IRS Audits on your Cryptocurrency Taxes


Hello everyone. This is Sal from BitcoinTaxes. Welcome to our podcast. Each week we speak to an expert with knowledge
related to cryptocurrency taxation. Our guests all have a unique perspective or
expertise related to cryptocurrency taxation. Our guest today is Alex Kugelman, a San Francisco
based tax controversy lawyer. He represents individuals and businesses on
audits and litigation with IRS and other tax agencies. Alex will be sharing his expertise on IRS
cryptocurrency audits, including risk reduction strategies as well as enforcement predictions
and misconceptions. Alex, thanks for joining us today. Thanks for having me, Sal. No problem. So can you tell us a little bit about yourself
as well as your expertise? Oh, sure. I’m an attorney out in California. I clerked for a US District Court Judge as
well as the United States Tax Court. I’ve been in private practice exclusively
doing tax controversy work for the past five years or so. I kind of got involved with crypto towards
the end of 2016. I tend to represent clients mainly with kind
of compliance and disclosure issues with respect to cryptocurrency. And I just really like it. Really interesting area. So you’ve had some clients that you’ve dealt
with cryptocurrency related audits. I’ve had that and kind of what started me
into the crypto space actually was when the IRS first issued summons for Coinbase. We started getting some interesting calls
regarding that. And at that time I thought to myself, this
might be an interesting area. So I started following the actual summons
enforcement proceeding at the District Court here in San Francisco and from there kind
of work with people under different types of compliance including international disclosures. Now we’re starting to see some of the first
cryptocurrency audits come through. Right. It’s certainly going to be a useful service
for those who are audited. So I’m sure it’s going to be some interesting
information you’re going to give us. Yeah, I’ll do my best. Great. Can you start off by giving us an overview
of IRS audits in general? Yeah, yeah, for sure. So it is important to understand the IRS has
this administrative agency and all different layers of it. So when it comes to an audit the term that
the IRS uses an examination and there’s kind of three basic levels. One’s a correspondence exam and that’s where
you get a letter that says, dear taxpayer, so-and-so reported that you had $100 of interest
income that wasn’t on your tax return – we’re going to increase your tax. If you want to challenge that, you can. And that’s basically termed an under reporter
notice. That’s probably not going to be a cryptocurrency
audit if you get that notice. Next one is an office exam. What that is someone in the local IRS office
sending you a letter that says, we have selected a certain tax return for audit and we’re going
to look at these issues. We’d like you to call us to schedule an appointment. And that’s going to be usually a tax compliance
officer that is doing that. The third and probably the most serious level
of exam is a field examination. And that’s also going to be a local IRS representative,
typically a revenue agent. There, the revenue agent may come to your
work or asked to come to your work or business to kind of conduct the audit. All three of those are going to start the
same and that’s going to be a letter that’s sent to you at your most recent address provided
to the IRS. And one of the things you can do if you get
one of those, if you’re trying to figure out what kind of audit is: usually there’s a letter
or notice number on the top or bottom right corner. You can Google that and go on the IRS website
and find what type of audit it is. And that’s what starts the fun process. Thereafter, they’re going to give you a something
called an information document request. They’re going to identify the scope of the
audit, which is usually going to tell you the tax year, the tax form, as well as the
items on that return they want to look at. From there you kind of actually go to the
audit and you deal with the IRS representatives. So you said for the correspondence exam you
said that that typically won’t be something cryptocurrency traders will receive. I wouldn’t expect it because typically that’s
going to be some sort of some sort of difference between what you reported on your tax return
and something that’s called a third party return, like a W2 or a 1099. And since really the only 1099s that are issued
right now are the 1099-K by Coinbase and a couple other couple of other of the US exchanges,
I wouldn’t expect a whole lot of cryptocurrency on to start that way. And especially considering most people are
worried about the Coinbase summons information as well as other larger kind of compliance
issues. Okay. Got It. Basically in an audit, it’s going to be either
you or you can have a representative that can be either an attorney or a CPA or another
admitted person. You’re going to kind of go through the items
on the return. There will be a number of open ended questions
that the auditors are trained to ask to try and find compliance issues. They’ll review a fair amount of documents. They might do something called a bank deposit
analysis to see if you’ve reported all of your income. At the end of that meeting, one of two things
are going to happen. One is there’ll be a few items that are remaining
that you or your representative will work with the IRS to kind of resolve or the auditor
is going to kind of expand the scope and ask for additional meetings or additional information. Then the IRS is going to issue its exam report
and that report is going to propose additional tax penalties. And at that point you have certain administrative
rights. But that’s the basic kind of beginning to
end of the actual audit itself. Moving ahead to the idea of a cryptocurrency
audit. I have two right now. I think most people who are concerned, I think
it’s likely that most audits are going to start with one of two things happening. One is there’s information from the Coinbase
summons that is inconsistent with what was on a taxpayer’s tax return. And I think for someone who’s involved in
