The Senate released 2,702 pages of the latest version of the bi-partisan infrastructure bill early Sunday evening. Notably absent is funding for increased IRS enforcement, but notably included is increased information reporting for cryptocurrency exchanges, or “brokers” of cryptocurrency transactions. Increased information reporting necessarily includes increased information reporting penalties. And these particular information reporting penalties are incredibly stiff.
New Reporting Requirements
The pending bill does not create new reporting requirements for individuals, create new penalties for individuals, or impose any new obligations on individual cryptocurrency holders at all. Instead, if passed, the proposed law would require cryptocurrency exchanges – defined as “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person” to file an information return reporting the transaction. While the form has not yet been created – indeed, the law requiring it to be filed has not yet been passed – the form would likely be created in short order. The proposed legislation would be effective 2023, giving exchanges a year and a half to get ready to meet the requirements.
While the words “cryptocurrency,” “virtual currency,” “bitcoin” or the like never appear in the almost 3,000 pages of the proposed legislation, a digital asset is defined as “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.” The definition is designed to include cryptocurrency and any other representation of value that may evolve in the future.
What is Information Reporting?
Information reporting is not the same as a tax return. Tax returns are reports of how much income is earned, how much tax is due, and how much tax has been paid. All U.S. Persons who earn income over a certain amount* must file tax returns. If a tax return is a cake, then information reporting makes up the ingredients in that cake. Employers have information reporting requirements, such as the requirement to file forms W-2 that report their employees’ wages and taxes withheld. Banks have information reporting requirements and must report how much interest is earned and paid over to account holders. If the proposed legislation in the latest version of the Senate Infrastructure Bill is enacted, then crypto exchanges will have increased information reporting requirements.
How is Information Reporting Used?
The IRS “matches” information reporting to taxpayer’s tax returns. For every W-2, 1099, and 1098-T that you receive, the IRS also receives a copy. When the IRS receives a tax return, a computer checks to make sure that every W-2, 1099, and 1098-T that the IRS has received is “matched” on the taxpayer’s tax return, for the same taxpayer identification number and in the same amount. Failures in matching typically lead to “matching error” IRS audits.
When it comes to items like stocks, which are only taxable on a gain, information reporting mismatches can create real problems. I’ve written previously about how when a taxpayer doesn’t file a tax return, the IRS will prepare a Substitute For Return, or SFR. Imagine you bought 10 shares of Amazon stock for $3,000 a share and you sold for $3,327 a share. Your gain is $3,270 (327 * 10) and your tax is calculated based on that gain, not the total sale of 10 shares for $33,327. The purchase price of the shares is your basis. But for taxpayers who never file a tax return, the IRS has no information about the purchase price of the shares, or the taxpayers’ basis. If no tax return is filed, the IRS will calculate the gain on the sale to be the total sale price, or $33,327, because information reporting is required when assets are sold, but not acquired.
Does this Proposed Rule Impact Crypto Investors or Just Exchanges?
The proposed legislation, if passed, would have a significant impact on both investors and exchanges. Exchanges will need to undertake significant efforts to comply with the reporting regime. Investors, on the other hand, won’t have to “do” anything. But under the new law, all of the information that the IRS would normally receive when an investor sells a share of Amazon stock will now be sent to the IRS when an investor sells one Bitcoin, one Ethereum, or the like. There’s a lot to be sorted out: what will happen with crypto stored in cold storage, wallets not on exchanges, so-called “self custody.” The proposed legislation does not address this “self-custody” cryptocurrency, because it is analogous to cash under a mattress. It is difficult to trace and even more difficult to devise an information reporting scheme that would encompass such an asset. Individual cryptocurrency owners and investors must still pay attention, however, because it is even more likely that the IRS will be made aware of their transactions and expect them to be reported on a tax return.
What are the potential penalties?
Information reporting penalties are the most onerous and costly in the Internal Revenue Code. As a tax litigator, I can say this unequivocally, without any hesitation. They are costly both in terms of the penalty assessed and the extraordinarily difficult path to contesting them in court. The proposed legislation does not expressly say anything about penalties, other than to state that section 6724 of the Internal Revenue Code is amended to include digital assets in the definition of what is included in an information return subject to penalty.
The failure to file a required information return is subject to a multi-part penalty. Under section 6721, the IRS may assess a penalty for the failure to file an information return required with the IRS. Under section 6722, the IRS may assess a penalty for the failure to furnish a payee with a proper information statement. The penalty is $250 for each return “for which a failure occurs,” not to exceed $3,000,000 in one year.
Think back to the example of a W-2. An employer who is supposed to file a W-2 will be assessed a penalty under both section 6721 for the failure to file that W-2 with the IRS, and under section 6722 for the failure to provide the W-2 to the employee. In my experience, the IRS always proposes assessing both penalties, never one or the other. To put it in perspective, Coinbase, the first major cryptocurrency exchange to go public, has over 56 million customers. That’s $250 for each customer who would be required to receive the form, but did not.
Even worse, these penalties are dramatically increased if the IRS determines that a required reporter engaged in “intentional disregard.” Penalties assessed under the general rule are capped at $3,000,000 per reporter per tax year (for a combined $6,000,000 per year cap under 6721 and 6722) but the penalty is not capped if the IRS determines the rules were not followed as a result of intentional disregard. And in my experience defending these information reporting penalty cases, the IRS almost always initially asserts intentional disregard was present, even in cases where taxpayers hired professionals to help them determine and meet their information reporting requirements.
Putting it all together
If the proposed legislation is enacted as currently written, cryptocurrency exchanges will need to work hard to ensure they are meeting the rigorous information reporting requirements to avoid information reporting penalties. And cryptocurrency holders will need to be even more vigilant in ensuring their cryptocurrency transactions are correctly reported.
**For those readers looking to go deeper into the technical requirements, last year I wrote a more detailed and technical article on information reporting requirements and penalties here.
*** I recently announced a “Top 10 Crypto Tax Mistakes to Avoid series and was not able to immediately publish the series. It is forthcoming.