Crypto tax reporting rule may flip unwitting buyers into felons

The meltdown in cryptocurrency markets couldn’t seem worse for clients invested in digital assets. But for some, it is.

A lesser-noticed provision in a $1 trillion law passed last November requires certain taxpayers who receive more than $10,000 in digital assets a year to tell the Internal Revenue Service who sent them.

Starting in 2024, recipients must report the sender’s name, address and Social Security number within 15 days. Civil penalties for those who accidentally overlook the requirement can hit $3 million. Those who intentionally disregard the requirement can be charged with a felony and face up to five years in prison and higher civil penalties. Corporate violators face fines of up to $100,000 per transaction. 

Not just wealth advisors appear unaware of the requirement and its potential impact on clients. Neither do many entrepreneurs who own small businesses that take payment in bitcoin, ethereum or other digital currencies, or who trade crypto assets frequently.

Ric Edelman, the founder of the Digital Assets Council of Financial Professionals, an educational and advocacy group, said the new law created concern for “anyone involved with the transfer of digital assets.” One problem, he added: The law doesn’t clearly define what it means to “receive” digital assets.

Bitcoin has lost roughly two-thirds of its value since a record high of nearly $69,000 last November, its worst time since 2011. Two stable coins pegged to the U.S. dollar, TerraUSD and luna, collapsed in May. Last month, a hedge fund invested in cryptocurrencies, Three Arrow Capital, bellied up. Some exchanges have halted trading and withdrawals.

Digital frost aside, some investors have made fortunes. But winners or losers, they now have to tell the IRS.

Why advisors should care
The new reporting requirement comes as bitcoin and other digital currencies appear to gain more usage. One in five Americans has invested in, traded or used cryptocurrency as a form of payment, according to a May 2022 poll by NBC News. One in five small businesses surveyed by Visa expect to offer digital payments options this year. While just 20% of financial advisors currently advise their clients on crypto, one-third expect to do so by the end of this year, according to an Arizent survey.

The IRS is worried that cryptocurrencies can be used for tax fraud and other criminal activities like money laundering, drug trafficking and ransomware. Federal coffers are  losing more than $50 billion a year from crypto traders not paying taxes on gains, according to a Barclays estimate in May. The nation’s tax collector seized $3.5 billion of digital currencies during its most recent fiscal year, which ended last September, a figure accounting for 93% of all moneys seized for 2021. 

The reporting requirement covers people who receive crypto through a trade or business, a concept the Internal Revenue Code refers to frequently but doesn’t define.

While its explication includes many day traders and business owners who accept crypto as payments for goods or service, it excludes ordinary investors. Still, the requirement may sweep in a much broader swathe of people. 

“Simply using digital assets can meet the ‘trade or business’ requirement,’” wrote Abraham Sutherland, a lecturer at the University of Virginia School of Law and an advisor at Coin Center, a nonprofit research and advocacy group, in a paper last year. 

The disclosure obligation is in addition to another requirement in the new law, a package of outlays for bridges, roads and power lines known as the Infrastructure Investment and Jobs Act. The 1,039-page law treats brokerages like Fidelity Investments, Vanguard and Robinhood as “brokers” that transfer digital assets to investors. Starting in 2023, it requires them to send to customers and the IRS an annual form detailing a client’s digital transactions for federal tax returns that will be filed in 2024. 

That rule has prompted criticism that many investors will receive inaccurate forms  because crypto exchanges don’t typically track the original price at which a customer buys a digital asset. Bloomberg reported on June 29 that Treasury officials may delay its start date.

The other requirement governing recipients, not senders, expands a long-standing rule on the disclosure of cash transactions. The new requirement for digital assets, including non-fungible tokens, effectively treats cryptocurrencies like cash — even though the IRS considers crypto to be taxable property like a stock or bond.

The rule covers people who are “engaged in a trade or business.” The IRS is fuzzy on that concept, which it defines as “an activity carried on for a livelihood or in good faith to make a profit.” The concept is meant to help the nation’s tax collector crack down on people who improperly claim business deductions from their part-time hobbies — horse breeding or photography, for example. Under tax law, hobby expenses can be deducted only up to the amount of a taxpayer’s hobby income. In contrast, business expenses can be deducted from a taxpayer’s total income.  

Sutherland wrote that the new reporting requirement “demands the impossible” of taxpayers. “Digital assets might not be ‘received’ from a person whose personally identifiable information can be verified and reported.”