with that issue, they’re going to have a good sense of that one because they should’ve gotten
an email notice from Coinbase that they were part of that group of about 14,000 clients
who they turned the information over. Or two, the audit notice is going to identify
older tax years – 2013, 2014 or 2015 because those are the years that the information related
to. The second reason I think people will get
audited is going to be information on the return is kind of incomplete in the sense
that the taxpayer or the cryptocurrency owner reports some transactions. Well, there’s not enough detail to really
ferret out what the actual basis is or exactly what’s being reported on that tax return. Recently we partnered with TurboTax Online. Our users were able to import their data from
Bitcoin.tax into TurboTax Online in order to file their cryptocurrency capital gains. However, TurboTax Online limited the amount
of transactions importable to 250 transactions – a lot of traders have many more than 250
lines on their capital gains form. So we offer an aggregated option. Turbotax suggested aggregating the data. So we have offered an aggregated data option. Can you touch on that at all? Is that putting people at higher risk for
an audit by showing an aggregated summary of their capital gains as opposed to a line
by line specific detailed report? That’s a good question. I don’t know the answer that that’s definitely
going to increase the likelihood. I mean one – to the extent that there’s going
to be a lot of taxpayers – a lot of people use TurboTax, right? If that’s the way TurboTax is preparing all
of those returns, it would seem to me you’re kind of in a herd of people like that. And at least it’s consistent with what a lot
of people are doing. The second part of that is going to be at
least those people who have prepare the returns in that manner, they’re going to have all
the underlying or should have the underlying data, right? So even if it’s an aggregate reporting of
each asset class as opposed to each individual trade, if there ever were questions then you’re
going to have your CSV files, you’re going to have your Bitcoin.tax exports, you’re going
to have all the information that you need to back that up. One thing that you could possibly do, or those
people could possibly do, is add a statement, which I like, I like to do with, or I recommend
clients to do. Add statements to tax returns explaining a
little bit more detail about what they are reporting and how they’re reporting it and
what information they have. I know a lot of times there are options to
add your own PDFs. So if you are worried about it, you might
be able to export and add a PDF to the actual return that is submitted with the tax return
itself. So that would be saying something like, what
I just mentioned – TurboTax Online limits it to 250 lines. I have all my data but I had to aggregate
the data in order to fit it into TurboTax Online, something like that? Yeah, exactly. I’ve seen the Bitcoin.tax printouts, it uses
the actual 8949 form where each specific trade is identified and you can’t get that many
trades on each page. Right? I’ve seen some people file tax returns that
a 500 or 1000 pages, but I like what I like to do is just use an excel spreadsheet and
format it a little bit as a substitute form 8949 and you can really pack and a lot of
trades on that. And so it’s not as quite as big or robust
an attachment. Right. So taking that extra step just to ensure that
the IRS knows why you’re submitting your capital gains that way. Yeah, and I mean to a certain extent, this
kind of goes to what we’re going to talk about a little bit later, but I’m a big proponent
of over-reporting – and I don’t mean paying too much tax. I just mean including too much information
cause at some point there’s the kind of two ways that you returned can be flagged; I guess
there’s more than two, but they can break down to a computer flags the return for some
reason or there’s a special unit or a person actually flags it. At the end of the day, a human being will
be looking at that return and deciding whether it actually is going to go all the way through
to an audit. And so to a certain extent, I kind of imagine
if there’s a person looking at it, I want them to completely understand what’s being
reported, why it’s been reported, and if there’s too much information that’s fine – it’s less
likely that someone’s going to have more questions. If it’s bare bones return, then I think it’s
more likely that someone’s going to have questions and it could get flagged for audit. Yeah, that’s a great point because we can’t
expect that every IRS worker, every IRS auditor that’s looking at these returns knows a whole
lot about cryptocurrency. So providing them with that extra information
is only going to do you good. Yeah, I totally agree. Can you talk a little bit more about what
a cryptocurrency audit looks like? Sure. So it’s like I said, it’s very likely going
to be a field exam, which means you’re going to have a revenue agent and those are kind
of the best of the best auditors for an IRS audit. And remember an IRS audit is a civil matter. This is not criminal at this point. Again, it’s unlikely that it will become criminal. It is the highest level of audit you’re going
to get. So you’re going to get your IRS audit notice,
your exam notice. It’s going to identify who’s doing the audit,
what the tax years are. That’s really important. What the items are. And it probably will not say cryptocurrency
on it, right? It’s going to say schedule D or capital gains
or something like that to identify. Or if you have like mining income and should
have a schedule C which is for self-employment income or small business -it might identify
that. Very likely it’s going to ask you to call
the auditor and give you 10 days to do so. If you don’t call it in 10 days, it’s not
like they’re going to come to your house or something. But you do want to call and you do want to
get an appointment on the books. If you’re going to hire a representative,
which you have every right to do, you should contact that person, let them know what’s
going on and probably have them interface with the auditor. You should receive, as part of the opening
