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Will Cryptocurrency Tax Returns Stand up to IRS Audits?

Feb 19th 2019
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With roughly a month left until the US tax season closes, the position of cryptocurrency investors is causing problems for accounting professionals across the country.

This situation developed from a few different events. First, the record highs that the cryptocurrency markets experienced in 2017 turned the eyes of the IRS towards those who had benefited most. Then, the downturn in prices that followed into 2018 caused many investors to consider harvesting their losses against tax liabilities. Finally, we’ve seen a number of stories in the past year where the IRS has elicited information from exchanges and where exchanges have partnered with software providers to enable tax reporting.

So, where do we stand now?

In all likelihood, accountants will start to receive - if they haven’t already - a number of reports from clients that detail crypto losses and are aimed at offsetting tax liabilities. The problem is, while much has been made of the partnerships between exchanges and accounting software providers, many of these reports by themselves will not stand up to IRS audits.

In fact, it seems highly likely the methodologies being used are not fit for purpose because they do not track individual crypto assets through their entire life cycles.

The Risk of Outlier Methodologies

The problem with using the wrong method for recording your cryptocurrency transactions and sales is that it can increase your chances of an audit from the IRS.

It’s well understood the more money you make, the greater your chances of being audited. In fact, wealthier individuals are already at least 10 times more likely to be audited than the average taxpayer. But you’re also more likely to be subjected to an IRS audit if you saw large gains during the ICO period.

When you consider that the IRS is known to be focusing on cryptocurrencies, all the signs suggest these investors should be making sure they do things correctly.

Unfortunately, most solutions are not enabling them to do this. The main methodologies being offered include FIFO (first in, first out), LIFO (last in, first out), HIFO (highest in, first out), ACB (adjusted cost base) and share pooling. However, none of these are likely stand up to IRS challenges when the blockchain is involved, as they do no track the asset through its life cycle.

What’s the Right Way to Track Cryptocurrencies?

One of the reasons tracking a crypto asset through its life cycle is important is because of the IRS’s classification of these assets as property. Therefore, it’s not entirely clear why some solution providers are suggesting certain methodologies that don’t allow these assets to be tracked correctly.

One possible reason is doing so isn’t easy.

Typical cryptocurrency investors use more than one exchange and, oftentimes, more than one wallet. Therefore, they have cryptocurrencies stored in various places that don’t talk to each other.

A LIFO report from one of the exchanges they use does not provide any information about the cryptoasset’s life cycle before it was deposited on that exchange. If it had previously been bought by the investor on a separate exchange and then moved to their wallet before being moved onto the exchange from which the report was generated, the report would have no way of showing this.

It’s important to take a tax position that aligns with existing standards of accounting and approved by industry authorities.

In the US, FASB-approved GAAP (Generally Accepted Accounting Principles) is an excellent guide and allows for FIFO or LIFO. Internationally, we have the IFRS (International Financial Reporting Standards), which allows only for FIFO.

Such standards do not allow for HIFO or other methodologies. That doesn’t mean you’ll be audited or found in violation if you choose to use them, but be aware you may stand a better chance of losing an IRS challenge without a compelling argument.

For investors with cryptocurrencies in multiple locations, an audit trail that can be verified against the blockchain is crucial. Investors should use solutions that provide this sort of granular detail, complete with downloadable worksheets that adhere to IRS guidelines and AICPA recommendations.

Why Crypto Tax Reporting Needs to Change

The unique situation we find ourselves in has come about as a result of cryptocurrency rises and falls, a lack of clarity from the regulatory authorities and general uncertainty about how to deal with a relatively new industry. Some teething problems can be understood. However, as a profession, this gives us a great opportunity to advocate for what we see as best and appropriate practices.

With this in mind, cryptocurrency investors should be seeking advice on how to plan their future crypto trading with an eye on tracking assets through their entire life cycle so recordkeeping is easy and audits from the authorities are avoided.

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