“Making payments with virtual currency has emboldened taxpayers to move money offshore, purchase illegal goods and services, and carry out other nefarious activities. Users may feel there is the possibility of avoiding tax reporting obligations.”
Treasury Inspector General For Tax Administration (TIGTA) Report, Virtual Currency Tax Compliance Enforcement Can Be Improved, July 10, 2024, Report Number 2024-300-030.
The number of virtual currency types has added to this problem. According to TIGTA, the number of virtual currencies has grown significantly since April 2020, from 5,000 to over 26,000 (420 percent) as of July 2023. The two most dominant virtual currencies had a total market value of over $1.7 trillion as of June 11, 2024. Bitcoin represented nearly 62 percent of the market capitalization at over $1.3 trillion, while Bitcoin and Ether together account for over 82 percent of market capitalization among the 10 largest virtual currencies.
TIGTA Findings
TIGTA investigated virtual currency tax compliance enforcement by the Internal Revenue Service (IRS), and released its findings in a report dated July 10, 2024. Its key findings were:
- The IRS Criminal Investigation has taken advantage of analytics tools to address virtual currency noncompliance. During Fiscal Years 2018 to 2023, Criminal Investigation investigated 390 cases involving virtual currency (hereafter referred to as “digital assets”). In that period, 224 cases were completed with a recommendation for prosecution.
- The IRS civil examination enforcement efforts focused on digital assets are mostly indirect and negligible.
- The IRS established “Operation Hidden Treasure,” describing it as a partnership between the criminal and civil functions to identify taxpayers who omit digital assets from their tax returns. However, its primary purpose has been limited to acquiring tools and training rather than pursuing taxpayers.
- Passage of the Infrastructure Investment and Jobs Act in November 2021, requires brokers to file an information return for digital assets transactions in a calendar year. In response, the IRS created a new information form to report the information needed to calculate gains (or losses) on transactions. While the Infrastructure Investment and Jobs Act was effective for transactions after January 1, 2023, the proposed regulations are effective for transactions after January 1, 2025, for gross proceeds reporting and January 1, 2026, for basis reporting. The proposed two-year implementation delay will hinder efforts to regulate the digital asset industry and may result in lost revenue and taxpayer burden.
TIGTA Recommendations
TIGTA’s report makes three recommendations to improve digital asset tax compliance efforts. Unfortunately, the first two recommendations are heavily redacted and the recommendations cannot be deduced from the unredacted language. The third recommendation, which is unredacted, is that the Large Business & International (LB&I) Division, Small Business/Self Employed (SB/SE) Division Examination, Criminal Investigation, Research Applied Analytics and Statistics (RAAS), and the Digital Assets Initiative Project Office develop a compliance plan that includes the use of newly-developed Form 1099-DA data, case identification, and case selection of digital asset cases.
Tax Treatment of Digital Assets
The IRS regards digital assets as property and not currency. When fiat currency (e.g., U.S. dollars) is used to purchase digital assets, no gain or loss is recognized by the purchaser. If the purchaser later uses the digital asset to purchase a good or service, gain or loss will be recognized on the transaction. The purchaser’s tax basis in the digital asset (the price it paid for the digital asset) will be compared to the value of the good or service acquired. If the value of the good or service is greater than the tax basis in the digital asset, the purchaser will recognize a gain. Conversely, if the value of the good or service is less than the tax basis in the digital asset, the purchaser will recognize a loss. Generally, the gain or loss will be capital gain or loss (as opposed to ordinary income) and will be long-term or short-term gain or loss depending on whether the purchaser held the asset for more than one year (long-term capital gain) or one year or less (short-term capital gain). See Podcast: DeFi and Tax: How are digital currencies treated by the IRS?
When digital assets are received in exchange for goods or services, the person receiving the digital assets is treated as receiving an amount equal to the value of the good or service provided. Generally, this will be the value of the digital asset at the time it is received and will need to be included in income at that time. By treating digital assets as property, a single transaction can create income (or loss) for both the purchaser and seller. This can include a transaction in which one type of digital asset is exchanged for another type of digital asset (e.g., Bitcoin exchanged for Ether). Because each digital asset transaction involves the sale or exchange of property, taxpayers owning digital assets must closely monitor and maintain records of all their transactions to correctly report their tax liability at the end of the year.
Information Reporting for Digital Assets
One of the enforcement challenges for digital currency is that the IRS has not received third-party income information reporting for digital asset transactions. According to IRS data for tax years 2014 – 2016, when there is income information reporting from third parties, tax compliance exceeds 90 percent; however, when there is no third-party income information tax compliance is 55 percent.
