Cryptocurrencies are often the currency of choice for illicit activities, including insider trading and other financial crimes. Many crypto tax evaders may gravitate toward evasion to preserve their anonymity and distance themselves from their behavior, rather than just to save on their tax bill.
A Treasury Inspector General for Tax Administration report this month highlights gaps in cryptocurrency tax enforcement. By improving compliance, the IRS can stanch nefarious endeavors and lend greater transparency to financial transactions in the process. This would address the crypto tax gap and curtail a broader array of illegal activities that rely on the anonymity of digital currencies.
In addition to netting substantial tax revenue, enforcing taxes on cryptocurrencies would have a butterfly effect on black market activities that are a drain on the economy in their own right. If the IRS seriously pursues cryptocurrency enforcement and financial transparency, it may find much more than the estimated $50 billion annual crypto tax gap.
Efforts and Shortcomings
IRS civil enforcement efforts with cryptocurrency transactions have been mostly “indirect and negligible,” according to the TIGTA report. The IRS Criminal Investigation division reported just 390 cases investigated between 2018 and 2023 that involved digital currency, with only 224 cases recommended for prosecution.
The agency’s broader operation, called “Hidden Treasure,” was supposed to be a collaboration between the civil and criminal divisions but has primarily focused on training and acquisition of tools rather than pursuing tax evaders in the crypto space.
The report further highlights the explosion of growth in digital currency usage, with over 26,000 different types of virtual currencies with a total market value surpassing $1.7 trillion. The IRS’s current efforts are clearly insufficient to address the scale of noncompliance.
Estimates of the percentage of US adults who have owned some form of virtual currency range from 21% to as high as 40%. Considering that, plucking 390 files for audit is tantamount to pulling a few blades of grass from an acre of lawn and assuming you have a full picture of what’s going on in the soil throughout the field.
Enhanced Compliance
The benefit of enhancing cryptocurrency compliance extends far beyond the immediate increase in tax receipts—it can significantly disrupt illicit activities that rely on the anonymity of cryptocurrencies.
Cryptocurrency use has been implicated in everything from drug and human trafficking to ransomware and terrorism. The IRS has offered a $625,000 award to anyone who can crack the anonymity of the cryptocurrency Monero, which represents only a $3 billion slice of the $1.7 trillion pie—indicating how valuable information on the identity of cryptocurrency tax cheats may be.
But there’s more than one way to catch a fraudster. If cracking crypto to catch the tax evaders doesn’t work, perhaps doggedly pursuing tax evaders to catch the bad actors exploiting crypto will have more success.
The IRS must take a coordinated and connected approach to data sharing rather than splice together pieces of information gathered from exchanges and audits. This may be an ideal role for artificial intelligence, which excels at analyzing vast amounts of data and identifying patterns that may not be readily apparent.
Efforts such as financial or asset tracing, which would have been administratively unworkable on a large scale, become feasible as technology can do more of the heavy lifting.
Form 1040 already requires filers to answer whether they have received or sold digital assets—this data is a huge piece of the larger puzzle. It should be cross-referenced against information gleaned from exchanges, other taxpayer audits, and taxpayers’ own reporting. Audits should follow, prioritizing high-income individuals first, as they stand to have the highest return on audit investment.
Moving Forward
The TIGTA report underscores how urgently the IRS must develop comprehensive and actionable compliance strategies that address the crypto tax gap. The strategies should employ advanced data analytics, including further collaboration with blockchain analytics firms and targeted audits of high-risk transactions.
The IRS should use the information it already has access to and collaborate with other agencies to curtail the use of cryptocurrencies for illegal activity.
Individual anonymized cryptocurrencies may not be crackable, and transaction histories may not ever be publicly accessible. But large transactions will have indicia elsewhere in the marketplace—most expenditures can’t be made in digital currencies, so a transfer to the traditional banking system is necessary.
An apt metaphor is detecting the size and shape of a tossed stone by the ripples it leaves in a pond. Given only one data point, such as an observer on a distant shore, the variables of tide and currents will make any inference on the stone nearly impossible. With more data points, and computational ability, a picture of the stone comes into view.
Crypto exchanges give the IRS information on traders that earn more than a de minimis return in a year. Large cash transactions through traditional banks are reported by banks, and the IRS has access to information from Form 1040 filings and the audits of other taxpayers—from individual taxpayers to exchanges.
The IRS doesn’t lack information on digital currency holders, but it may lack context. Working to contextualize the information they have already gathered is a plausible inroad to connecting taxes owed to individual taxpayers, closing the crypto tax gap, and disrupting criminal enterprises that rely on cryptocurrency anonymity.
Andrew Leahey is a tax and technology attorney, principal at Hunter Creek Consulting, and adjunct professor at Drexel Kline School of Law. Follow him on Mastodon at @andrew@esq.social
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