- The IRS is relying on “bad information” to issue tax demands to cryptocurrency users
- The burden of proof is on the taxpayer to prove the IRS is wrong, but data may be hard or even impossible to get
- “It comes across as a very offensive campaign, and it rubs you up the wrong way and it’s very scary,” said Ryan in an exclusive interview with BitStarz News.
Sean Ryan is the co-founder of NODE40 Balance, a software product designed to help cryptocurrency investors, traders, and users grapple with the complexities (and absurdities) of the tax system when it comes to cryptocurrency use. With the news that the Inland Revenue Service (IRS) is sending out waves of letters informing cryptocurrency users that they haven’t paid enough tax on their crypto earnings, BitStarz news writer Mark Hunter sat down with Sean to discuss the letters, what recipients can do about them, and how much of a mess the current crypto tax system is.
MH: What is the importance of the recently sent CP2000 letters over the previous letters sent out by the IRS?
SR: The CP2000s are actually not related to the other letters. For the first time we’re seeing CP2000 letters being issued, and the reason they’re being issued is cryptocurrency-related. This is the first time that the IRS has information from cryptocurrency exchanges, so any discrepancies between this information and what people have reported as their income are being included into the already going to be sent out letters, and this is what’s frightening people. The CP200 letters are more significant in that you have to respond to them and you have 30 days to correct your return and explain why they’re wrong. It’s very stressful for the taxpayer when they receive this letter, but if they are actually trying to follow the letter of the law and they’re trying to stay above board and pay taxes, using a software product like Node40 Balance can produce the audit trail necessary to hand over to the IRS and say “you’re wrong, I’m right”, here’s why I’m right. It could take more than 30 days just to get that information into a system and then work through those numbers and make sure they reflect your belief in your crypto trading activity.
MH: How seriously should recipients of CP2000 letters take them?
SR: The reason why it’s so important to take the CP2000 letters seriously is that they’re the first communication from the IRS to taxpayers that says, “it looks like you did something wrong”. The problem here around cryptocurrency is that the information the IRS is getting is bad information. If you use a stockbroker, the brokerage firm will usually issue a 1099-B form with what stocks you bought and sold, how long you held them for, and the prices at which you bought and sold them. That information is considered very good and very accurate information, and you are obligated to pay taxes on that. With the 1099-Ks in the cryptocurrency world, the information going to the IRS and to the customer is a very small piece of the picture. What’s being reported is considered income, but when you trade cryptocurrencies you are realizing benefit from increases in price valuation – the 1099-K doesn’t reflect your profit, it reflects your gross amount. So these 1099-Ks are grossly inflated and they’re just not representative of what you owe in taxes. It paints a tiny picture but its incomplete.
MH: How did this problem come about?
SR: The deal that the IRS struck with Coinbase a number of years ago to issue 1099-Ks instead of 1099-Bs was great for the exchange, but the consequence of allowing the 1099-Ks to be used is now coming to fruition. Everybody’s realizing that they’re wrong. No human at the IRS is looking at your returns and saying, “it looks like you did it wrong, I’m going to send you a letter”. These are all automated processes, and the automated processes are assuming its good data in, and you’re getting a lot of these letters going out now that are affecting cryptocurrency customers. This is going back for many years now. The IRS is looking back a number of years and saying, “you did it wrong”. Well you never told me how to do it right, and you’re only giving me 30 days to make good on the last six years of my entire digital trading activity?
MH: What is the IRS saying in these CP2000 letters?
SR: The IRS is making a bold claim here. Not only are they saying, “we think you did it wrong, please correct it”, the CP2000 letters are also saying “you did it wrong, you owe us this specific amount of money. That’s scary. So you have to fight that, and fighting the IRS is almost always a losing battle. There are exchanges that no longer exist. If you were trading on an exchange in 2014 and that exchange disappeared, you can’t go back and get that data. The nice thing is the IRS also can’t go back and get that data, but if they’re making a claim that you owe something and your evidence that you don’t owe something is in data that’s not longer accessible to you, that’s going to be a real challenge.
