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Don’t Avoid the IRS’s Cryptocurrency Letters, Tax Advisers Warn

Aug. 9, 2019, 8:45 AM

Individuals who received letters from the IRS recently should heed the agency’s warnings about reporting their cryptocurrency assets.

Failure to take the letters seriously could mean big penalties down the road, said Evan Fox, practice leader in the Digital Asset Advisory Services group at Berdon LLP in New York. “The IRS likely after this will not be lenient if they happen to catch people.”

The agency in July began sending letters to more than 10,000 cryptocurrency users suspected of failing to report or misreporting their digital assets. The letters warn of potential civil or criminal enforcement action if the assets aren’t properly disclosed to the Internal Revenue Service.

There are traditionally several ways taxpayers can avoid penalties when they’ve failed to file or pay their taxes on time—for example, they can prove they had reasonable cause or are first-time offenders.

But now that the IRS has directly warned cryptocurrency users, it’ll be harder for them to justify getting penalty relief, Fox said.

“The more the IRS publicizes an issue, the less likely it is to buy the argument that ‘I really didn’t know,’” said Bryan C. Skarlatos, a partner at Kostelanetz & Fink LLP in New York.

Innocent or Willful Mistake

The IRS sent cryptocurrency letters to a broad swath of taxpayers, including those who have been fully compliant, according to Fox, who had a client receive a letter even though that person had been accurately disclosing the assets to the IRS.

Taxpayers who are in compliance shouldn’t have to take any further action, he said.

Crypto investors who have misreported their digital assets should consult an adviser because their next steps may vary based on whether they intentionally dodged tax liabilities or made an honest mistake, Skarlatos said. The amount of money at stake can also make a difference, he said.

“If it was an innocent mistake, you may be OK just filing an amended return,” he said. The same logic applies to small dollar amounts, he said.

But for taxpayers who acted intentionally or willfully and are dealing with large amounts, voluntary disclosure may make more sense, Skarlatos said.

The IRS in September 2018 ended its Offshore Voluntary Disclosure Program, which offered taxpayers the opportunity to avoid criminal penalties and to settle outstanding tax charges stemming from noncompliance relating to foreign assets. The agency replaced that program with more general voluntary compliance procedures in November 2018 that combined the process for international and domestic issues.

Once accepted into the new program, taxpayers must provide six years of tax returns to the IRS and will typically owe a single civil fraud penalty for the year during that period with the highest tax liability.

For voluntary disclosure to work, taxpayers need to go to the IRS before the agency is able to prove they willfully avoided paying their taxes. “If they catch you, you could be criminally prosecuted,” Skarlatos said.

Hidden Tax Guidance?

The IRS’s letter campaign has upset some crypto advocacy groups that say the agency shouldn’t be prioritizing enforcement until it issues new guidance clarifying issues that have confused taxpayers, including how to treat hard forks or air drops.

An air drop occurs when users get tokens for free. A hard fork occurs when there is a change to the software of a cryptocurrency, like bitcoin, that creates two separate versions of the blockchain—bitcoin versus bitcoin cash.

The only IRS guidance on cryptocurrencies is Notice 2014-21, which is written in the form of frequently asked questions. Most practitioners say that the guidance leaves many questions unanswered.

IRS Commissioner Charles Rettig said in May that more guidance would be released “soon.”

James Foust, senior research fellow at the advocacy group Coin Center, suggested in an Aug. 5 blog post that the recent cryptocurrency letters contain “hidden tax guidance.” The letters note that taxpayers must report exchanges of one virtual currency for another, such a bitcoin for ether.

This language appears to indicate that taxpayers can’t apply like-kind exchange principles to cryptocurrency trades, Foust said. A like-kind exchange is a tool under tax code Section 1031 that allows taxpayers to postpone paying tax on the gain of a sale if the proceeds are reinvested in similar property.

It’s clear that taxpayers can’t use like-kind exchanges for cryptocurrency trades beginning in 2018 due to changes made in the 2017 tax overhaul. But tax practitioners have disagreed about whether that tool can apply to transactions prior to 2018.

Skarlatos agreed that the phrasing seems to shed light on what the IRS might say in its forthcoming guidance with respect to like-kind exchanges.

Reasonable, Consistent

In the absence of more guidance, taxpayers should consult with their advisers and make sure they are taking positions on their tax returns that are easy to justify.

“As long as you have some sort of reasonable stance and can defend it, even if you’re wrong it can help you get out of penalties,” Fox said, referring to IRS regulations that exempt taxpayers from accuracy-related penalties under tax code Section 6662 if they act reasonably and in good faith.

Taxpayers will generally still be subject to interest if they are wrong, but penalty relief can create significant savings, he said.

It’s also important for taxpayers to be consistent and not appear as if they’re flipping their position from one year to the next in order to get a better tax outcome, said Dashiell C. Shapiro, counsel at Shartsis Friese LLP.

Taxpayers should take this logic into account when dealing with gray areas, such as determining the fair market value of their cryptocurrency assets or applying like-kind exchange principles, he said.

“One of the worst things you can do is take one position in one year when it’s favorable, and then the opposite position the next year when it’s also favorable,” Shapiro said.

To contact the reporter on this story: Allyson Versprille in Washington at aversprille@bloombergtax.com

To contact the editors responsible for this story: Patrick Ambrosio at pambrosio@bloombergtax.com; Karen Saunders at ksaunders@bloombergtax.com