypto becomes more frequently traded.

 

While cryptocurrencies might be handy for buying illicit materials, their resulting association with lawlessness is not necessarily helpful for their growth. For example, one of crypto’s early exposures to the world at large was its use on the Silk Road dark-web markets, which were well known for selling illegal drugs. The FBI shut down two different versions of Silk Road, and the founder of the original site is serving life in prison.

 

So, while there’s nothing wrong with investing in cryptocurrencies, the crypto concept itself can carry something of a stigma, which might be enough to drive some investors away. And some in the crypto community like it that way.

 

“There’s a real anti-government sentiment in the cryptocurrency community,” says Tom Koceja, CPA, senior tax associate at Anton Collins Mitchell. “A lot of people take the ‘come-find-me’ kind of attitude.”

 

That feeling, however, is far from universal, as Koceja notes: “People in the movement are trying to move it out of the dark web and the stigma of it being for money laundering,” he says. “The next step forward is maintaining a more stable price structure, making people feel safer about putting their money into it.”

 

With massive investment firm Goldman Sachs setting up a cryptocurrency trading desk, crypto’s mainstream credibility is growing. And further regulation, including taxation, could actually have a stabilizing effect on crypto, boosting its legitimacy and easing concerns about its use for questionably legal purchases.

 

“It’s not going to get mainstream widespread adoption without people paying their taxes,” Koceja says. But just how much governments should regulate crypto and what that taxation should look like remain very much evolving questions.

Resistance to cryptocurrency regulation

For years, government agencies have attempted to tighten their grip on cryptocurrencies. In 2016, as part of its successful suit against the exchange, the IRS issued what’s called a John Doe summons to Coinbase. The summons required Coinbase to turn over information on its investors, most of whom were not paying taxes on crypto investments. The IRS also requires that exchanges report tax information for eligible investors. Coinbase is now in compliance.

 

Then, earlier this year, the SEC required trading platforms to register as national security exchanges. Exchanges have to either register or be exempt from registration, or risk operating illegally. The SEC’s move effectively put crypto exchanges in the same category as stock or commodities exchanges.

 

Government activity around crypto has raised some alarm bells in the crypto community. For example, in late March, a contingent of executives and attorneys met with the SEC, seeking limited regulation of crypto coins. Specifically, they asked that initial coin offerings (ICOs), essentially initial public offerings for cryptocurrencies, be exempt from SEC oversight. Currently, the SEC’s Division of Corporation Finance oversees ICOs.

 

At this point, the SEC seems unlikely to take a completely hands-off approach, and the IRS is definitely setting itself up to capitalize on tax revenues from cryptocurrency trading. However, governments are still deciding how to regulate virtual currencies, and uncertainty about regulation can lead to uncertainty about the value of cryptocurrencies.

 

Abroad, particularly in Asia, tough government regulation was the likely cause, at least in part, of wild swings in cryptocurrency prices. China has banned crypto exchanges and ICOs altogether. While regulation could end up having a stabilizing effect on crypto, even helping popularize the concept, government oversight will need to be fixed and stable before crypto values can begin to settle.

 

Right now, it isn’t. Part of the reason for that is the decentralized nature of crypto. With no central infrastructure at all, cryptocurrencies run on technology called blockchain, a sort of distributed database hosted across millions of machines, with no single point of storage. Beyond that, there are multiple cryptocurrencies and currency exchanges, with new ones popping up continually. They operate without any sort of common standard.

 

And then there’s the fact that the IRS doesn’t even consider cryptocurrencies to be actual currencies.

When currency isn’t really money

Individuals who invest in foreign currencies, such as the Euro or the Yen, report their investments to the IRS with form 8938, Statement of Foreign Financial Assets. Not so for crypto. The IRS treats cryptocurrencies as property, not currency, meaning they are subject to capital gains tax in a way the Euro or Yen would not be.

 

Individuals even have to pay taxes on items purchased with cryptocurrencies because, technically, they have converted an asset into a currency and “traded” it for something else, rather than making a purchase with standard money. The trade triggers a capital gains tax.

 

And global regulation differs greatly. For instance, the Swiss regulator, FINMA, treats crypto coins according to their function, meaning FINMA can treat them as currency when they’re used for payments and as investments when they’re not. The way FINMA taxes a currency, then, can and does change depending on what an investor does with the coins.

 

From an IRS reporting perspective, cryptocurrencies are likely to cause confusion. In order to ensure compliance with the IRS, exchanges should issue 1099-K forms to customers. The 1099-K is the same form companies in the sharing economy, such as rideshare or home-share outfits, send to the drivers and homeowners who use their platforms.

 

The 1099-K covers income individuals receive through third-party settlement organizations, or TPSOs, which process credit card payments online. The TPSOs themselves are responsible for sending 1099-K forms to payees and to the IRS. For example, a popular rideshare app would send 1099-K forms to its drivers and report the income to the agency as well.