notice or letter, the information document request – which is identifying what things
to bring for the auditor, as well as it’ll tip to what topics might be important. And for example your typical things you’re
going to see are going to be bringing bank statements, any sort of – I’ve seen it termed
as financial or asset account statements -I view that as requesting exchange statements
or exchange CSV files, any documents that go to cost basis for cryptocurrency trades. Anything used to prepare the return – work
papers and the like. And I think one of the things that I’ve just
seen generally with audits is that when you see an auditor who is looking to expand the
scope, which means very likely other tax years, they often ask for copies of tax returns for
other tax years as well. And you’re not obligated to provide that,
to be honest with you, it’s not really relevant to the audit itself, but you can selectively
decide what information to provide and you have a reasonable basis not to provide information
outside of the scope. So just because it’s on the IDR does not mean
that you have to provide the information to the auditor. Interesting. So if they do expand the scope and you don’t
have to provide, necessarily, past years’ tax documents, like you said, can they audit
you for those past years in order to get that information? Yeah, and it’s kind of – I mean, that’s more
of an art as opposed to a science. I mean, frankly the auditor has a fair amount
of power. So if you play real hardball that’s not going
to prevent the auditor from expanding to other years. And so when you get that audit notice ,and
let’s say that you’re going to deal with this yourself, the first thing you want to kind
of figure out is assess what are the areas that I wouldn’t want to go into, and what
are the areas that I don’t have good records? That will kind of help guide maybe the way
to respond or what information to pull together. But the reality is, and let’s just be honest
here – for most people reporting cryptocurrency gains, they have all of the information. The IRS does not have much. They might have some records from Coinbase,
but it’s not as if as this treasure trove of third party data that you might be getting,
for example, if you were self-employed and people that paid you for your consulting business,
issue 1099s. That’s not really there for them. Or even bank account statements. That’s a great source of information for the
IRS. There might not be that much reflected in
traditional US bank account statements. So the burden is really going to be, in every
audit, on the taxpayer to prove their tax return is correct. But I think especially in cryptocurrency,
I mean I think probably the best tactic is to have really good records that are really
complete and well-rounded and provide those from the outset to show that your figures
are correct. If your figures aren’t correct and you update
your accounting, I think it’s good personally to kind of go in there and, and make that
clear from the beginning so that everyone can agree what is the taxable income and you
don’t get left a really unfair result. Now do think that the IRS is a bit more lenient
with past years because of how few people actually reported their cryptocurrency taxes
in the past. Define lenient for me. Well, I mean if they open up a scope and look
into your past years and they see that in 2017 and 2018 you’re reporting, you have all
your information, but in 2015 and 2016 crypto tax was a completely foreign concept to you. So you really didn’t have regular…you didn’t
back up your exchange files, you don’t have a lot of information. Maybe some of the exchanges closed down. I guess by lenient I meant would they be understanding
that a few years ago crypto taxation was a foreign term to most people. It still is today but much less so obviously. Yeah, that’s a good question. I think the way that I would look at it is
that maybe the standard of records required to really substantiate older years might be
a little bit lower for older years as opposed to now because it’s different now. Right? I mean there’s, there’s a lot better information
provided by some of the exchanges. There’s a lot more software out there to help
you, especially for people who are newer to crypto. I mean they should have access to all their
bank records. They should be still have a lot of their emails,
reflecting on-ramping off-ramping or other purchases. You should be able to kind of pull this all
together. I can understand when we have clients who
come in and are early adopters and they’re missing chunks of information. So I do think that and those types of circumstances,
yes, I think there would be a little bit of leniency. But I don’t think if you’re asking, hey, I
reported my gains in 2017 but I never really did it 14, 15 or 16 – I don’t think that’s
going to be viewed very favorably. Especially for the group in the Coinbase summons. I think that’s where people were really kind
of exposed. It’s also likely dependent on how much they
made. If you made $10 in gains in 2014 they’re probably
not going to harp on you too much to get that information. I’d imagine at least. Yeah, no, I think that’s right. And there’s also certain statute of limitation
of statutes of limitations that apply here. Typically three years from the time that you
filed the return. It can, it can be longer than that, up to
six and sometimes indefinite depending on circumstances. So look, I mean the IRS is an agency with
limited ability for enforcement because it’s not funded properly. And so as a result, I wouldn’t expect an auditor
just to go to the end of the earth and try to change every year. They’re going to take the years that they
can have the most meaningful impact in the time that they have. That being said, I always think whenever work
with a client and we try to reconstruct records, it’s hard to pick a more recent date and start
from there. You almost have to start from the very first
on-ramping and kind of move forward because, as anybody who’s done a lot of trading understands,
this stuff just gets convoluted extremely quickly. And so to kind of port basis through or be
