The IRS is sending out CP2000 tax letters to certain crypto users who received a Form 1099-K from crypto exchanges. These letters typically show a large proposed tax amount and terrifies the recipient at the first glance. This post describes how these letters are generated and steps you can take to not pay the proposed taxes by the IRS.
What Are CP2000 Letters?
CP2000 letters are automatically generated by the IRS system when it detects a discrepancy between the crypto income you reported on your Form 1040 and the amounts reported to the IRS by crypto exchanges.
Receiving a CP2000 letter doesn’t mean you are under an audit or you are liable for the large tax amount printed on the front page. The amount shown is merely a proposed amount. It is not the final tax obligation (if any). You can successfully avoid paying the proposed amount by properly responding to the letter.
How To Respond To a CP2000 Letter?
Before responding to the letter, first, make sure the letter is legitimate and not a scam. Check if there are any spelling errors. Make sure your personal identification information is accurate. Use this sample CP2000 letter as a reference.
Next, pay attention to the tax year printed on the top right corner. This is the year where you need to reconcile the differences with the IRS. CP2000 letters give you 30 days to respond. Make sure you respond within this timeline to avoid getting a Notice of Deficiency letter which is a much more serious letter than the CP2000.
As you go further down the letter, “Explanation of changes to you 20XX Form 1040” section shows the differences between the amounts you reported on your tax return and what the IRS believes to be correct based on information transmitted to the IRS by the crypto exchange. This section will also show you the exact cryptocurrency exchange in question.
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Under “Changes to your 20XX tax return” section, you will most likely see an inflated income amount related to your crypto activity. This is because the IRS system directly takes information from the Form 1099-K which only reports your gross proceeds from crypto trading. Since this form doesn’t report your cost basis, your crypto income is overstates. This is the culprit behind the large proposed tax amount shown on page 1.
Now you know why these letters are generated by the IRS system, successfully defending yourself is just a matter of showing the IRS your cost basis calculations and checking “I don’t agree with some or all of the changes” on the “Response form”. You can then fax this form with supporting documentation – cryptocurrency gains and loss report with correct cost basis information and a cover letter – to the IRS. In order to calculate your cost basis information, you can rely on a crypto tax software of your choice or an excel spreadsheet. Do not reach out to the exchange in question because it will not have your cost basis information.
The good news is that the majority of cryptocurrency related CP2000 notices are resolved in favor of the taxpayer after sharing the correct cost basis information with the IRS. Going forward, these letters will not cause any problems to crypto taxpayers because exchanges like Coinbase are abandoning Form 1099-K reporting effective 2020 tax year.
Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional