Cryptocurrencies have become a magnet for unsavory actors interested in money laundering or tax evasion. For example, Silk Road's founder famously leveraged Bitcoin to facilitate anonymous transactions. But the IRS invests heavily in crypto enforcement, and crypto asset seizures break new records yearly.
This article delves into how the IRS taxes crypto on a high level, where you might run into trouble, and how the agency can seize crypto assets.
How the IRS Taxes Crypto
The IRS treats cryptocurrency as property for tax purposes, meaning it's more similar to stocks than dollars.
Buying cryptocurrency with fiat currency (e.g., dollars) doesn't initiate a taxable event, but receiving, selling, or otherwise disposing of crypto assets typically creates a tax obligation.
The amount of tax you owe depends on your tax bracket, the nature of the transaction, and the holding period. For instance, if you earn crypto as compensation, you typically owe ordinary income tax. If you invest in Bitcoin and sell it two years later, you owe the lower long-term capital gains tax. Additionally, any losses can offset your taxable gains.
Can the IRS Track Crypto?
How does the IRS track crypto transactions? While the blockchain provides pseudo-anonymity, tracing transactions back to a wallet and seeing where funds move is easy.
Many exchanges provide 1099s to the IRS, enabling them to associate accounts with identifying information. So, if you use one of these exchanges, the IRS can easily see that you made crypto transactions and estimate your tax liability. As a result, they can impose penalties and interest if you fail to make an adequate payment.
If you don't use exchanges, the IRS could theoretically trace crypto transactions to a fiat currency transaction. Then, they could subpoena the financial organization processing that transaction to disclose identifying information typically required under know-your-customer laws. However, you may be less likely to be targeted via this method.
While evading taxes with crypto is possible, the potential liability if discovered compounds over time. There's no statute of limitations for fraud, so if you make a mistake down the road, you could be on the hook for a significant tax penalty and possible criminal charges. It's usually a good idea to stay above board.
IRS Penalties & Interest
The IRS may impose penalties and interest if you don't report or pay taxes on time. Before looking at IRS crypto seizures, it's a good idea to understand what might lead to an asset seizure and how your tax bill might grow if you don't correctly report and pay your taxes.
The most common penalties include the following:
- Failure-to-File Penalties: You will incur a failure-to-file penalty if you don't report your crypto transactions on a tax return. These penalties are 5% of the unpaid tax each month the tax return is late, up to 25%.
- Failure-to-Pay Penalties: You will incur a failure-to-pay penalty if you report your transactions but don't pay the amount due. These penalties amount to 0.5% of the unpaid tax each month a payment is late, up to a maximum of 25%. But if you have an approved payment plan, the penalty is just 0.25%.
- Accuracy Penalties: You will incur an accuracy penalty if you substantially underpay taxes due to negligence or disregard for the rules or regulations. These penalties amount to 20% of the understated tax bill. And you'll usually incur them if you understate your tax by 10% or $5,000 (whichever is higher).
- Civil Fraud Penalties: You will incur penalties of 75% of the unpaid tax if the agency believes you're committing fraud. Moreover, the IRS may refer the case to the IRS Criminal Investigations Division for possible criminal prosecution if there's strong evidence of fraud, leading to possible jail time.
It's important to note that these fines and penalties are not mutually-exclusive, meaning you could owe multiple penalties on the same tax bill. For example, if you don't file or pay, you will owe both the failure-to-file and the failure-to-pay penalty. And worse, interest accrues on these penalties over time, making them more substantial.
IRS Crypto Seizures
The IRS' classification of cryptocurrencies as property laid the foundation for asset seizures – and the rest is history.
The IRS seized roughly $7 billion in cryptocurrency last year, double the amount in 2021. In early 2023, the agency is working on hundreds of additional cases that could push crypto asset seizures even higher.
According to Jim Lee, the IRS Criminal Enforcement Division Chief, most cases involve taxpayers who didn't report crypto transactions on their tax returns rather than money laundering or past areas of focus.
Most asset seizures begin with a notification of your taxes due. If you don't reply within 30 days, the agency can levy your crypto assets, bank accounts, or other tangible assets to collect your debts. Moreover, if they suspect fraud, you may not even have 30 days to comply – they can immediately try to collect your tax debt.
When a seizure occurs, the IRS will immediately sell the crypto assets to pay your tax debt. Therefore, the value paid off will be the proceeds from the sale transaction – not your original cost basis. Plus, you may need to pay additional collections-related fees.
How to Avoid Problems
The best way to avoid IRS penalties, interest, and seizures is to report crypto transactions on your tax return. Using ZenLedger, you can aggregate transactions across wallets and exchanges, compute your capital gain or loss, and generate the necessary tax forms. And if you use TurboTax, you can integrate directly to streamline taxes.
If you have unreported transactions from the past, consider using the IRS' Voluntary Disclosure Program to avoid penalties and interest. You qualify if the IRS hasn't audited your return or contacted you about the issue. But it's a good idea to contact a tax professional to help you through the process to avoid any unexpected problems.
And finally, if you receive any IRS notices (especially levy notices), ensure you take action before the deadline. You can often avoid a levy by setting up a payment plan, applying for an "offer in compromise," or obtaining a "currently not collectible" exemption. But again, it may be a good idea to enter negotiations with the help of a tax professional.
The Bottom Line
The IRS continues to invest in crypto tax enforcement, leading to record-high asset seizures in recent years. If you have unreported crypto transactions, it's a good idea to come clean sooner rather than later to avoid any problems. And in general, using ZenLedger or experienced accountants can avoid running into issues in the first place.
Get started with ZenLedger for free today!
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.