able to ascertain basis, you have to have a full picture, a full historical picture. It’s nearly impossible otherwise. Actually on that point, I spoke with your
colleague John Stead earlier today, and we talked about not having a full picture of
your cryptocurrency trades, which does happen with a lot of people, especially early adopters
as we were just talking about. So he had mentioned something that you guys
conduct some sort of analysis. Did you want to touch on that a little bit? Sure. Well, I mean, I think the first thing is,
I mean, outside of cryptocurrency and just generally in audits, I mean, how many people
have complete records for to support everything on their tax return from three years ago? Right? It’s just not the reality. And there’s a lot of people who have incomplete
accounting records for small businesses and they don’t have all their statements saved
or, but that’s just, that’s just the norm for a tax controversy attorney. Right? And so part of, part of our job is to help
people rebuild those records. And to have a compelling set of analysis that
will help the IRS understand, hey, this is a totally reasonable conclusion here. And the numbers that we’re saying are actually
correct. What we do, John and I, is that we basically
start with an interview. Because the best source of information in
a lot of these cryptocurrency clients are the clients themselves, right? They kind of know what they did and they kind
of remember. There’s some who take good notes and other
people don’t, but as you go through and kind of ask people: what exchanges have you’ve
been on, what type of coins, if you bought any ICOs, have you ever sold for actual US
cash, and have you ever bought goods or services? As you talk through things people tend to
recall kind of what happened. And we use that information and we cross check
that against bank statements as well as CSV files to pick out what those transactions
look like. The other big one that we see all the time
– and anybody listening to this, please hear this, do not trade for your friends on your
exchange accounts because that type of commingling causes such major problems. And essentially you are walking into those
taxable gains just because you’re allowing someone access to the exchange to make sales. So all of those types of things are things
that we look at. And then from there we build a record that
we think is a pretty compelling one and there’s a lot of people who – 2013, 2014, 2015, don’t
have records. We do our best to kind of come up and recreate
that. And we think it’s a good product. And that would be, it is persuasive when reviewed
by third party. That’s a great service because I do see a
lot of people with chunks of data missing. It’s common and even more so I find that many
people forget that small exchange that they traded a little bit of crypto on or that they
bought a little bit of Bitcoin or some other coin on. Even myself. I mean, I primarily use Coinbase and Coinbase
Pro, but I definitely have used smaller exchanges in the past and those are easy to completely
forget and to gloss over. And then those add up. You have a few Bitcoin or a fraction of a
Bitcoin missing and you can’t even think of where it came from. Yeah. And I mean the other thing too is even if
you’re missing certain files right? Let’s say from one random exchange. Most people have some sort of records, at
least reflecting the transfer in and the transfer back out of that exchange. Right? And so you can use historical data and historical
pricing information to essentially estimate what that transaction would have been. And then what we do is we provide a written
statement summary of what we’re doing and why we’re doing it. And reality is if you can show that and kind
of fill those little holes, it really does kind of help and making a complete process. Plus too, we’re not making assumptions that
are aggressive. We’re making assumptions that are frankly
very conservative. Really nowhere for the IRS or anyone else
to go when they’re dealing with these issues. And one more thing – you mentioned representation
a few times when you were talking about audits in general. Is that a service that you offer? Are you somebody that would represent a client
during an audit? Yeah, absolutely. And basically, like I said, there’s different
types of people that can represent you from attorneys to, accountants, all the way down
and including enrolled agents. My general rule is that I think that attorneys
are, I think experienced representatives are really important. I probably would not hire the CPA that prepared
my return unless they were: one, experienced with being a representative in audits. And two, you felt comfortable that they weren’t
going to go in there with a conflict of interest. Concerned that maybe they signed a return
that has issues with it. But I do think if you’re worried about going
into audit – hiring a skilled, and experienced rep is really, really important. I think too, to the extent that you have a
more aggressive position on a tax return, let’s say 1031 like kind exchange, but you
have a lot at stake. Look an audit is the first step of litigation
and that’s the reality. And so if you don’t prevail at your audit,
you’re going to go to the IRS office of appeals. If you don’t prevail there or get a ruling
that you want then you’re going to file a petition with the US Tax Court or you’re going
to pay the tax due and file a complaint in US District Court. So to a certain extent, when major taxpayers,
talking Fortune 50 companies, when they take an aggressive position on tax returns – they
don’t have the CPA show up and represent that. They have high powered council. Because they know that everything they do
is really building towards challenging this in federal court. So that’d be kind of my recommendation for
the more aggressive or the taxpayers who have more at stake with certain kinds of legal
rulings. Right. If there’s a lot on the line, you want to
bring the big guns with you. You don’t want to hire the wrong representation. Yeah. Yeah. And I think the other thing nice about hiring
a rep is that – for most people dealing with the IRS is really stressful, right? And sitting in either an IRS office or in
