Cryptocurrency Tax Evasion.

When Does Unreported Cryptocurrency Activity Become “Willful” Tax Evasion?

1. 26 U.S.C. Section 7201 (Criminal Tax Evasion)

26 U.S.C. Section 7201 is the statute that creates the offense of criminal tax evasion, and it applies to:

“Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof...”

Failure to report cryptocurrency activity, standing alone, does not constitute the affirmative act required for criminal tax evasion under Section 7201, although other conduct may do so.

2. Willfulness as a Requirement for Criminal Tax Prosecution

Generally, a criminal tax conviction requires the government to prove “willfulness” beyond a reasonable doubt. This is a demanding standard of proof, and if the government cannot meet it, then a taxpayer cannot be found guilty of tax evasion. A taxpayer who simply fails to report his or her cryptocurrency transactions is not necessarily deemed to have acted willfully, and if he or she did not act willfully, criminal charges are not appropriate.

3. IRS Notices Do Not Automatically Establish Criminal Liability

Receiving an IRS notice regarding failure to report cryptocurrency transactions is not a clear-cut indicator of criminal liability. An IRS notice does not, by itself, establish that a taxpayer has violated Section 7201 (or any other federal statute), and a taxpayer subject to an IRS audit will not necessarily face civil tax enforcement action, let alone criminal prosecution.

4. Negligent Reporting Errors vs. Criminal Tax Evasion

Ultimately, cryptocurrency reporting errors resulting from negligence may invite civil enforcement action, including fines, penalties, and increased IRS scrutiny, but they do not necessarily invite criminal prosecution. However, if the government can establish that a taxpayer’s reporting violations are the result of willfulness, criminal prosecution may be warranted.

Which Cryptocurrency Activities Create Taxable Income or Gains, and How Is the Amount Calculated?

1. IRS Classification of Cryptocurrency as “Property”

The IRS explicitly classifies virtual currencies as “property” for federal tax purposes. Specifically, virtual currency is neither a “currency” in the traditional sense nor a form of “money” as far as federal tax law is concerned. As property, cryptocurrency (including non-fungible tokens (NFTs)) is subject to the same rules and regulations as other property transactions, which is why the IRS has consistently argued that cryptocurrency transactions generate taxable income and taxable dispositions in many cases.

2. Selling Cryptocurrency

If you use your cryptocurrency to buy something, or if you sell it for cash, this event can create a reportable capital gain or loss. The rules that apply to selling cryptocurrency are largely the same as those that apply to selling stocks or real estate. Whether you sell your cryptocurrency for U.S. dollars, gold, or another form of cryptocurrency, the result of the transaction must be recorded and reported in your federal tax filings.

3. Payments Received for Goods and Services

If you accept cryptocurrency as payment for goods or services, the receipt of the cryptocurrency generally constitutes taxable ordinary income. You will need to calculate the value of the cryptocurrency in U.S. dollars as of the date you received the payment, and then include that amount in your federal tax return.

4. Mining Rewards

Cryptocurrency mining rewards (including tokens from hard forks) can also create taxable ordinary income for the recipient. The amount of income generated by mining is typically equal to the cryptocurrency’s fair market value (in U.S. dollars) at the time it is received.

5. Staking Rewards

Similar to mining, staking rewards received in the form of tokens can also create taxable ordinary income. For a cash-method taxpayer, staking rewards generally are included in gross income at fair market value when the taxpayer gains dominion and control over them.

6. Token Swaps

Under the IRS’s property treatment of cryptocurrency, token swaps, or exchanging one form of cryptocurrency for another, can also result in a taxable disposition. When a taxpayer swaps one cryptocurrency token for another, the IRS considers this to be the sale of one token in order to buy another. While cryptocurrency tax laws are continuing to evolve, cryptocurrency taxation is not new, and the IRS has a clear understanding of the tax implications of selling, staking, mining, and accepting payments.

Todd Spodek is the managing partner of Spodek Law Group, a second generation criminal defense firm that has been practicing since 1976.

How Do Holding Periods, Losses, and Lost or Stolen Cryptocurrency Affect the Tax Picture?

1. Form 8949, Schedule D, and the Cryptocurrency Reporting Process

Taxpayers use Form 8949 to report the vast majority of cryptocurrency transactions in order to calculate capital gains and losses for the taxable year. As a general rule, the figures that are reported on Form 8949 will flow into Schedule D for reporting purposes. From there, cryptocurrency transactions are netted against other capital transactions, and the taxpayer’s net gain or loss for the taxable year will be calculated for purposes of determining income tax liability.

When calculating net gain or loss from cryptocurrency transactions for federal tax purposes, the taxpayer’s holding period also matters. Under 26 U.S.C. Section 1222, a short-term capital gain or loss results from the sale or exchange of a capital asset held for one year or less, while a long-term capital gain or loss results from the sale or exchange of a capital asset held for more than one year.

