If you IRS on the Hunt
This summer the IRS issued 10,000 letters to taxpayers who it believes should have reported virtual currency sales (also called cryptocurrency). Virtual currency, in a nutshell, is a digital unit of value. So like money this virtual currency can be used to buy and sell goods. What makes virtual currency different than actual currency (like US dollars or British pounds) is that this digital currency is part of an exchange where the value of the currency (like bitcoins) changes depending on the market.
The IRS has been concerned for some time that taxpayers are using this virtual currency to either engage in tax evasion (as virtual currency operates outside the regular financial market) or in laundering the proceeds of illegal activities (like drug trafficking or financial fraud). The IRS was instrumental in shutting down the Silk Road, called the Amazon.com of drug trafficking, an online store for buying and selling illegal drugs. The Silk Road used a private network to protect buyer’s and seller’s identities combined with virtual currency (mostly bitcoin) to make the purchases without running it through banks or using cash. You can read more about it here on Wikipedia.
The IRS was able to obtain thousands of taxpayer’s virtual currency activity through a John Doe summons to Coinbase (and the IRS may have obtained even more since then). A John Doe summons just means the IRS requested the target company to provide potential information about US taxpayers. In this case, Coinbase had to search its records for bitcoin users who appear to be US taxpayers which the IRS then compared to its database.
So now that I have set the stage, here is what the IRS is doing.
IRS Combines Letter Campaign and New Form 1040
The IRS first sent out 10,000 letters to taxpayers who were did not report their virtual currency transactions properly. Unlike other letters, the IRS knows the taxpayers bought and sold virtual currency. The taxpayer failed to report the sales or reported it wrong. There are three types of letters sent out by the IRS. Two types of letters merely request the taxpayer to review his or her return. The other type of letter requires a response signed under penalties of perjury. This final letter is mailed to IRS Criminal Investigation Division in Philadelphia. Yikes.
Additionally, the IRS has issued a draft Form 1040 which requires taxpayers to report whether or not they have engaged in any transactions involving virtual currency. Now you will have to declare whether or not you have bought or sold virtual currency, so how should you report it?
What This Means for You
If you have virtual currency, the problem the limited guidance on taxation from the IRS. The only published guidance are two notices and a frequently asked questions page. That’s it. While the IRS believes that virtual currency has been used to evade taxes or launder money but most taxpayers just don’t know that virtual currency is not like regular currency. Once you or other taxpayers realize this then the problem becomes reporting it on your tax return.
Right now the IRS’s guidance is that virtual currency transactions are taxed like buying and selling property. This means every transaction you make (for gas or groceries let’s say) results in a potential gain or loss. There is no de minimis requirement and so any transaction large or small must be reported. So if you have virtual currency then you need to talk with an accountant to make sure you are reporting it correctly. The IRS is on the hunt, will you be the prey?!
I am Maine’s IRS Problem Solver. My firm helps Maine taxpayers in trouble. If you or someone you know in Southern Maine wants more information on how to resolve your unpaid taxes, please feel free to contact me directly at 207-502-7181 or by filing out my contact form. A Maine tax attorney can help you consider your options.