a conference room where the IRS revenue agent and that, that can make someone feel uncomfortable. So the rep, and that’s why I say experienced
– If they’re experienced with this, they should understand the appropriate ethical standards
and go in there and kind of essentially help resolve portions of the audit to kind of move
it to a resolution that you can deal with. The other thing too that’s important to understand
is that an experienced rep also understands the administrative layers. And I know if I get a bad revenue agent – or
not a bad, but a revenue agent who’s taking a position that I think is really, unfair
to my client. I’ll tell my client, look, let’s not worry
about this. Let’s just kind of wrap this audit up and
get to the IRS office of appeals because that’s a whole ‘nother person who’s going to be totally
independent at that previous ruling. And we’re going to get another bite at the
apple. And so that’s the other thing too. You don’t always understand, taxpayers actually
have a lot of leverage in an audit. And that sounds crazy to say, but there is
a lot of truth to that. And so as you’re kind of working through the
audit itself, you want to make sure that you’re not just agreeing to something to be done
with it. You’re not agreeing to something just because
you think that you’ll get more trouble, you get a worse result. Once the audit report is generated and you
get what’s called the 30 day letter or 30 day notice, at that point, the audit is basically
over and it’s on you whether you want to challenge it further or if you just want to pay the
additional tax and penalties of interest. Right. I think the word audit conjures an image of
a small padded room with a small desk in it and you are sitting there sweating bullets
as you are being interrogated by an agent. I think that is the image that is conjured
for a lot of people and it’s an intimidating word in itself: audit. Don’t forget the single light bulb hanging
in the center of the room. Exactly, exactly. That’s just blinking, blinking as you’re being
grilled. So keep in mind- cryptocurrency; I’m convinced
it’s going to be a huge enforcement area for the IRS. But all the revenue agents working on this,
I bet you very few are really experienced with cryptocurrency audits. All they have a basic understanding of the
landscape and I’m sure the IRS is developing some sort of guidelines and procedures for
these types of audits right now. So you want a rep that can go in there and
explain, look, let me tell you how this all works. Let me show you: alright, so this is what
on-ramping and off-ramping mean, these are the exchanges, these are the major US exchanges,
this is what altcoin trading needs, here’s how the spreadsheets look – and to walk them
through all that. I think most people think of a lawyer as kind
of being defensive and kind of protecting the client, right? And I think sometimes the best way to protect
the client is to kind of, hey, let’s open the Kimono and show you what we actually did. Here’s the additional income, this is what
the tax should have been. At the end of the day you’re paying your rep
a lot of money and the longer that goes, that may not be in the ultimate best interest for
you. Can you go into a little bit more detail about
some risk reduction strategies for cryptocurrency audits? Yeah, for sure. For sure. I think the, I think the first thing that
you really want to do, is kind of just assess; for those of you that are really worried about
an audit is just assess what it is you’ve actually done over the years. When did you start trading, what exchanges
were you on, do you have records that reflect on-ramping and off-ramping? And that’s going to be your bank account statements. Do you know where you’ve been, what exchanges
you’ve been on? If you’d been on domestic exchanges – most
of those exchanges, at least the ones that are trying to become more mainstream, they’ve
gone through the AML KYC process, which I’m sure a lot of dealt with. Having to provide your driver’s license and
social security number. So there is now a record o you trading on
there or having an account there. For foreign exchanges, there may not be as
much of that AML KYC compliance, but I really believe that you do have reporting requirements
under FATCA for FBARs and something called an 8938, which if you listen to the podcast
with Tyson, he kind of explains what that is. But it’s basically if you have ownership of
a foreign bank account or asset, you have certain reporting requirements, whether you’ve
had income or not. And the reason that’s such a big deal is that
the penalties associated with that are enormous. So to a certain extent, just kind of getting
a handle on, all right, what exchanges was I on? Where are those exchanges? Figuring that out to see if you have a compliance
issue there – cause even if you reported your gains and losses, you might have a whole foreign
reporting issue that you don’t even know about. Some of the other things you want to make
sure you at least track a little bit is when you’ve actually exchanged crypto for cash
or vice versa. That’s partly because that’s one of those
areas where when people get in trouble with some sort of federal investigators – it’s
involved with those type of transactions because that can be considered potentially money laundering. Also ICOs and when you’ve used crypto to buy
goods or services. So all of those things – that will give you
kind of your universe of crypto activity. We talked about the commingling. Really don’t want to do that. And if you did do it, try to figure out where
you did that. And then once you have that, then you should
have the information you need either through using software or, a professional, to get
accounting records. And once you have that you really want to
reconcile with what is in the accounting records with what you reported. And also what’s reported on 1099k forms, if
you got one of those from Coinbase or another exchange showing the gross proceeds of your
transactions. I think the other things you really want to
do here when you are looking at your returns is for those who believe that they’ve taken