Taxpayers’ cryptocurrency losses can reduce their taxable gains, and taxpayers can use reported losses to offset gains from other investments (subject to applicable statutory limitations under 26 U.S.C. Section 1211). Generally, this is a highly beneficial provision under the Internal Revenue Code; and, as a result, taxpayers’ cryptocurrency losses (and the fact that these losses can be used to reduce the taxpayer’s income tax liability) are closely scrutinized during IRS audits.

2. The Implications of Stolen Cryptocurrency, Lost Keys, and “Lost” Private Wallets

Unfortunately, a taxpayer’s loss of access to his or her cryptocurrency portfolio does not necessarily erase his or her tax liability. If a taxpayer sells cryptocurrency and then loses access to his or her wallet before he or she can file a tax return for the year in question, then he or she still owes federal taxes on the sale. Similarly, while the theft of a cryptocurrency wallet may give rise to a deductible loss, it does not otherwise create immunity from federal tax enforcement.

How Can the IRS Prove Willfulness When Blockchain Addresses Do Not Identify Their Owners?

1. Direct and Circumstantial Evidence of Willfulness

If the government is unable to establish the intent required to pursue criminal tax evasion, the government will still be able to pursue civil tax enforcement. However, a finding of willfulness will generally justify criminal charges. The fact that a taxpayer previously adhered to reporting requirements (if his or her transactions did not require reporting), accepted cryptocurrency payment in place of (and then refused to file his or her) personal returns, or has no prior experience with tax preparation may also support an inference of willfulness. In any event, to obtain a conviction, the government must prove the taxpayer’s intent beyond a reasonable doubt.

Crucially, ignorance of cryptocurrency tax rules does not necessarily defeat a government’s prosecution for criminal tax evasion. While taxpayers’ failure to recognize the IRS’s property treatment of virtual currency could defeat the government’s ability to establish the “willfulness” required under Section 7201, taxpayers generally cannot rely on this defense if they fail to file a return despite knowing that they have a legal obligation to do so.

2. Blockchain Ledgers vs. Blockchain Addresses

To establish a taxpayer’s tax liability, the IRS may rely on blockchain ledgers, blockchain addresses, or other digital records. The following, in short, are the fundamental differences between blockchain ledgers and blockchain addresses:

• Blockchain Ledgers: These ledgers reflect the transaction history of the blockchain, and blockchain ledgers are available to the public online.
• Blockchain Addresses: These are numeric codes that users assign to a cryptocurrency account, but they do not inherently identify the account holders who control the cryptocurrency in the wallet.

3. IRS Investigations of Unreported Cryptocurrency Transactions

To establish a taxpayer’s tax liability in the context of virtual currency, the IRS may use a number of methods. In addition to blockchain analysis, federal investigators may subpoena records from cryptocurrency exchanges. The information contained in an exchange’s records (such as, for example, the taxpayer’s exchange account details, login credentials, and transaction history) may help establish a taxpayer’s identity and use for purposes of linking a blockchain address to a specific wallet owner. Additionally, the IRS can seize the taxpayer’s devices. The information contained on the taxpayer’s devices may prove to be more than enough to establish the taxpayer’s tax evasion.

What Penalties and Collateral Charges Can Follow a Federal Cryptocurrency Tax Case?

1. Section 7201 (Criminal Tax Evasion) Penalties

A federal conviction for criminal tax evasion under Section 7201 can result in a variety of penalties. Depending on the specific facts and circumstances involved, a taxpayer convicted of criminal tax evasion under Section 7201 can be sentenced to imprisonment, fined, and remain liable for unpaid taxes and, in some cases, interest and penalties.

2. Section 7206(1) (Fraud and False Statements) Penalties

IRS investigations can also lead to criminal charges for criminal tax fraud (or, “Willfully makes and subscribes any return, statement, or other document, which contains or is verified by a written declaration that it is made under the penalties of perjury, and which he does not believe to be true and correct as to every material matter;”). Under Section 7206(1), a conviction for fraud or false statements can result in up to three years of imprisonment. Individuals convicted of filing a false tax return under Section 7206(1) may also be fined up to $100,000, and corporations convicted of filing a false tax return under Section 7206(1) may be fined up to $500,000. Criminal charges under Section 7206(1) are by far the most common charges in cryptocurrency-related tax cases, and taxpayers who have been charged under Section 7206(1) may be at risk of criminal prosecution under Section 7201 as well.

3. Collateral Charges

Finally, IRS investigations can often lead to a variety of other federal charges. In order to prove allegations of criminal tax evasion and criminal tax fraud, federal prosecutors can present evidence of a variety of other criminal acts as well. While federal investigators may pursue a case for criminal tax evasion, criminal tax fraud, or a fraudulent loan application, they can also pursue a case for wire fraud, money laundering, structuring (under 31 U.S.C. Section 5324), or even computer crimes. In many cases, cryptocurrency-related tax allegations will accompany allegations of this nature.

Talk to Spodek Law Group

Every case turns on its own facts, and general information is no substitute for advice about yours. Todd Spodek, managing partner of Spodek Law Group, and the firm's attorneys defend federal criminal and white collar matters nationwide. Reach the firm at 888 348 8028.