To get more information on digital asset ownership, the IRS created a question on Schedule 1 of Form 1040 in Tax Year (TY) 2019 asking taxpayers if they received, sold, sent, exchanged, or acquired an interest in virtual currency. For TY 2020, the IRS moved this question to Page 1 of Form 1040, where it remains. See IRS Provides Guidance on How to Answer Digital Asset Question on Tax Return. The IRS has expanded this question to Form 1065, U.S. Return of Partnership Income; Form 1120, U.S. Corporation Income Tax Return; Form 1120-S, Income Tax Return for an S-Corporation; and Form 709 (Line 20), United States Gift (and Generation Skipping Transfer) Tax Return.
Congress stepped in to help with digital asset reporting by including provisions in the Infrastructure Investment and Jobs Act (IIJA) that amended the Internal Revenue Code. These provisions impose information reporting requirements for brokers with respect to digital assets. They clarify the definition of broker to include “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” I.R.C. § 6045. The law also adds digital assets acquired on or after January 1, 2023, to the list of covered securities subject to cost-basis reporting. These information reporting provisions do not kick in, however, until final regulations are issued with respect to them.
In response to these changes, the IRS has developed a new information return, Form 1099-DA. The form is designed to include proceeds from digital assets transactions and to be used by brokers once the regulations for digital asset reporting are finalized. The information required on Form 1099-DA so that taxpayers can calculate gains (or losses) from digital asset transactions will include:
- name and address;
- account number;
- Tax Identification Number of filer and recipient;
- broker type;
- gain or loss;
- date and time acquired;
- date and time sold; and
- cost or another basis.
Even though brokers do not have to report on Form 1099-DA until the regulations are finalized, taxpayers must report taxable transactions resulting from digital activities.
TIGTA Report
TIGTA’s overall objective in reviewing tax compliance with digital assets was to determine how effectively the IRS identifies income earned from digital asset transactions. The current lack of third-party information reporting hinders the IRS. It prevents the IRS from having a clear line of sight to digital asset transactions. The IRS’s knowledge of digital asset transactions is expected to improve once the information reporting regulations for digital assets are finalized and brokers are required to report digital asset transactions.
The TIGTA report found that the IRS Criminal Investigation Division is using investigation tools to identify digital asset transactions. Criminal Investigation has taken advantage of analytics tools to address digital assets noncompliance and has successfully worked with blockchain analytics firms to identify individuals who may be evading taxes by using digital assets to hide their income. Its special agents use these tools to obtain both private sector and public blockchain data to identify digital asset transactions that are potentially being used to fund criminal activity. For example, one such software tool analyzes the blockchain public ledger data, which is primarily used to track digital assets. With this data and other open-source information, Criminal Investigation uses available IRS tax information to enhance its investigative efforts to identify potentially fraudulent blockchain activity. Even with these tools, Criminal Investigation faces challenges. Special agents typically identify the potential criminal transactions before identifying the perpetrator (taxpayer).
Notwithstanding the challenges, Criminal Investigation (CI) has significantly increased its prosecution of criminal activity involving digital assets.
- Between FY 2018 and 2023, CI saw a 113 percent increase in cases with digital assets.
- As a result, digital asset seizure values have increased substantially, with the highest occurring in FY 2022 at $7 billion.
- Cases recommended for prosecution have more than doubled from FY 2018 to 2022.
Civil investigations of digital asset activities are a different story. TIGTA found that the civil investigation enforcement efforts are mostly indirect and negligible when it comes to identifying digital asset transactions. For example, since FY 2020, the Small Business/Self Employed (SB/SE) Division’s Examination (civil investigations) performed over 365,000 taxpayer examinations. Although not specifically selected to address digital assets compliance, during that same period, Examination performed 1,144 examinations of taxpayer returns that included a review of digital assets activity. According to TIGTA, the IRS’s coverage of digital assets activity could be considered insignificant, with only 1,144 (0.31 percent) of the 365,391 total examinations conducted having a digital asset component.
Takeaway
The IRS already has implemented several programs to address digital asset tax compliance enforcement. These include the Digital Asset Advisory Committee, the Digital Asset Initiative, and the Digital Asset Initiative Project Office. Once brokers are required to report digital asset activity on Form 1099-DA, the IRS will have more information to identify taxpayers engaged in digital asset transactions and potential under reporting of income from those transactions. The reporting of gross process from digital asset transactions on Form 1099-DA will likely begin for the 2025 taxable year, and basis reporting will likely begin for the 2026 taxable year.
Before reporting begins on Form 1099-DA, civil examinations may start benefiting from some of the examination tools CI has been using. IRS has been using its increased funding to expand its bandwidth for examinations. IRS agents will receive more training on digital asset activities, systems for identifying cases will improve, and there will be more agents to conduct examinations.
The days of not reporting (or under reporting) income from digital asset transactions and not getting picked up for examination by the IRS may soon come to a close. This will increase the importance of taxpayers owning digital assets to monitor and maintain records of all their transactions to correctly report their tax liability at the end of the year.