like kind or used like kind exchange rules to defer taxable gains -you should look on
your tax returns to see if you filed the form 8824 which is where like kind exchanges are
actually reported. And that kind of goes back to the over reporting
issue I was talking about before. I think that if you didn’t report the actual
trades that you’re taking like kind treatment in past years, I don’t know that you’ve actually
taken light kind treatment to be frank with you. I think objectively that might be viewed as
just not reporting certain transactions. And so that’s something I would take a look
at if that was me. I mean I think the last thing that you want
to do here is that, everybody listening to this and you pointed to and alluded to it
Sal – three years ago the tax reporting rules here weren’t particularly clear. Even with the 2014 notice, I mean there wasn’t
a lot of guidance out there, right? And there still isn’t. To a certain extent people are starting to
really understand and appreciate and it’s unfortunate that with this down market, so
a lot of people don’t want to…are hesitant to lean into a big tax bill. Right? But at the end of the day, that’s just the
reality. And so you want to make sure that you address
these issues sooner rather than later. And certainly if you are someone who’s in
a position where you think an audit or something, some other enforcement actions is coming down
and your direction. You mentioned 1099-k forms. Just briefly on that – a lot of the times
the 1099-k values differ from the values that we show for proceeds. And what I found is that that is because certain
exchanges include your fees in your proceeds. They don’t deduct the fees that you paid from
your proceeds, whereas you’re not actually getting that money when you pay a fee. So it really shouldn’t be a part of your proceeds. Whereas our report shows proceeds minus the
fees that you paid on trades for example. Anybody who’s listening – don’t freak out
if you see a 1099-k form, that looks like a ton of money that you certainly didn’t make
because again, that’s just proceeds and looks a little bit different from the proceeds that
you are seeing on our service BitcoinTaxes. Yeah, that’s a really good point. And just to kind of do a side by side comparison. So imagine that you have a you have a stock
account portfolio with a traditional US brokerage. And at the end of the year, after you’ve made
a few trades, you get what’s called a 1099-B. And anybody who’s gotten this knows, it basically
says that x taxpayers sold a certain amount of the certain type of stock for the gross
proceeds. And it also contains the basis. And so that information is provided to the
IRS, it’s provided to you. You put that on your Schedule D, your 8949,
it’s totally reconciled by the IRS systems. No issue. A 1099-K is different, right? This is actually a merchant processing third
party information returns. And it really is typically associated with
people who have credit card sales and so it’s going to reflect a gross amount and typically
on a monthly basis. I’ve also seen this in the area of AirBnb
and VRBO people get these as well, but it shows that the gross amount and what I’ve
seen too is that sometimes transfers actually get caught into that amount as well. So it’s not even gross sales or purchases
or anything like that, but it may have other information. So 1099-K can be really inflated. And that’s why really reconciling that against
accounting records is really, really important because that is one of those issues that I
think could lead to exam. Especially with more and more exchanges sending
out 1099-K forms. It’s very important to be aware of what exactly
a 1099-K is and how to interpret it. Yeah. And that’s exactly why if you’re going to
be prepared to respond to that, that’s all you really need to preserve complete records
and that’s all your exchange CSVs, bank account statements reflecting on-ramping and off-ramping,
coherent accounting – and then other types of things like emails or even keeping a log
of your activity that’s kind of contemporaneous with your transactions. I mean all of these things you could provide,
if you were audited and you had an auditor saying, oh, I see that you had x amount of
proceeds from transactions this year from Coinbase. The other point is you have to understand
that from an auditor’s perspective, if they see a 1099 k with let’s say $1 million of
gross proceeds, the burden is going to be on you to show that that’s wrong, that that’s
too high. And that’s just the reality. Yeah, absolutely. That’s what you get into when you trade cryptocurrencies. That’s just something you need to know. And as you said, it’s reality. There’s nothing we can do to change that right
now, aside from just having your records and understanding cryptocurrency trading. If you’re trading cryptocurrency, you should
understand the taxation behind it. Most people don’t, but I think more and more
people are trying to at least, and that’s why we’re doing these podcasts – so people
get a better picture of cryptocurrency taxation in general. Yeah. I think as people wrestle with these issues
and they want to get to a point where they feel comfortable that they’re in compliance
and they’ve taken all the reasonable steps. I think going through and figuring out, hey,
what was my taxable income? What records do I have to support that? And then how do they reconcile? If they don’t reconcile my past year’s returns
– I mean, I would amend those returns. I mean, because to a certain extent, I mean,
you’re going to get ahead of these issues. You can at least at least take the pressure
off yourself of what if I do get audited, because you can imagine even if you’re audited
for let’s say 2017 tax return – if you’ve been involved in for four or five or six years. Like I said, everything goes back to the initial
on-ramping, or for the most part it does. And so you can see what a slippery slope it
is that you’re going to be discussing older years and issues related to that. So it’s kinda hard to have this partial compliance
for a single year with respect to cryptocurrency. We do have some clients who just came in for
