Many crypto holders are reporting their crypto transactions for the first time as a result of the United States Internal Revenue Service’s question about “virtual currency” on the 2019 tax return form.
It is a big question for some taxpayers — many have not reported their crypto gains in the past or may have done so without a great deal of precision. Should a taxpayer let bygones be bygones or file an amended return to accurately reflect their historical income from crypto? The IRS subpoenas of crypto exchanges for taxpayers’ trading histories certainly raise the stakes. To layer more on, statutes of limitations, potential penalties and/or IRS leniency may vary based on the degree of previous noncompliance.
Decisions in one tax year have consequences in future years. This is because gain/loss amounts vary based on which crypto assets are treated as purchased or sold and when these trades occur. Sale of an asset in one year raises the question of how or when a taxpayer acquired that specific asset in the past. If an acquisition was the fruit of mining, staking or an airdrop that was not reported, a taxpayer may need to explain why this transaction was not reported as income on their previous year’s tax return.
Given the recent changes and uncertainties, new software has been designed for investors, traders and other participants in the crypto ecosystem. Such tax compliance software is necessary because, unlike traditional financial assets, trading and other activities in crypto are not reliably reported — or often not at all — on IRS information returns (such as 1099 forms).
Trading in cryptocurrency differs from trading in traditional financial assets in a variety of ways. This includes the movement of taxpayer assets across exchanges in nontaxable transactions, paying fees in capital assets (rather than cash), differing tickers from one exchange to the next, decimal precision and the unique transactions that only occur in the cryptosphere. These are some of the reasons why traditional or generic tax compliance software often falls short in serving the crypto ecosystem.
However, not all crypto tax software is created equal:
- Some ignore fees associated with transacting in crypto that typically leads to an overpayment of tax on gains or an understatement of losses — which can be used to offset taxable gains. It’s important for your software to properly account for transaction fees so your taxable income is not overstated.
- Some do not properly address the uniqueness of crypto data, such as the differing tickers across exchanges for the same asset and varying decimal precision. Mistakes in these two areas can lead to inaccurate taxable income calculations and risk of an audit.
- Some do not provide sufficient flexibility for the particular taxpayer’s circumstances or blindly apply imprecise or generic tax principles. This rigidity can have adverse financial consequences for taxpayers in the absence of detailed IRS guidance. One example is the reporting of airdrops, mining and staking rewards where some taxpayers believe the IRS’s guidance is too broad when applied to different factual variations. Another example involves the potential for claiming ordinary, rather than capital, loss treatment for certain crypto assets. Ordinary losses are often easier to use for reducing taxable income.
- Some offer taxpayers accounting methods for crypto that are impermissible in the United States — e.g., average cost — without adequate warnings. Others do not support or display the benefits of tax optimizing methods that allow taxpayers to identify assets with the highest tax bases as the ones sold, a method known as highest-in, first-out.
- Some only match acquisitions and dispositions on a single exchange rather than across all of a taxpayer’s different trading venues. This can have a material impact on taxable income calculations. Generally, this will also result in non-optimal taxable income calculations when applying different accounting methods such as first-in, first-out, last-in, first-out and highest-in, first-out.
- Some were developed in a vacuum and not subject to the rigors of independent audits for Service Organization Controls relevant to software-as-a-service providers. Only crypto software providers with the highest level of internal controls for reporting, security, privacy and processing have both SOC 1, Type 2, and SOC 2, Type 2 certifications. The use of software without these certifications increases a taxpayer’s risks — both tax and non-tax related.
The list goes on, and there are even more points that can be made in choosing the right crypto tax software for an area where there is little specific tax guidance. The lack of specific guidance for crypto does not mean that there are no rules, however. It just means that a finer-tooth comb is needed to determine which tax rules apply to crypto, and how that application differs from traditional financial assets.
There can be advantages to such an analysis that can significantly reduce tax expenses or increase a taxpayer’s refund. A flexible tool is often needed to help users make informed decisions that can ultimately save taxes or increase a refund.
The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Roger Brown is the head of tax and regulatory affairs at Lukka. He has more than 27 years of experience as an international tax and financial products lawyer. He spent a decade at the national office of the Internal Revenue Service writing regulations and other guidance, and prior to Lukka, he spent a similar period of time as a partner in Ernst & Young’s financial institutions and products office. After being tasked to be the lead international tax partner on a number of Ernst & Young’s largest banking, insurance and other capital markets clients — often bridging the intersection of tax and capital markets regulations — Roger became one of the company’s leaders in the fintech and blockchain space.