Cryptocurrencies have seen strong gains going into 2021 and the IRS is gearing up to ensure that traders and investors pay their fair share of taxes. With a widening $500 billion tax gap in the United States, many experts believe that the half-trillion-dollar cryptocurrency space could be a major source of underpaid taxes, particularly given its meteoric rise.
Let’s take a look at the IRS’ move from education to enforcement and how your crypto tax software can help you avoid any tax problems.
Crypto Education to IRS Enforcement
The IRS has historically taken an educational stance when it comes to cryptocurrencies. Over the past couple of years, the agency sent out thousands of letters warning taxpayers of their responsibility to pay taxes on cryptocurrency gains. While these letters warned of potential penalties, the agency has not taken aggressive enforcement actions thus far.
The addition of a new cryptocurrency question at the top of Form 1040 suggests that the agency may be transitioning from education to enforcement. While the question simply asks if you’ve transacted in cryptocurrencies, a failure to accurately answer the question could constitute a willful omission that carries higher penalties and even a criminal investigation.
At the same time, the agency has sought to hire cryptocurrency experts and met with tax authorities from other countries to share data and enforcement strategies. These activities suggest that it may be ramping up its resources to begin auditing individuals that it suspects have been evading taxes on their cryptocurrency gains.
Many other government agencies are also taking aim at cryptocurrencies and related blockchain technologies. For example, the SEC has taken action against ICOs and other crypto-related projects that could impact investors, whereas the Treasury has sought to identify instances of illicit cryptocurrency transactions in the U.S. and abroad.
Coming Clean with the IRS About Crypto
Many individuals may have been unaware that they owed taxes on cryptocurrency gains in the past. While they may be aware of these requirements now, they may be unsure whether the IRS can go back and audit their past tax returns and/or be intimidated by the process of amending past tax returns and arranging a payment schedule.
The IRS can go back three years to audit tax returns that it feels may have underreported taxes. If they suspect fraud, they can go back even further to uncover unpaid tax liabilities. The agency may levy fines and penalties for the underpayment of these taxes, as well as assess backed interest on the amount owed, which can add up to significant sums of money.
Many taxpayers believe that the decentralized and pseudo anonymous nature of the blockchain makes it impossible to identify delinquent taxes—but that’s not the case. For example, the IRS forced Coinbase to turn over records in the past and targeted many of those users with “education letters” while improving its expertise in blockchain analysis.
Most tax professionals recommend coming clean as soon as possible with any tax liabilities. By filing an amended return, you may be able to avoid paying fines and penalties if it was an honest mistake. Taxpayers can also negotiate discounted lump sum payments or installment plans to help pay large amounts of unpaid taxes over time.
If you owe a significant amount of money, you may want to consult a tax attorney or other professional to help negotiate on your behalf in order to reduce the amount that you owe and avoid any potential fines or penalties.
Why You Should Use Crypto Tax Software
Crypto tax software can help automatically make capital gains or losses calculations with greater accuracy than hand calculations or spreadsheets.
For example, ZenLedger integrates with most popular crypto wallets and exchanges to automatically import transactions and calculate the cost basis and capital gain or loss of each trade. The software then auto-populates popular IRS forms, such as Form 1040 Schedule D and Form 8949, with the correct data to avoid any mistakes.
In addition to reducing errors and finding ways to lower taxes, there’s at least one reported IRS case that suggests that taxpayers could be relieved of penalties if software is to blame for mistakes. In other words, the simple act of using reputable tax software could absolve you from the penalties associated with any mistakes that the software makes.
You should weigh the cost of crypto tax solutions with their benefits. While simple solutions may be the cheapest option, many of them lack features that may save you a lot more money in the long run. You should also ensure that crypto tax solutions are transparent in how they calculate everything in order to defend yourself in an audit.
In addition to crypto tax solutions, it’s important to keep crypto transactions and tax records on hand for at least five years (and preferably indefinitely).
The Bottom Line
Cryptocurrencies have experienced strong gains over the past several years and the IRS reckons that many traders and investors have underreported their gains. While education was the focus in 2019 and 2020, the agency may be moving toward an enforcement focus in 2021 and beyond as it seeks to penalize and recoup understated taxes.
The best way to avoid these issues is through the use of crypto tax software. In addition to accurately calculating your tax liabilities, ZenLedger and other solutions can minimize taxes and avoid any penalties by ensuring that taxes are accurately computed and filed. Try ZenLedger for free!