Cryptocurrencies and non-fungible tokens (NFTs) have become a trillion-dollar asset class over the past decade. But, while most crypto traders and investors are above-board, the IRS believes it's missing out on more than $50 billion annually in unpaid taxes. As a result, the agency has been stepping up its enforcement activities to close the tax gap.
If you're a crypto trader or investor, it's essential to understand the potential IRS tax penalties resulting from improper reporting or non-compliance with tax laws. That way, you can ensure you fully comply with the law and avoid unnecessary penalties.
In this article, we'll cover the different types of penalties the IRS can impose on crypto traders and investors and the steps you can take to avoid them.
Types of IRS Tax Penalties
The IRS imposes several different penalties on taxpayers. It's important to note that these penalties are not mutually-exclusive, and you may owe multiple penalties for the same offense. In addition, the IRS charges interest on penalties, which can add up over time. So, it's critical to take measures to avoid these penalties.
If you incur a penalty, the IRS may remove or reduce them if you acted in good faith and show reasonable cause (e.g., death, serious illness, natural disasters, or system issues). You can also dispute a penalty if you disagree with your owed amount.
Taxpayers that don't file a tax return may incur a costly failure-to-file penalty. If you don't report your crypto gains and losses on a tax return, you could incur a penalty of 5% of the unpaid tax for each month the tax return is late, up to a maximum of 25%. If your return was over 60 days delinquent, the minimum penalty is $435 or 100% of the required tax.
Taxpayers that don't pay their taxes may incur a less costly failure-to-pay penalty. If you don't make a payment on time, you will typically owe a penalty equal to 0.5% of the unpaid tax for each month the payments are late, up to a maximum of 25%. However, if you have an approved payment plan, the monthly penalty is reduced to 0.25%.
Taxpayers that substantially underpay taxes due to negligence or disregard of rules or regulations may be subject to an accuracy-related penalty equal to 20% of the understated taxes. According to the IRS, a substantial underpayment occurs if you understate your tax liability by 10% or $5,000, whichever is greater.
Civil Fraud Penalties
Taxpayers that willfully understate their tax liability or commit fraud may be subject to a civil fraud penalty equal to 75% of the unpaid taxes. Moreover, examiners that find strong evidence of fraud may refer the case to the IRS Criminal Investigations Division for possible criminal prosecution. So, both civil sanctions and criminal prosecution may occur.
How to Avoid IRS Penalties
The best way to avoid IRS penalties is to file and pay your taxes on time. But, when it comes to crypto, that's easier said than done. It's challenging to aggregate crypto transactions across wallets and exchanges, and the agency offers little guidance on how to treat some complex transactions. Fortunately, a handful of tools and strategies can help.
Always File on Time
The failure-to-file penalty is the most common and costly IRS penalty. Fortunately, it's also the easiest to avoid. If you need more time, file for an automatic extension (Form 4868) to avoid triggering penalties. And, even if you cannot pay, always file on time to minimize the penalties you incur – 0.5% monthly is much less than 5% monthly!
Keep Accurate Records
The first step in avoiding IRS penalties is keeping a record of all your crypto transactions. That's relatively easy on exchanges but may be more difficult when using software or hardware wallets. Fortunately, you can use crypto tax software, like ZenLedger, to aggregate all of your transactions in one place and keep them organized.
Understand Tax Implications
The IRS provides clear guidance for most crypto transactions. In short, the agency classifies crypto as "property," subjecting it to rules similar to stocks and bonds. Some situations are unclear, though, like whether wrapping a token is taxable. So, it's essential to understand what a conservative versus aggressive accounting treatment entails.
Our Crypto Tax Guides provide some insights into specific situations to help you understand how taxes may apply.
Seek Professional Help
Most crypto traders and investors can rely on crypto tax software, like ZenLedger, to generate Form 8949, Form 1040 Schedule D, and other forms they need to file (and even integrate with TurboTax). But, if you have a complex return, consider hiring professional help. A CPA can help provide advice and counsel during an audit.
The tax treatment of crypto assets continues to evolve, particularly in decentralized finance (DeFi). As a result, it's a good idea to keep up with the latest guidance and legal cases surrounding these topics.
A great example was Joshua and Jessica Jarrett's lawsuit against the IRS in 2021 to recover federal income taxes levied on their stake-generated Tezos. While the couple tried to get the IRS to reach a definitive legal ruling, a federal judge dismissed the case after the IRS offered to issue the plaintiffs their requested refund.
At the same time, other lawsuits reinforce the importance of filing and paying crypto taxes. For instance, in 2020, the IRS won a case against Coinbase, requiring it to provide customer data. These successes have helped the agency go after tax evaders, making it harder to get away without paying taxes. And there are signs enforcement will continue stepping up.
The Bottom Line
The cryptocurrency and digital asset world can be complex, and navigating IRS tax regulations can be challenging. However, it's essential to be aware of tax laws to avoid penalties. By doing so, you can continue to benefit from the crypto market and its potential while minimizing your exposure to IRS tax penalties.
If you trade crypto assets, ZenLedger offers one of the best ways to avoid IRS penalties. Our platform aggregates transactions across your exchanges and wallets and autocompletes the forms you need to file, ensuring accuracy. We also make it easy to identify ways to save with tax loss harvesting and other techniques.
This material has been prepared for informational purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.