The Inflation Reduction Act is breathing new life into IRS enforcement action.
Crypto cases will top the agency’s criminal-investigation ‘to-do list’ in 2023.
T he Internal Revenue Service’s (IRS) criminal-investigation (CI) function is charged with investigating allegations of criminal tax fraud, and assisting the Department of Justice (DOJ) with the prosecution of those cases.
The Inflation Reduction Act is breathing new life into IRS enforcement action, including CI. Next year, the agency intends to hire an additional 360 special agents, who will investigate alleged tax and financial crimes, along with another 150 professional support staff. These include technology experts trained to unravel complicated digital transactions. That will push CI’s workforce to 2,427 special agents and 1,088 professional support staff, the highest it’s been since 2010.
The complicated digital transactions awaiting scrutiny are cryptocurrency transactions. According to CI’s 2022 annual report,
Digital assets pose a significant risk of facilitating money laundering, cybercrime and ransomware, narcotics and human trafficking, terrorism, and proliferation financing. Digital assets may also be used as a mechanism to circumvent U.S. tax law and financial sanctions.
This is why CI is currently teeing up hundreds of crypto cases for investigation and potential prosecution. Such cases will be a priority throughout 2023. In fact, because of the rise in crypto cases overall, in 2021, the IRS created the Office of Cyber and Forensic Services under the umbrella of CI. That office unifies the agency’s digital-asset investigations, cyber-crime investigations, digital forensics, and physical-forensics support teams, all in one place. A key priority, according to the annual report, is to investigate “the illicit uses of digital assets and how they can be used to exploit the U.S. tax and financial system.”
The Internal Revenue Code does not address the tax consequences for cryptocurrency in particular. A few years after its emergence on the scene in 2009 as a financial asset, IRS Notice 2014-21 deemed “virtual currency” — Bitcoin in particular — as “property,” to be treated no differently than a share of stock or an automobile. The IRS refers to “virtual currency” as “convertible” currency in that it has a value measured in real currency, or it acts as a substitute for real currency. Any one of the hundreds (and growing) of today’s digital currencies meets this broad definition.
Tax problems with cryptocurrency arise as a result of two issues: (1) the failure to report the gains on trading crypto assets, and (2) the failure to report income paid in the form of crypto assets. Let me address them in turn.
Reporting Crypto Gains
When Bitcoin showed up on the market in 2009, it was essentially worthless. By the end of 2009, it had some value only because of very limited trading. However, by November 2021, at its peak, one Bitcoin was worth nearly $69,000. As of this writing, it is trading for about $16,440. Much trading was done by investors throughout this wild ride. Those who bought low and sold high (the key to making money, I’m told) realized gain on their trades. The gain is taxable as income. For example, suppose you purchased crypto at $5 per coin, and sold at $15. You realize gain of $10 per coin. That gain is subject to capital-gains tax. The rate of tax depends on a number of factors, most notably the period of time for which you held the asset.
The problem is that people often do not understand that gains realized from trading crypto must be reported and the tax paid. But as I point out above, as early as 2014, the IRS classified virtual currency as an asset to be treated, for tax purposes, just like any other asset.
The other element of the trading problem shows itself when there are mere portfolio transactions. Suppose you have a portfolio of 50 Bitcoin, worth $1,000 each. Your basis (cost price) in the Bitcoin is $100 each. You trade all your Bitcoin for some other digital currency without taking any cash from the portfolio. The typical taxpayer would probably believe there are no tax consequences for this trade because he took no cash. He would be wrong.
The swap of the Bitcoin is treated as a sale. The fact that you acquire another digital currency without taking cash in the process does not change the fact that you, in fact, sold Bitcoin. It’s no different from selling 100 shares of IBM stock and using all the proceeds to purchase 3M stock. You are taxed on the profit of the IBM stock, measured as the difference between the purchase and sales prices.
Payments in Crypto
Now let’s address what happens when you take crypto as payment for goods or services rendered. Suppose you’re in business as an attorney. Your retainer fee is $5,000. A client pays you with five crypto coins worth $1,000 each. The fair market value of the coins as of the date they are paid to you is $5,000. That amount must be reported by you as income in the year received.
Now, you may counter by saying that since you didn’t sell the coins, there’s no profit: not true. Your profit is measured by the fair market value of the coins as of the date you take them as payment.
At that point, your basis (purchase price) in the coins is equal to the fair market value on the date of receipt — in this case, $1,000 per coin. Suppose you sell the coins later for $1,500. At that point, you have a profit (capital gain) of $500 per coin, which also must be reported on your tax return in the year of the sale. On the other hand, if you sell for $800 per coin, you have a loss of $200 per coin, which may be claimed as a capital loss (subject to certain limitations) in the year of the sale.
IRS and the Tracking of Digital Currency
Too many people believe that the IRS has no way to track digital currency and, therefore, if one fails to report trades, nobody will be the wiser. This is a serious mistake. The IRS has made great strides in tracking digital currency. The best proof of this is the case of Ilya Lichtenstein and his wife, Heather Morgan, of New York.
The pair were arrested in Manhattan in February 2022 and charged with conspiracy to launder $4.5 billion in Bitcoin that they allegedly stole by hacking a virtual-currency exchange in 2016. The IRS’s CI was instrumental in breaking the case.
CI traced this crypto using the Bitcoin blockchain to various destinations, including: (1) accounts on the dark web, (2) seven interconnected accounts at various virtual-currency exchanges, (3) various unhosted Bitcoin wallets, (4) accounts owned by Lichtenstein at six virtual-currency exchanges, and (5) an unhosted Bitcoin wallet containing most of the stolen crypto. CI accessed the wallet by decrypting a file saved to Lichtenstein’s cloud account, which it obtained via a search warrant. The cloud account contained a list of 2,000 virtual-currency addresses, along with corresponding private keys. Special agents then recovered more than 94,000 Bitcoin valued at over $3.6 billion at the time of seizure.
For all the bungling the IRS sometimes displays, the agency’s special agents are not among the bunglers. They are highly trained professionals who are singularly focused and know exactly what they are doing. If you have crypto profits, do not make the mistake of believing that the IRS cannot or will not find them. The agency is making these cases a priority in 2023.
If you are unaware or unsure of the tax consequences of your crypto trades, do not go it alone. Get counsel. Proceeding otherwise is simply not worth the risk. For that matter, none of the above should be treated as tax advice. If you have questions in this area, please get in touch with your tax advisor.