six months and made a lot of money and got out. For those people, it’s just a single year
item. But for anybody has been in it for a number
of years or for the foreseeable future is going to stay in the market. It’s not a problem that is going to go away. It’s only going to build on itself. What do you have to say to people who say
the IRS will never catch them in terms of cryptocurrency? Because there’s obviously regular tax evaders-
but in terms of cryptocurrency, given the nature of cryptocurrency, there’s a lot of
people that say “we shouldn’t have to pay taxes on these”, “they’ll never catch me”,
“I’m not going to pay taxes”. It’s common, especially on social media and
Reddit. There are a lot of people that say that. So what’s your advice or what’s your input
on that? I think it’s shortsighted to be frank. I mean, number one, the current commissioner
of the IRS is Charles Rettig and he’s a really well known practitioner in tax controversy. I know from people that know him well, that
he’s actually mentioned Reddit as one of the reasons that it’s his number one enforcement
priority right now – cryptocurrency enforcement. And I think one of the reasons, if you think
about the technology and what it means potentially means for financial transactions, how could
the IRS not try to figure out how to do this? I think one of the reasons that the IRS had
been so slow to provide guidance, besides the fact that it’s completely underfunded,
is the fact that it’s a really complicated tax question. This is technology that moves much faster
than the tax code. So to a certain extent, I think that they’re
thinking through these issues, but the issues that you and I are talking about today are
pretty straight forward, right? It’s people not reporting or failing or haven’t
fully reported their taxable gains. I saw, I saw commissioner Rettig at a conference
about eight months ago – I kind of rubbed elbows with them for a minute and brought
up cryptocurrency and he just said, “that’s a good place to be for the next four or five
years”. I don’t think he’s joking. I think it’s really an issue of priority for
them. The other person that I’ve seen speak a couple
of times is the head of the IRS Criminal Investigation Unit. His name is Don Fort and every year he does
a presentation at the National Tax Controversy and Criminal Tax Conference. The last two years cryptocurrency has been
number two and number one on his list. As much as the IRS lacks the funding and the
manpower that needs for all the enforcement. IRS CI – they are really, really good and
they are probably best agency at dealing with cryptocurrency enforcement issues. And in fact it was that agency that really
took the lead on the Dread Pirate Roberts case as far as kind of tracking and breaking
down if some of the issues there. So I wouldn’t fool yourself into thinking
that this is just going to go away. I would say certainly everyone in the tax
controversy world a year ago, there were a lot of people talking about it. I mean, now there are panels that all these
conferences on how to deal with these issues. So I really think that it’s gaining steam
and I think once the audits from the Coinbase summons kind of get going, I think it’s going
to be , a really scrutinized area. And I think people who have gone through the
end of the cost and the pain of disclosing and amending returns and doing everything
they can, will we happy that they did in a couple of years. I think other people who are going to be sweating
it out – I don’t know if it’s ever really worth it to be honest with you. I would recommend people do their best to
kind of get in compliance. I think that’s great advice. And I agree completely. And it’s funny because everybody in crypto
wants adoption. We want adoption of crypto so that it becomes
more mainstream and that it is utilized more easily and there’s better tax laws written
for it. But with adoption is obviously going to come
scrutiny and the government looking into it and the IRS and – they go together, adoption
and oversight and the government having their hand in the pot, it all goes hand in hand. So it’s inevitable. Yeah. I mean unfortunately or fortunately, however
you want to look at it – it’s just a reality. And I mean ultimately one of the problems
here is that for people that are out of compliance is that if you never report your foreign exchange
accounts, those statutes just remain open and you just never know when these are going
to come back to you. What if, what if another exchange starts providing
information to the IRS? For anybody who wants, who wants to kind of
a parallel understanding, you can take a look at basically all of the issues with the Swiss
Banks. This is kind of what happened in the last,
over the last 15 years or so. with the IRS getting information from all the Swiss Banks
and kind of prosecuting people for that. And so that, that program recently wrapped
up – OVDP program, and it’s kind of coming to an end. I really do think cryptocurrency is going
to be the next wave and those kind of enforcement on unreported income. Do you have any more risk reduction strategies
that you want to share with our audience? ,
Yeah. I think for, I think for people who have potential
issues with past years, one is getting a consistent record and just amending your past years,
so they’re consistent – you’re going to address your noncompliance. And I think for people who have the foreign
account issues, let’s just say for example, had an account with Binance and that Binance
account was never reported, the IRS has disclosure, a disclosure programs that allow you to amend
certain returns, pa the tax that you report and pay a penalty, which might be would be
5% of the highest account value that you have. For people for current year issues – let’s
say you just started with cryptocurrency. I think you want to report as much as you
can on that return, and to the extent you’re taking any position where the, there’s not
great guidance, for example whether an airdrop is taxable income, just make sure that you’re
consistent every single year. So whatever you start with this year or you
have done in past years, keep doing it, don’t change it to give yourself a benefit, a tax
