With the increasing popularity of cryptocurrencies and digital assets, it’s evident that the Inland Revenue Service (IRS) has shifted its focus, actively scrutinizing transactions and focusing on taxpayers who neglect to accurately report their gains and losses. Looking at it from the point of view of a crypto CPA, much of the IRS scrutiny directed at investors often stems from avoidable mistakes rather than intentional wrongdoing. As such, the team at Onchain Accounting will shed some light on the most common red flags in crypto accounting that can trigger IRS scrutiny and the best ways to remedy them.
What are the red flags that can trigger IRS scrutiny?
Failing to answer the virtual currency question
Since 2019, the front page of IRS Form 1040 has come with a question about virtual currency where you have to answer “yes” or “no.” The question reads as follows:
“At any time during (this tax year), did you (a) receive (as a reward, award, or payment for property or services) or (b) sell, exchange, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”
You must always answer this question truthfully because it is very easy for the IRS to figure out if you are trying to deceive them. This is because they will receive 1099 forms from major crypto exchanges, which they can use to cross-reference your transactions. Providing false information in this regard is akin to perjury and can invite greater scrutiny into your dealings.
Massive discrepancies between your returns and crypto exchange 1099 forms
The IRS will regularly receive Forms 1099-B, 1099-MISC, and 1099-K from crypto exchanges, and they will use this information to compare the tax return you’ve filed. If the income you’ve reported does not match the information in these forms, the IRS system will flag the mismatch. The disparity between records is quite common with traders who have not maintained their records and cannot properly identify their cost basis.
Use of crypto mixers and privacy coins
While crypto mixers and privacy coins are used by many for legitimate privacy purposes, the IRS will view them suspiciously since the obscuring of funds is often associated with illicit activities such as money laundering and tax evasion. When the IRS uncovers a mixer, you can expect them to conduct a deeper investigation.
Repeated amendments to records
While there will come a time when you or your crypto accountant needs to amend your crypto records. However, frequent amendments to your return can signal greater accounting issues or even something nefarious to outside observers.
What can you do to prevent IRS scrutiny?
If you never want to find yourself receiving a “love letter” from the IRS, maintaining good accounting practices is a must. To that end, here’s what you need to do to minimize your risk of IRS scrutiny:
- Report all crypto activity—Disclose to the IRS all your crypto transactions. With the IRS reach expanding every day, it’s better for you to be transparent about your dealings from the very beginning.
- Keep proper records of every transaction—document all your transactions with the help of a crypto accountant or the use of reputable crypto accounting software.
- Maintain accurate cost basis records—By accurately tracking your cost basis, you can make sure that all your gains and losses are properly calculated and defensible when questioned.
Conclusion
Investors do not attract IRS scrutiny for simply dealing with crypto—what does attract their attention is when your crypto accounting doesn’t add up. As crypto evolves day-by-day, it’s only going to get easier for the IRS to spot discrepancies. The good news? Most of these errors can be fixed and outright avoided with accurate recordkeeping. If you’re looking for a crypto accounting firm that helps you keep your accounts in order, then Onchain Accounting is the firm for you. We’ve been helping thousands of clients with their crypto accounting needs for over 8 years, and we are ready and willing to help you do the same.