Innocent until proven guilty is the mantra of the U.S. legal system—except when the IRS is involved. With its broad powers, the IRS can garnish wages, levy fines, and imprison tax evaders. The agency's recent focus on the crypto markets has alarmed many traders and investors that may not know whether their actions are legal or illegal.
The IRS estimates that there's a tax gap as high as $1 trillion due to offshoring and underreporting of income.
Let's examine the differences between tax avoidance and tax evasion and how you can walk the line to minimize your tax bill legally.
Tax Avoidance: Minimizing Your Tax Bill
Tax avoidance is the legal minimization of taxes using methods included in the tax code. For example, tax deductions and tax credits reduce tax liabilities, while tax-advantaged accounts like IRAs and 401(k)s defer taxes. The key is to understand the tax code and take advantage of the available deductions and credits.
There are several legal ways to avoid crypto taxes:
- Capital Losses: The IRS treats cryptocurrencies as property. Therefore, if you sell your position at a lower price than you bought it for, you will create a deductible loss that you can use to reduce capital gains in other types of assets (e.g., stocks).
- Holding Time: The amount of tax that you owe on a crypto transaction depends on the holding time. You can reduce your capital gains tax liability by waiting at least a year to sell, putting you in the long-term capital gains tax bracket.
- Mining Deductions: Cryptocurrency miners often incur expenses related to their mining activity, such as the cost of electricity and internet service. Hobby miners can itemize these deductions, while businesses can deduct these costs as ordinary expenses.
- Crypto Donations: Donating cryptocurrencies enables you to avoid paying capital gains tax on the accrued profits. In addition, you can take a full deduction for the current market value. It's a great way to support charities while avoiding taxes.
- Use Tax-Advantaged Accounts: A growing number of brokers allow you to hold Bitcoin and other crypto assets in a Roth IRA or different tax-advantaged account. Using these accounts, you can avoid paying capital gains tax or receive an immediate deduction.
Tax Evasion: Illegally Evading Tax Liabilities
Unlike tax avoidance, tax evasion is the use of illegal means to avoid paying taxes. For example, if you're lying on a tax form or hiding income, you're probably evading taxes. While mistakes happen, and the IRS will likely penalize mistakes with fines or penalties, tax evasion is a much more serious offense that can lead to felony convictions and even jail time.
Specifically, the IRS penalizes tax evasion as a felony with five years of jail time or a fine of up to $250,000 for individuals or $500,000 for businesses—and you have to pay the court costs too! In addition, civil penalties can easily double the amount of tax owed initially through a combination of fines, interest, and penalties.
There are several examples of crypto tax evasion:
- Unreported Income: A crypto trader or investor might decide not to report the income they receive from the sale of crypto assets. Or, they may choose not to amend a past tax return to account for past income they omitted from their taxes.
- Hiding Assets: Transferring assets overseas to avoid paying taxes is a textbook example of crypto tax evasion. After the transfer, the crypto trader or investor may sell the stake in a foreign jurisdiction that charges less or no taxes on the transaction.
- Falsifying Deductions: Overstating or falsifying deductions to reduce crypto taxes is another form of tax evasion. For instance, a crypto trader might claim that they donated crypto to receive a tax deduction when they just kept it in an offline wallet.
- Claiming Personal Expenses as Business Expenses: Crypto miners might try to claim personal Internet or electricity costs as deductions for their business. When calculating deductions, you need a strict delineation between personal and business use.
The IRS has become a lot better at tracking down crypto tax evaders. For example, the agency subpoenaed multiple exchanges to find individuals who conducted at least $20,000 of transactions between 2016 and 2020. President Biden's 2022 budget proposal also contains a raft of new crypto reporting requirements for exchanges dealing in cryptocurrencies.
Tax Loopholes: The Middleground
It’s not always a question of tax avoidance vs tax evasion.
A tax loophole is tax avoidance that involves taking advantage of a legal "hole" in the tax code that was often unintended by lawmakers. While tax loopholes are entirely legal, traders and investors who use them should prepare for changes. After all, these loopholes tend to close over time as regulators catch on to the scheme.
The most popular tax loophole for crypto traders and investors is tax-loss harvesting. The strategy involves selling a losing position to realize the capital loss in the current year. Thanks to a loophole in the tax code, you can repurchase the same position within your portfolio. That's because the IRS treats crypto as "property," exempting it from the Wash Sale rule.
Tax Avoidance vs Tax Evasion: Walking the Line
There’s a fine line between tax avoidance vs. tax evasion.
Crypto traders and investors shouldn't hesitate to use every legal tax deduction and credit to their advantage. Using crypto tax software like ZenLedger, you can automate the process of finding these deductions. At the same time, conventional accountants can help expand the search for credits that minimize your overall tax bill each year.
It’s also a good idea to hire a professional accountant to complete your taxes each year. That way, you can be sure that you’re realizing all of the possible deductions and credits while simultaneously ensuring that you’re not underreporting any income.
If you're on the fence about a particular issue, most accountants suggest taking a conservative approach to minimize the chances of an audit or costly fines and penalties. If you have undeclared income from the past, it's always a good idea to amend prior returns and find a way to come back into compliance, even if it means setting up an IRS payment plan.
Checklist of Ways to Reduce Crypto Tax Liabilities
- Sell long-term assets before short-term assets to pay the long-term capital gains tax rate.
- Choose an accounting method that will minimize your tax liabilities over the long term.
- Harvest tax losses throughout the year to maximize capital losses and offset your capital gains.
- Deduct any legitimate expenses from crypto mining or other business-related crypto options.
- Consider using tax-advantaged accounts to hold long-term crypto assets.
- Donate crypto assets that have appreciated significantly in value to avoid paying taxes on the would-be gains.
The Bottom Line
Tax avoidance and tax evasion may sound similar, but there's a fine legal line between tax avoidance vs. tax evasion. By understanding the differences between tax avoidance vs. tax evasion, you can avoid overpaying taxes and sidestep the risk of an IRS audit—or worse.
ZenLedger can help achieve these goals by automatically aggregating your transactions across wallets and exchanges and computing capital gains and losses each year to easily complete your crypto taxes.