benefit. Again, the foreign accounts report, the FBAR. I think ultimately do your, do your absolute
best to be, to be a, to pull the report, everything as you can. One of the things that I think I learned very
early in dealing with audits and tax compliance is that you can always make things worse. And I think for people who don’t want to deal
with this, I think taking evasive steps is the best way to get the worst result possible. And I think you really just want to address
it and kind of resolve the issue while you have a good opportunity. I think that’s the overall lesson in terms
of risk avoidance strategies here is that if you are not trying to be dishonest and
if you are not trying to pull one over on the IRS to pay less taxes, you’re very likely
going to be good. You might get audited and then you’ll provide
the documents and you’ll say, sorry, this is my mistake and I tried my best and you’re
likely not going to get in much trouble. You might have to pay a fine or pay some extra
taxes. But if you are not trying to deceive the IRS,
you don’t have to worry a ton. But if you’re trying to defraud the IRS, that’s
where you’re going to be in trouble. That’s where people have to worry. And so I think the overall lesson, in my opinion,
and this is the lesson I’m taking, is that just don’t try to lie to the IRS. Would you agree? Yes. That’s the best piece of advice you could
ever give anybody. Cool, great! Hopefully people understand that. But unfortunately the reality is there are
people that do not understand that. And I don’t know if it’s just the nature of
cryptocurrency because it started as a technological, generational type thing. I’m part of that generation, but it’s a generation
of thinking that things don’t apply to them I guess. But people who are going to try to defraud
the IRS are going to be greeted with a lot of trouble. Yeah, I think too, I mean, one thing I’d comment
about that people involved in cryptocurrency, they just skew younger, right? And for a lot of them, this is the first time
they really had to deal with a real tax issue. Maybe they had a job before and a w2 and paid
taxes that were withheld. But to get someone telling you, hey, you owe
x amount of dollars in tax or all these things that you did means that you now owe more and
you have to mend all these returns and pay professionals and all that. That’s a tough pill to swallow. And that’s also tough for a lot of people,
not even in the cryptocurrency world, when they don’t normally kind of deal with these
types of costs in their daily life or normal life. So to some extent I kind of get it, but I
think people now have to realize it’s just, it’s just the way it is. Nothing you can really do about that now. That’s a good view, though. That’s a good way of looking at it. That’s like self-employment taxes, for example. Maybe some people don’t understand that they
have to pay quarterly taxes. I mean that’s a whole other topic, but it’s
kind of in the same vein. People may not be used to it – so that’s a
good way of looking at it. So can you give us some predictions for IRS
enforcement – in regards to cryptocurrency taxation? Yeah, and I think the two things that I’m
fairly certain we’re going to see: one is, we’re going to see the IRS use the information
provided by Coinbase to start auditing the biggest account holders from that period. I think that’s very likely. And a lot of people who’ve hired us are people
that were in that group and that’s why they’re trying to get ahead of it. Probably the second one that I would say is
very likely is that you’re going to see limited, but probably some criminal prosecutions related
to cryptocurrency. And these are going to be people that I think
I have some sort of level of notoriety, whether actually famous or, maybe famous in the cryptocurrency
world. And that’s typically how the IRS and Department
of Justice uses its limited resources to prosecute criminal tax crimes. I believe that’s already happening a bit with
some ICOs and some celebrities. Correct me if I’m wrong or if you’re not sure. Yeah. I remember reading about the SEC that got
involved with an ICO, I don’t know if it was a couple of different rappers who had, I think
unknowingly probably kind of promoted the ICO that kind of put them on the wrong side
of securities law. And the reason that they do that frankly is
because people read a lot and you hear about it people talking about tax crimes and everyone
always talks about Wesley Snipes and The Situation from Jersey Shore, right? There’s a reason that they got prosecuted. There’s other people like them who do very
similar types of things and it never goes criminal, but at the end of the day the IRS
wants to get the word out. I think that’s very likely what we’re going
to see here in the next couple of years. Right. I mean, out of all the enemies that Blade
fought, the only one that was able to take him down was the IRS… I appreciate all of the information you’ve
given us today, Alex. What would be the best way for somebody to
contact you? You can go to my website. It’s Kugelmanlaw.com. Or you can email me at [email protected] I have clients all over the country, international
clients, and if you need any sort of help, whether that’s representing you, or at least
doing the nitty gritty audit investigation, we’re always willing to talk to people and
help them out as best we can. Awesome. And we’ll put a link down on the page, so
in case anybody was having a hard time spelling that, we’ll have that right on our page. Everybody, thank you for listening to our
BitcoinTaxes podcast today. Be sure to stay tuned for future podcasts
discussing a range of topics within the intersection of cryptocurrency and taxation.

One thought on “IRS Audits on your Cryptocurrency Taxes”

  1. Wow best video I've seen so far on taxes I received a letter from the IRS claiming I owe on 295,000 when I only had around 23k at the most on exchanges so problem now is getting Transactions. I'm having a lot of trouble considering I haven't used some wallets or exchanges in over a year. I feel like I'm loosing my mind being so stressed out over this.

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