How to Handle an IRS Audit with Unreported Cryptocurrency Gains or Income

How to Handle an IRS Audit with Unreported Cryptocurrency Gains or Income

Dealing with an IRS audit can be stressful, especially if you have unreported cryptocurrency gains or income. With the rise in popularity of cryptocurrencies like Bitcoin and Ethereum, more people are investing and trading, sometimes without properly reporting gains and income on their taxes. If the IRS flags your return for an audit, don’t panic. Here’s what you need to know to handle an IRS audit smoothly when you have unreported crypto.

Why You Might Get Audited for Crypto

In recent years, the IRS has been ramping up enforcement and audits related to cryptocurrency reporting. There are a few reasons you might get flagged for an audit:

• Not reporting crypto gains or income at all
• Underreporting the amount of crypto gains or income
• Reporting gains or income inaccurately
• Trading on exchanges that don’t provide tax forms like Coinbase or Binance.us

The IRS is getting better at matching data from crypto exchanges with individual tax returns. So if you don’t report or underreport, they will likely catch it. An audit notice can come in the mail or as a phone call from an IRS agent.

Gather Your Crypto Tax Records

If you get an audit notice related to crypto, the first thing to do is gather all your records. This includes:

• Transaction histories from all exchanges and wallets
• Records of crypto you received from mining, staking, airdrops, gifts, etc
• Trading logs, account statements, and other records
• Documentation showing your cost basis for each crypto (like purchase receipts)

You’ll need to provide records for at least the tax years being audited, but having additional years handy can also help. The IRS may ask detailed questions about your specific transactions, so comprehensive records are key.

Use Crypto Tax Software

Analyzing crypto transactions across exchanges, DeFi protocols, and wallets can get extremely complex. The best way to prepare is to run everything through cryptocurrency tax software like CoinTracker or ZenLedger. These platforms can:

• Import all your transaction histories
• Match transfers between wallets and exchanges
• Generate audit reports showing your gains, income, losses, and more

This gives you an authoritative report of your crypto taxes, with all calculations done for you. You can show the IRS exactly how your taxable income was determined and demonstrate good faith compliance.

Amend Your Original Tax Return

Once you have your complete crypto tax history from the software, if you determine you underreported or failed to report crypto activity, you should amend your original tax return. Use IRS Form 1040X to file an amended return and pay any additional tax owed as soon as possible.

This shows the IRS that you’re voluntarily coming into compliance. It can help avoid penalties and reduce interest due. Be sure to file 1040X even if you can’t pay the full tax bill right now. You can work out payment arrangements later.

Respond to Audit Requests

During the audit, the IRS may send one or more requests for information (RFIs). These will detail what records, forms, explanations, and other documentation they need from you. Respond to each request in a timely, thorough manner. Include:

• Completed tax forms like 8949 for capital gains
• Full transaction histories from your exchanges and wallets
• Audit reports from your crypto tax software
• Documentation of your cost basis for each crypto
• Explanations of how you calculated taxable income

Work with your tax professional to ensure you provide everything the IRS asks for, even if some records have gaps. It’s better to be over-complete than leave anything out.

Request a Postponement If Needed

If you need more time to prepare your responses, you can request an extension by filing Form 872. This gives you up to 60 extra days. But don’t delay too long, as the IRS may see it as non-cooperation.

Consider Using a Lawyer or Tax Pro

You have the right to legal counsel during an IRS audit. Consider having a tax attorney or CPA represent you and handle communication with the IRS. They can review your documents, ensure responses are complete, and negotiate on your behalf. This provides a buffer and may help resolve the audit faster.

Negotiate Penalties and Interest

If the audit concludes you owe additional tax, the IRS will charge interest on the unpaid amount. They may also assess civil penalties like:

• Failure to file penalty
• Failure to pay penalty
• Accuracy penalties for underpayment

Your representative can negotiate these penalties and interest down, especially if you show good faith attempts to comply. Reasonable cause arguments can also sometimes get penalties waived.

Set Up a Payment Plan

If you end up owing significant tax, penalties, and interest, the IRS will work with you on a payment plan you can afford. Options include:

• Short-term payment plan – Pay owed amount within 120 days
• Installment agreement – Pay over 6 years
• Offer in compromise – Settle for less than the full amount

As long as you stay compliant with the agreed payment schedule, the IRS will not pursue further collection actions. This prevents wage garnishments or property liens down the road.

Learn for the Future

Going through a crypto tax audit is stressful, but take it as a learning experience. For future tax compliance:

• Carefully record all crypto transactions in real-time
• Run tax calculations early in the year
• Report all gains, losses, and income accurately
• Keep detailed records organized for easy access
• Consider using a crypto tax professional to review your return

Staying on top of crypto tax reporting requirements will help avoid issues and give you peace of mind.