Just a few months ago in July 2019, the United States Internal Revenue Service (IRS) sent approximately 10,000 letters to cryptocurrency holders regarding their crypto address holdings. The letters detailed that recipients may not have reported their transactions properly, or failed to report income and pay taxes on their digital currency transactions.
The IRS asked the recipients to check their reports and submit delinquent returns or file amended returns according to specific requirements. According to the letters, the reports must be “true, correct and complete” in order to be approved by the IRS. But how can the IRS know the submitted reports meet its criteria?
It is a well-known fact that the IRS used Chainalysis back in 2015 to possibly assist them in its case against Coinbase, in which Coinbase was ordered by a U.S. federal judge to report 14,355 users to the IRS.
What many people don’t know, however, is that the IRS continually contracts Chainalysis to support its intelligence work on cryptocurrency investors. The last contract was signed on July 2019, with a completion date of August 2020.
Additionally, the IRS has enlisted the help of Elliptic, another company involved in blockchain analysis that supports regulatory compliance under several contracts, the last of them signed on September 2018, with a completion date of September 2019.
These contracts are a signal that the IRS has the following abilities:
- Connecting one cryptocurrency address to another: The IRS can automatically find connected paths of crypto addresses and trace the flow of funding, source and destination of a specific transaction. This technology enables the IRS to find the link between crypto addresses that have been reported to it with others that may not have been reported.
- Identifying exchange activity: While crypto trading on exchanges is off-chain and cannot be found on the blockchain, every trader must use a crypto address on the blockchain in order to deposit or withdraw their cryptocurrencies. The blockchain analysis systems have collected big data of exchanges addresses, which enables the IRS to link reported addresses to exchange activity.
- Identifying estimated revenue and cash-outs and monitoring large volumes of activity.
- Investigating criminal activity: Blockchain analysis companies provide support to the IRS in criminal and forensic cryptocurrency investigations.
Why is it difficult to complete a report as per IRS requirements?
Traders who have a lot of activity or trade on many exchanges and use many wallets sometimes have difficulties tracking all their past addresses.
Furthermore, crypto investors that use crypto as a means of payment make many transactions to third parties, just like any other payment service. However, unlike credit cards, crypto payments do not specify who is the third party, and those who did not keep records in real-time will struggle to reconstruct the data. With Bitcoin (BTC), this transaction will also contain a change address that needs to be associated with the payer to get an accurate and complete report.
What can you do to make sure your report is complete?
- Collect all your data before you start your calculation. First of all, you need to understand that although tax filing is something that most people feel like they “just want to get it over and done with,” it is a process that should be done properly. So, ensure you take the time to properly collect your data. Collect your addresses from all the wallets, all data from your crypto exchanges, and all of your activities during the required tax period.
- Make sure nothing is missing. After you have successfully collected all your data, check for incomplete or incorrect information. There are some crypto tax platforms — such as Bittax or Blox — that track all your crypto addresses and combine them with exchange information. In the event that information is missing, the system will alert the user and will continue to send alerts until the user has completed or corrected all required information in order to provide a complete report.
- Disclose your missing information. Over time, it is possible that one of your crypto exchanges shut down, an address was rendered inaccessible due to hacking, or you misplaced your seed password and are unable to restore the information. If you are unable to restore or gather the information required, disclose the reasons to the IRS with supporting documentation, if you have any. It is important to consult with a professional before filling with the IRS. Make sure that your CPA or legal advisor understands crypto taxation.