MH: It’s almost as if you’re trying to fight inaccurate data with no data at all.
SR: That’s right, in some cases that may be the case. You’re in a real pickle there. When you’re fighting the IRS the burden of proof is on the customer and not on the IRS like it would be in the rest of the legal system. It’s reliant on you to prove them wrong. You should be in a defensive position, but you give me a CP2000 letter and I have to go back and prove that you’re wrong with more overwhelming evidence.
MH: What exactly is wrong about the way the current data is collected and reported?
SR: Say I received Bitcoin as payment for services I performed and after a while I transfer that Bitcoin into Coinbase. Coinbase sees that as inbound value at a certain dollar amount, even though I may have received it at a much lower dollar amount. That basis should follow me, but Coinbase has no idea about the previous history of that currency. So it doesn’t know the true basis, and this is really where the problem comes in – if you don’t know the basis, how can you report gains and losses? So these 1099-Ks don’t’ make a distinction between how you were using the currency, where it came from, and where it was going. 1099-Bs are better than 1099-Ks in that they provide a little bit more information, but in terms of the context of knowing how much you owe, I’d say that 1099-B’s are not much better than 1099-Ks.
MH: What measures can individuals take to protect themselves from this point forward?
SR: Ideally use a software solution like NODE40 Balance because it’s easier, but failing that you can use traditional accounting software. When you make a transaction you record it and annotate it, you say what it was for and you put it into your accounts. You need to track it at that level of detail, no differently than any other type of payment or receipt in fiat currency. The problem is people are just getting around to realizing that’s the way they should have been doing it from the beginning. Remember that digital currency has been around for more than a decade now. That’s a lot of history, and people don’t remember what they did and the IRS didn’t really tell them that they had to be tracking this until recently.
MH: What powers does the IRS have if you fail to respond?
SR: If you don’t reply to these messages within 30 days, the IRS has the influence to reach out to exchanges and say, “you have to withhold 24% of this citizen’s earnings”. This is called backup withholding. And would foreign exchanges shut me down because they want to play nice with the US government? Probably. Every exchange’s terms and service will say that they will comply with legal regulations, so there’s your loophole.
MH: What approach should the IRS be taking with cryptocurrency users?
SR: They have to stop coming off as a scary organization. Come off as an organization that says, “you owe taxes – we’re going to help you understand what that means”. If it was more of an educational type campaign you’d feel less threatened and I think more people would embrace it and try to do the right thing. Instead it comes across as a very offensive campaign, and it rubs you up the wrong way and it’s very scary. I’ll pay my taxes but you have to tell me how to do it. The IRS by saying, “you owe taxes” but not telling you how to calculate them…you just want to take them and just shake them and say “are you kidding me?!”.
MH: Do you foresee any changes in cryptocurrency taxation soon?
SR: In late May, early June I had high hopes that the IRS would release new guidance by the end of June because they said as much, but then June passed…nothing, July passed…nothing, now we’re at the end of August…nothing. So do I have high hopes that anything’s happening? No, I have pretty low hopes. In terms of what might eventually happen, specific identification is a way of calculating gains and losses by isolating specific portions of a cryptocurrency so that when you sell you can identify how much you bought that exact piece for. That might be a potential solution to part of the problem.
MH: And most people either rely on themselves to get their sums right, or trust an accountant who says they have experience.
SR: That’s scary! You’re still obligated as an individual to get it right, but they’ve made it so complicated that you have to put all your trust into somebody else who says they’re an expert or has a history of doing this, and crossing your fingers and hoping they’re right.
Clearly, Sean is no fan of the IRS’s current stance, and here’s hoping they make life a little easier for crypto enthusiasts in the coming months. If you have received a CP2000 letter, or you want to get ahead of the game, NODE40 Balance can help you quickly create a cryptocurrency audit trail that should hopefully keep the IRS off your tail for a while!