The next filing deadline is right around the corner. If you have cryptocurrency trading activity to include on your tax return, preparing as early as possible is a very sensible approach.
While not an impossible task given the proper tools, organizing and understanding your crypto tax liabilities does require some thought. The level of complexity involved certainly played some part in the low number of US individuals who have reported Bitcoin gains so far, which was just 800 between 2013 and 2015.
Given the major price increases that have occurred since January 2017, many more people are expected to have realized the types of gains that should have been reported to the tax authority. Certainly, that is the expectation of the IRS, which has been pursuing some of the biggest crypto exchanges with the aim of tracking down those who owe taxes.
There are a number of stories on social media that demonstrate how individuals have seemingly found themselves on the wrong side of the law. Some of these are as a result of the IRS having come to an agreement with a large exchange to issue 1099-K forms to a section of the exchange’s user base, forcing the hand of individuals to report their crypto tax liabilities.
The IRS has yet to provide firm guidance on the specific ‘form’ to use in reporting gains for crypto gains and losses, but the change in 1031 (like-kind exchanges) legislation earlier this year, moved many of these transactions closer to the 1099-B space. Lack of clarity from the exchange leaves much up for interpretation. Given the 1099-K is intended for reporting gross amounts paid via electronic payment methods (which is very different than gains reported on a 1099-B),it is worth understanding the differences.
1099-K vs 1099-B
The stated purpose of information reporting is to increase voluntary tax compliance. This suggests it is in everyone’s best interest to report the most relevant and accurate information to both the IRS and the individual. Reporting on payments received by individuals selling crypto, which the 1099-K allows, tells only part of the story. Not only that, it is a potentially very inaccurate.
Imagine the following scenario - a person purchases $100,000 of crypto on January 1, 2018 and, after seeing the markets tumble, sells it all for $90,000 a month later on February 1, 2018. The person believes they’ve experienced a $10,000 loss but a 1099-K form would show a payment received of $90,000.
By reporting activity in the form of a 1099-K, relevant information is missed and can sow confusion for the individual, and requires additional due diligence by payors. Moreover, it could potentially mislead the IRS in terms of expected revenue. Generally, the 1099-K is used by Third Party Settlement Organizations (e.g., credit card companies, payment processors, etc.) to report transactions they process for retailers or other third parties.
Individuals do not think of themselves as being involved in payment card or payment network transaction when they trade cryptocurrencies as they would with traditional ‘securities’. However, there may be instances where 1099-K forms could be populated by an exchange, when payments are made in this manner, adding to the confusion.
Therefore, the seemingly more appropriate form based on the guidance provided for the trading of cryptocurrency would be on Form 1099-B, which covers proceeds from broker and barter exchange transactions. There are four scenarios the IRS outlines for when an exchange must file a 1099-B. One of those is for individuals “who exchanged property or services through a barter exchange” and ”property” is precisely how the IRS Notice 2014-21 guidelines may require crypto transactions to be treated.
The reason this is important is because the cost basis of an investor’s cryptocurrency holding is critical when determining the taxes owed. For example, if an individual purchased one Bitcoin in 2015 and transferred it through an exchange in 2018, the 1099-B reporting that the exchange could generate could aid the taxpayer in correctly determining the amount of capital gains taxes due.
The fundamental issues in reporting Form 1099-K rather than Form 1099-B to the individual is that it could result in all manner of overpayment or underpayment of tax, simply because the IRS is not being supplied with all the information it needs to make a proper judgement.
A better approach to crypto taxation
The reality is that on their own, crypto exchanges may struggle to provide all the information required to correctly assess the tax obligations of more than a small portion of its customer base.
For the crypto exchange to be able to do this, its customer would have had to direct all of their crypto transactions through that single exchange. This just simply isn’t the case for the vast majority of people involved. Most crypto traders and investors use multiple exchanges, moving cryptocurrencies between them, as well as through one or more personal wallets.
All of these transactions and movements are assessed in different ways for tax purposes, so using a single exchange’s data isn’t enough for accurate cost basis to be included on Form 1099-B. Crypto taxation experts have known this for sometime and have been calling for clearer guidance from the IRS on how it will treat cryptocurrencies for this exact reason. Recent developments in the legislative environment and most recently with the government of the United Kingdom providing clear guidance on the trading of cryptocurrencies, will hopefully move the agency to act accordingly.
In the meantime, ensure you are keeping accurate records and working with tax professionals to ensure you calculate and pay the proper amount of taxes due on those exchanges.
This article was a collaboration between Sean Ryan of NODE40 and Mike Atwood of Sovos
Originally published in coincodex.