 

The trick with the 1099-K is that it leaves a huge gap in terms of potential tax revenue. In order for an individual to be eligible to receive a 1099-K, the person has to meet an annual threshold of 200 TPSO transactions and (not or) $20,000 earned. For crypto traders, that might not be a particularly high bar, as Koceja notes even casual traders can have between 500 and 200,000 transactions per year. Still, the 200/$20,000 threshold will leave some crypto payments untaxed.

 

The 1099-K isn’t the only form potentially involved with crypto trading. Form 1099-B, used to report proceeds such as stock trades, could come into play for investors who trade one type of coin for another. For instance, if an investors trades Bitcoin for Ethereum, the transaction would trigger a reportable event, possibly a 1099-B. But exchanges currently aren’t required to issue 1099-B forms the way brokers do for stock trades.

The inherent complexity of crypto regulation

It all sounds very simple and clean, with two basic forms involved for reporting, but it isn’t. That’s because no other investment has ever worked the way crypto does. Nothing about crypto is centralized, and it’s easy to move coins form one exchange to another. That makes capital gains exceptionally difficult to track.

 

Investors can switch coins from one exchange to another at any time. The exchanges don’t communicate, nor do they have any sort of common standard. Some require investors to identify themselves, while others promise complete anonymity. Some are very restrictive, others less so. So, it’s impossible for an exchange to accurately report how much an investor originally paid for a crypto coin.

 

Koceja explains: “You move two Bitcoins from Coinbase to Bittrex to buy some Monero, Neo and Dash. Bittrex doesn’t know your basis in the Bitcoins. How could they give you a 1099-B?”

 

“It’s not like a 1099 you get from an investment brokerage, where it tells you where you bought it and where you sold it,” Koceja says. “Your basis doesn’t come with you. Most of the people we service trade on between 5 and 12 exchanges, and there are more than a thousand different coins.”

 

But the IRS is going to collect taxes one way or another. Individual investors should track their own transactions and report them on their tax returns accordingly. That’s not easy, though.

 

“If you traded some Bitcoin for Dash, the exchange reporting is most likely going to report the transaction as a percentage of Bitcoin, such as 0.4 Bitcoin, without actually referencing the price of Bitcoin at the time of sale,” Koceja notes.  “It then becomes your responsibility to calculate both sides of the transaction, filling in the missing pieces where needed.” 

 

Plus, many crypto investors would rather not report their investments to the IRS, anyway.

The risks crypto exchanges face with tax information reporting 

Individual investors might be able to get away with dodging taxes, although that’s likely to become a risky practice at some point. Crypto exchanges, on the other hand, won’t be so lucky. With the IRS and SEC increasing oversight, exchanges will be—and already are—liable for reporting tax information to clients and to the IRS. And the IRS does not mess around with entities that don’t report tax information.

 

Penalties for late or incorrect forms can quickly become severe. IRS penalties for late or incorrect filings for Tax Year 2017 are: 

  • Files received not more than 30 days late: $50 / form
  • 31 days late-August 1: $100 / form
  • After August 1: $260 / form
  • Maximum fine: $3.193 million

For Tax Year 2018, the fine for files submitted after August 1 will move to $270 per form, and the maximum will jump to $3.282 million. And should an exchange just decide not to report tax information at all? That’s when things can really get nasty. The fine for “intentional disregard” of tax reporting is $530 per form with no maximum.

 

There’s more to regulatory risk than just fines, though. Crypto regulation is still very much in the development process, meaning it could change rapidly and without warning. For exchanges, the burden of tax reporting comes coupled with the hassle of keeping up to date on how to stay compliant. 

 

Crypto exchanges just getting acquainted with tax information reporting are going to need some help staying compliant. Third-party reporting providers can provide it with solutions that minimize risk by facilitating the centralization and automation of reporting, both of which are key to avoiding penalties and developing efficient reporting processes. Solution providers can also play a vital role for exchanges by helping them keep up with the latest in regulatory developments.

 

Many individual investors, too, will want to stay in compliance with regulations but will find the process extremely difficult. If they can work with compliant exchanges, both the exchange and the investor will benefit from the assurance that they are not running afoul of IRS regulations.

Regulation is the only certainty

Cryptocurrency as a concept is disruptive, which makes it either frightening or exciting, or maybe a little of both. Central banks fear it. Commercial banks have been hesitant to invest in it. But tax authorities definitely want a piece of it, despite the desire of some members of the crypto community to fly under the taxation radar.

 

There are few guarantees about how cryptocurrency regulation will develop or look in the years to come. The inherent challenges of regulating cryptocurrency will continue to exist, but it might be regulation that fully delivers crypto from the perception of being used for shady purchases in corners of the dark web.

 

The future of crypto regulation is uncertain, except for one certainty: Regulation will exist, and it will evolve. Now that it’s in the crosshairs of tax authorities, crypto will be a regulatory target. And crypto exchanges will have to do their part to stay in compliance, no matter where that road may lead.

 

Take Action

Sovos has been facilitating tax information reporting compliance for more than three decades. Find out what Sovos and its partners can do for crypto exchanges just navigating the field. Or contact Sovos for more information.

 

 

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