Although the IRS set guidelines for the taxation of bitcoin and other cryptocurrencies back in March of 2014 with Notice 2014-21, only 800 Americans reported their bitcoin transactions from 2013 through 2015, according to Node40.
With the skyrocketing price and popularity of Bitcoin over the last 5 years it is far fetched to say that only 800 Americans recognized a capital gain or loss during this period. So what is happening? Simply put, nobody is actually reporting income from the sale of bitcoin.
Lack of Reporting and Awareness
It is not self-evident that buying and selling bitcoin is taxable so few people report it as income. You get a W-2 for wages, 1099-misc for independent contractors, 1099-R for retirement income, so on and so forth. But when you buy, sell, trade, or transact in bitcoin there is no 1099-BIT that you receive.
For businesses that regularly transact in Bitcoin and use services like Coinbase, a 1099-K is typically used to report business transactions in excess of $20,000 per year. A Form 1099-K includes the gross amount of all reportable payment transactions for the year and is reported to the IRS.
For Bitcoin users who use virtual wallets for personal purposes they will receive no such forms. This means reporting taxable gains and losses or other income from cryptocurrency is difficult and complex – but more importantly, unregulated.
Unregulated Bitcoin Markets
The reason why Bitcoin and other cryptocurrencies are so popular among users is because it is a decentralized and unregulated system. If you wanted to make a secure payment for goods and services you can do so without a bank or intermediary.
Going even further, cryptocurrencies are ideal for individuals who want to buy and sell goods while avoiding taxes altogether. This is especially true for people who are trying to buy and sell illegal goods and services without a paper trail for the IRS or FBI to follow. Some have theorized that the underlying value of Bitcoin is not rooted in its use as a currency but instead its use as a means to engage in illegal online activities.
This isn’t a surprise to the diehard supporters of Bitcoin because the ability to conduct transactions without the need of financial intermediaries or other governmental agencies is the cornerstone of this technology. So, the fact that so many users have been able to avoid regulatory agencies, including the IRS, with no ramifications, means that Bitcoin is being used as intended.
Over the last few months the IRS has been cracking down on users of Bitcoin who have failed to report taxable Bitcoin transactions. The most notable example is the IRS’s John Doe Summons on Coinbase, Inc., the cryptocurrency transaction hub.
If courts rule in the IRS’s favor then 14,000 users could be first in line for an IRS audit. Although the repercussions of an IRS audit won’t be felt immediately, if not for years to come, the penalties and interest associated with under-reporting income can be astronomical.
How to Avoid IRS Fines and Penalties
For users who want to get ahead of the IRS crackdown they can amend prior year returns or stay in compliance going forward. There is a laundry list of ways the IRS can penalize taxpayers who have failed to report taxable Bitcoin transactions, so it is best to consult with a CPA specializing in tax resolution – specifically one knowledgable on the tax treatment of cryptocurrency.
Click here for more information on how Bitcoin and other cryptocurrencies are taxed.