Will Your Crypto Trading Lead to an IRS Audit?

What happened

The IRS is actively engaged in addressing non-compliance related to cryptocurrency transactions. In 2019, the tax authorities issued more than 10,000 tax notices to potentially non-compliant taxpayers. In mid-2020, it sent out a new batch of tax notices to suspicious taxpayers. No letter was sent out in 2021, though that omission likely had more to do with the IRS moving to telecommuting and addressing stimulus-related issues rather than a lack of focus.

Much of this effort was in pursuit of crypto traders and investors who underreported gains. But with the market reversal this year, the tax authorities’ focus is also likely to include traders who overreport losses in an attempt to lower their tax bill.

In addition, IRS audit efforts are expected to increase with the passage of the Inflation Reduction Act (IRA) in August. The Act appropriated $45 billion for enforcement activities that specifically include “digital asset monitoring and compliance activities”. Over the next decade, the agency will invest these funds in tools and personnel focused on auditing and tax collection.

In light of these developments, taxpayers may be concerned about their exposure to IRS audits when dealing with cryptocurrency. Knowing the ins and outs of IRS audits and how to avoid them can alleviate some of the fear.

Key concepts

Types of IRS Audit

There are four types of IRS audits.

Correspondence audits.

Correspondence audits are the most common type conducted by the IRS. These represent nearly 75% of the service’s tax audits, and so far are the only type of crypto audit initiated by the IRS based on current information. As the name suggests, these audits are conducted by mail. Postal inquiries usually ask for additional evidence to prove certain amounts reported on the tax return.

For example, in 2019, the IRS issued Letter 6173 to some taxpayers exposed through the Coinbase subpoena to share detailed profit and loss calculations for the reported cryptocurrency gains and losses. Coinbase’s subpoena was followed by more than 10,000 taxpayers who received tax notices (Letter 6173, Letter 6174 and 6174-A).

IRS office audits

IRS Office audits are face-to-face meetings conducted at an Internal Revenue Service office. During these audits, you are required to attend a designated IRS office and present documentation requested by the examiner.

IRS field audits

Field audits are more serious than correspondence audits and office audits. They are carried out at your home (or office) to obtain detailed documentation. It is quite common to see businesses being subject to these audits (as opposed to individuals).

Taxpayer Compliance Measurement Program (TCMP) audits

TCMP audits are the most stringent type of audit and can be an unpleasant experience for taxpayers. The tax authorities analyze here every detail of a taxpayer’s return and validates data with sources as opposed to checking a particular segment of information.

How You May Be Subject to a Crypto Tax Audit

Crypto holders may trigger an IRS audit under the following circumstances.

1099 Discrepancies

Crypto exchanges can issue you three tax forms: Form 1099-K, Form 1099-B and Form 1099-MISCs. If you do not report the amounts reported on these forms on your tax return, you will receive a CP2000 letter and be subject to a correspondence audit.

For example, say you earned $1,000 in betting earnings on a stock market and received a Form 1099-MISC showing that amount. If you file a tax return that does not include this amount, the IRS computer system (Automated Underreporter (AUR)) automatically flags the tax return for underreporting taxes by $1,000. If you receive Form 1099-B or 1099-K and do not report them correctly, the same principles apply.

Therefore, if you receive a tax form from an exchange, the IRS already has a copy of it, and you should definitely report it to avoid a correspondence audit.

Information collected through subpoenas issued to exchanges

The IRS also relies on information obtained through subpoenas to subject crypto holders to audits. For example, in 2018, Coinbase had to disclose approximately 13,000 user accounts including taxpayer identification numbers, names, dates of birth, addresses, records of account activity, transaction logs, and all periodic bank statements or invoices (or equivalent) pursuant to a John Doe subpoena. In 2021, the IRS issued a John Doe subpoena to San Francisco-based crypto exchange Kraken seeking information related to “the investigation of an identifiable group or class of persons” whom the IRS has reasonable grounds to believe “may have failed to comply with internal revenue laws .” In 2022, SFOX another exchange based in Los Angeles was subpoenaed for releasing information about certain crypto users.

Random selection

In addition to 1099 reporting errors and subpoenas, you may also be selected for a random audit.

According to the IRS, “sometimes returns are selected based solely on a statistical formula. We compare your tax return against ‘norms’ for similar tax returns. We develop these ‘norms’ from audits of a statistically valid random sample of returns, as part of the national research program the IRS conducts.”

For example, say you’ve reported $50,000 in annual income for the past few years. However, in 2021 you reported $2 million in crypto gains because one of the coins you invested in super early made a huge profit. In this case, it’s possible that you could be singled out for an audit (even when you report things accurately) because your tax return is a departure from the average taxpayer making $50,000 a year.

The same principles can apply when deducting large losses during bear markets. Reported losses are subject to more scrutiny than gains because they lead to lower overall taxable income and higher tax refunds. As the market has turned downward in recent months, it is possible that the IRS may be on the lookout for tax filings that overstate the amount of losses.

Tax loss harvesting allows you to sell your underwater digital assets and claim a capital loss that can offset your income. This is a legitimate practice followed by investors in both the crypto and stock industries. These losses are valid as long as assets are sold to an unrelated party under unmanipulated market conditions.

But during extreme bear markets, bad actors may be tempted to engage in fraudulent tax loss harvesting to create artificial losses. For example, they can create artificial losses by selling underwater assets to themselves at significant discounts. This is quite easy to do in the crypto space due to pseudo-anonymity.

For example, Sam owns $1 million worth of NFT on Wallet A. Sam also owns another wallet called Wallet B. Sam can “sell” the NFT for $100,000 to Wallet B and fraudulently claim a $900,000 ($100,000 – $1,000,000 ) loss. These types of oversized and fraudulent losses can be flagged under Random Selection.

How to reduce audit exposure

1099-related audits are the easiest to avoid. They can be avoided entirely by accurately reporting amounts reported on 1099s on your tax return. Surveillance triggered through subpoenas is out of your control, so unfortunately there’s nothing you can do. If you are selected for an audit through subpoenas, be sure to keep detailed records of your cryptocurrency transactions and profit and loss calculations so you can defend yourself. Finally, you can work with an experienced tax advisor and have your tax return professionally prepared to reduce the risk of random checks.

Next step

• Collect all 1099 forms and report them accurately on your tax return.

• Work with an experienced tax advisor if you have a tax year with large gains (or losses).

Further reading