18 Sep 23

How to Avoid IRS Cryptocurrency Tax Notices, Audits, and Criminal Prosecution

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Last Updated on: 19th September 2023, 12:48 am

How to Avoid IRS Cryptocurrency Tax Notices, Audits, and Criminal Prosecution

The IRS has cryptocurrency traders in its crosshairs. Failing to properly report crypto can lead to scary IRS letters, exhausting audits, or even criminal tax charges. This article covers key strategies to avoid IRS scrutiny of cryptocurrency transactions.

We’ll examine reporting rules, common mistakes, audit red flags, and options if you receive an IRS notice. With smart planning, traders can stay off the IRS radar and sleep better at night.

Overview of Cryptocurrency Tax Rules

First, a quick refresher on the tax rules. The IRS treats cryptocurrency as property, not currency. This means taxable events occur when you:

  • Sell or trade crypto for a gain or loss
  • Use crypto to buy goods or services
  • Receive crypto as income

You must calculate capital gains or losses on each taxable event. These get reported on your tax return. Failing to report can lead to penalties.

Common Reporting Mistakes

Many traders make basic mistakes that increase audit risk:

  • Not reporting crypto income received as payment
  • Forgetting trades across multiple exchanges
  • Using the wrong cost basis for gains/losses
  • Failing to convert crypto costs to USD properly
  • Not keeping detailed records of transactions

Even honest mistakes can look suspicious if the IRS suspects unreported trading. Traders must take reporting seriously to avoid trouble.

Audit Red Flags

Certain factors may increase your odds of a crypto audit. Watch out for:

  • Trading through foreign exchanges
  • Using mixers or tumblers to obscure transactions
  • Not reporting income from crypto mining
  • Claiming the Foreign Earned Income Exclusion
  • Large unexplained bank deposits from crypto exchanges

The IRS looks for major discrepancies suggesting unreported income or impossible losses. Be prepared to explain any red flags.

Options If You Get an IRS Notice

If you receive an IRS notice about cryptocurrency, don’t panic. You have options:

  • Do nothing – If the notice is incorrect, you can simply ignore it.
  • Amend your return – File an amended return to correct small mistakes.
  • Call the IRS – Discuss the issue with the IRS agent who sent the notice.
  • Send a response – Formally respond to the notice in writing.
  • Request an appeal – Appeal the issue to the IRS Office of Appeals.

Weigh the costs and benefits of fighting versus resolving the issue. Seek tax professional help here.

Key Strategies to Avoid IRS Scrutiny

Now let’s review proactive tactics to avoid IRS notices and audits on cryptocurrency:

1. Properly Report All Taxable Transactions

First, accurately report all taxable crypto transactions on your return. This includes:

  • Trades, sales, swaps, and payments made in crypto
  • Mining income and airdrops
  • Gains/losses from trading, spending, or exchanging crypto
  • Income from staking, lending, or yield farming

Report earnings, buy/sell activity, and capital gains/losses from all wallets and exchanges.

2. Maintain Complete Records

Keep detailed records of your crypto activities, including:

  • Dates of transactions
  • Purchase/sale prices
  • Crypto wallet addresses
  • Exchange records
  • Mining activity
  • Fair market values on key dates

The IRS allows traders to use “first-in, first-out” cost accounting to simplify records. But strive for completeness.

3. Disclose All Foreign Accounts

If you have accounts with foreign crypto exchanges, disclose them on FinCEN Form 114 and IRS Form 8938. Otherwise, you face huge penalties.

4. Explain Large Deposits

If you deposit large amounts of cash from crypto trading, be ready to show basis and explain the source to the IRS.

5. Hire a Tax Pro

Consider hiring a crypto-savvy CPA to prepare your tax return. A tax pro can review your records, handle reporting properly, and help defend your return if audited.

Other Measures to Consider

Here are some other proactive steps traders can take:

  • Trade through U.S. exchanges when possible
  • Avoid “mixing” services intended to obscure transactions
  • Steer clear of tax fraud promoters
  • Notify the IRS of reportable transactions done incorrectly
  • Ask the IRS for binding guidance on unclear issues

With the right compliance approach, traders can stay off the IRS radar. But if notices do arrive, don’t go it alone. Get experienced legal and tax help right away.

The Bottom Line

Cryptocurrency tax reporting is complex but critical. By understanding the rules, keeping careful records, filing accurately, and promptly addressing any IRS notices.