The IRS is sending letters this summer to more than 10,000 taxpayers who may have failed to properly report their virtual currency transactions. Taxpayers should take these letters “very seriously,” warns IRS Commissioner Chuck Rettig.
Types of IRS Virtual Currency Letters
The IRS letters come in three versions. Each version:
- explains why the IRS is sending the letter,
- summarizes the federal tax rules for digital currency, and
- tells the taxpayer what to do next.
Taxpayers who receive any one of these letter should review their past virtual current transactions and related tax returns. If necessary, the taxpayer should then file correct returns and pay any tax owed, plus interest and penalties.
However, a taxpayer who receives the most severe version of the letter should also consider seeking professional advice.
Taxpayer Must Respond to Virtual Currency Letter 6173
The most serious cryptocurrency letter is Letter 6173. It says that the IRS has not received a required return or schedule to report the taxpayer’s virtual currency transactions for at least one tax year from 2013 through 2017. Thus, it sounds like the IRS has evidence that the taxpayer has failed to correctly report at least one specific transaction.
Taxpayers are required to respond to Letter 6173. The taxpayer may:
- file a delinquent return,
- file an amended return to correct errors, or
- swear that all required returns were filed and the information on them was correct.
The taxpayer must respond by the deadline given in the letter, or risk examination or audit. However, a taxpayer who intends to submit an original or amended return may request a 30-day extension.
Sworn Statement Response
Taxpayers who do not submit original or amended returns must swear that that they already filed correct returns. They must also submit a statement of facts that:
- explains the taxpayer’s position,
- Includes a complete history of the taxpayer’s previously reported income from virtual currency transactions,
- describes how the taxpayer complied with reporting requirements,
- attaches copies of previously filed documents that confirm compliance, and
- provides the taxpayer’s contact information.
The taxpayer must swear, under penalties of perjury, that the statement and the supporting documents are true, correct and complete. In addition, the taxpayer must acknowledge that the IRS may:
- make further contacts with the taxpayer or the taxpayer’s representative, and
- check the taxpayer’s submissions against information provided by banks, financial advisors, and other sources.
Legal and Accounting Advice
It is this sworn statement that makes advice from lawyers and accountants so imperative. It’s easy for taxpayer to make errors–even unintentional ones–in the supporting documents and in other communications with the IRS. This could be especially costly if the IRS has third-party information that contradicts the taxpayer’s claims.
These types of errors may give auditors the ammunition they need to impose or increase civil penalties, or even seek criminal sanctions against taxpayers who, knowingly or not, mislead the IRS about their digital currency transactions. Taxpayers can reduce this risk if they get competent legal or accounting advice before they submit their statements.
Taxpayers Do Not Have To Respond to Letter 6174 and 6174-A
The other two versions of the letters are less dire than Letter 6173. In fact, Letters 6174 and 6174-A both tell taxpayers that they do not have to respond.
These two letters are almost identical. Both of them:
- explain that the IRS believes the recipient may have current or previous virtual currency accounts,
- summarize how to report virtual currency transactions,
- advise the taxpayer to review the compliance information and, if necessary, file delinquent or amended returns, and
- provide an IRS contact phone number for taxpayers to ask questions, and promise a response within three business days.
Letter 6174-A also warns the taxpayer that the IRS may send additional correspondence.
Confusion About Virtual Currency Compliance
The IRS has not made it easy for taxpayers to properly report their digital currency transactions. The only formal guidance is Notice 2014-21, which treats cryptocurrency as property, rather than currency.
Thus, taxpayers must report gain or loss whenever they spend something like Bitcoin or Ethereum. This means taxpayers must:
- calculate their basis in the digital currency,
- determine the fair market value (FMV) of the currency in U.S. dollars at the time they spend it,
- figure out the FMV of any property they acquire in exchange for the virtual currency,
- deduct basis in the virtual currency from the FMV of the purchased property to determine gain or loss on the transaction, and
- report the gain or loss on their tax returns and the appropriate schedules.
Similarly, a taxpayer who is paid in digital currency for goods or services must determine and report income based on the FMV of the currency when it is received.
Unsettled Virtual Currency Issues
This limited IRS guidance leaves many unsettled issues for owners of digital currency. Among the most pressing:
- How do taxpayers determine the current FMV value of digital currency?
- How do taxpayers convert the current FMV into U.S. dollars – especially currencies that may have different values on difference exchanges, or currencies that are not listed on any exchange?
- What kind of digital currency records do taxpayers need?
- How does cryptocurrency compliance interact with Foreign Account Tax Compliance Act (FATCA) compliance and Form 114, Report of Foreign Bank and Financial Accounts (FBAR)?
The IRS has been promising for several months that it will release additional cryptocurrency guidance “soon.” However, it is not clear how comprehensive that guidance will be.
No Other IRS Compliance Initiatives
It also is not clear what steps the IRS will take next. However, taxpayers should not wait for a voluntary disclosure and compliance initiative, like the Offshore Voluntary Disclosure Program (OVDP) the IRS offered several years ago to encourage FATCA compliance. The OVDP streamlined procedures for filing amended returns, and granted some relief from civil penalties.
However, the IRS announced last year that it is not planning any similar voluntary compliance program for virtual currency. Thus, it appears that a taxpayer’s best bet for minimizing noncompliance penalties and interest is to do just that the cryptocurrency letters say – review past returns and quickly correct any errors.
Little Cause for Panic—Yet
Still, most taxpayers who receive the digital currency letters probably don’t need to panic. Many observers believe that some of the letters, especially Letter 6174, are something of a fishing expedition based on the records that the digital currency exchange Coinbase turned over to the IRS last year. These records include names, taxpayer ID numbers, birthdates, addresses, and transaction histories for about 13,000 of Coinbase’s higher-transaction customers.
However, most observers also agree that the IRS will only get more aggressive in its virtual currency compliance efforts.
By Kelley Wolf, JD, LLM