The Tax Man Cometh: Crypto Traders Cannot Avoid Paying the Governments Cut of Gains Sean Ryan, CTO of NODE4, Explains

Several weeks ago, Crowdfund Insider reported on letters being mailed by the US Internal Revenue Service (IRS) to individuals regarding possible taxes owed on crypto trading gains. These “CP2000” letters are largely driven by mandatory reporting from cryptocurrency exchanges.

As CI has been told, many of the investors who received a 1099-K form from a crypto exchange realized it was incorrect, so they paid what they thought they needed to pay based on their own evaluation of their liability. But once that happens you may end up with a discrepancy: a taxpayer may pay something different from what the IRS expected. If that is the case, you may have a problem.

Don’t Mess with the Feds

According to NODE40, a cryptocurrency reporting software firm, Node40 estimates that approximately 100,000 people have received CP2000 letters, based on the number of 1099-Ks the IRS has received from exchanges, brokers or anyone required to report 1099-Ks in the last five years.

If you have received one of these CP letters and you don’t fix the taxes that you owe or you don’t write in and prove tax return items within 30 days of receiving the letter, the IRS can tell the exchange to start holding back (backup withholding) part of the money you would be withdrawing from that exchange.

Node40 shares the following example:

“let’s say I have a $10,000 loss on the exchange. I withdrew $100,000 resulting in a $10,000 loss, so I should be taking a loss, but the IRS sees that as a $100,000 payment. If the reason I was taking that out was to pay my taxes, now with backup withholding, the IRS are going to take 24% out of that, so $24,000. And they have a right to do so, but that money is not actually owed.”

That’s no fun having to pay money to the IRS that may not be owed.

Recently, Crowdfund Insider spoke with Sean Ryan, co-founder of NODE40, to better understand the potential tax risk for crypto investors in the US. Our conversation is below.

Are you receiving a lot of inquiries regarding crypto taxes – CP2000 letters?

Sean Ryan: Yes. We saw an uptick in activity when the early letters were issued (6173, 6174, and 6174-A), but the CP2000 ones are more serious and require action from the recipient that includes either back taxes being paid, or proof that the correct payments were made. A defensible audit trail has become the only way to backup claims made by the taxpayer.

You estimate there are 100,000 CP2000 letters – are those all for crypto exchange transactions?

Sean Ryan:  CP2000s are not directly related to cryptocurrency. The IRS issues CP2000 letters every year but they are not issued to 100% of all taxpayers with known discrepancies. The latest data I found was from the 2013 tax year in which 27.6 million returns out of 147.9 million filed had reporting discrepancies. The IRS issued only 3.7 million letters (2.5% of all returns) because the agency is so understaffed, it’s not capable of handling responses from all delinquent filers. Although the letters are not cryptocurrency-related, the methodology used to report cryptocurrency information by exchanges to the IRS results is a high percentage of reporting discrepancies. Consequently, there will be a higher percentage of cryptocurrency traders caught up in the process used to identify under reporters.

Are all domestic exchanges (US) providing data to the IRS? What about exchanges operating outside the US?

Sean Ryan: It’s not clear how many or which exchanges are reporting this information to the IRS but since the CP2000 letters include the source of the information reported incorrectly, we know some. Any exchange intending to continue operations in the US (or operating outside of the US and serving US citizens) will be reporting such information soon if they aren’t already. The IRS has a long history of targeting financial institutions behaving badly, and the Coinbase case made it clear that exchanges have a duty of information reporting. Over the last 2 years, we’ve seen exchanges like Bittrex, Binance and others stop – or plan to stop – serving US customers because it’s easier to eliminate the reporting need than to comply with unclear or evolving regulatory rules.

Once all FATF rules are implemented will it be far simpler to track gains/losses?

Sean Ryan: Not likely. Unlike securities where they are bought and sold in a controlled manner through regulated financial institutions with robust reporting in-place, cryptocurrencies can be held and transferred by anyone. Today, it’s still ill-advised to let third parties hold your cryptocurrency, so people tend to hold it themselves off-exchange. When transferred to an exchange, the platform is entirely unaware of the origin so right away the basis will be incorrect. Cryptocurrency can also be used in a retail purchase so users can dispose of and receive cryptocurrency independent of financial institutions.

IRS Internal Revenue ServiceDo you believe there is a lot of avoidance? Or is it just more a lack of understanding?

Sean Ryan:  Avoidance? The IRS seems to think so with its apparent major push for enforcement on an industry with a tiny market cap compared to securities and other asset classes. I do believe there are some willfully avoiding their tax obligations, I think the real problem facing taxpayers is uncertainty. The variety of accounting approaches (right or wrong) give the appearance of options for traders so instead of risking overpayment, they just choose to wait and see what the IRS expects. Unfortunately, this is a strategy that will probably work out since the IRS is understaffed and slow to help. According to the Electronic Tax Administration Advisory Committee, you are statistically unlikely to be contacted by the IRS even if they know you are misreporting.

In the US, the IRS treats as property. Other jurisdictions treat crypto differently. Does this create an uneven playing field? An incentive to hold outside the US?

Sean Ryan:  Not really. If you are a US citizen, keeping assets abroad does not exempt you from financial obligations on those assets. For instance, traders using foreign exchanges are still required to file FBAR and FATCA forms to the government.

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