June 05, 2020

Are You Confused by Form 1099-K? Don't Worry, You Should Be

Justin Woodward, Tax Attorney

Justin Woodward
Crypto Tax Attorney

This past year saw tens of thousands of IRS audits into taxpayers’ cryptocurrency activity. Most of these IRS investigations came about due to the IRS receiving information reporting from various cryptocurrency exchanges using Form 1099-K. Form 1099-K reports a user’s total aggregate volume of payment transactions. It is important to note that Form 1099-K does not take into account cost basis, and as such does not represent what a cryptocurrency investor actually owes in taxes. Form 1099-K was not intended for digital asset transactions.

If you received Form 1099-K from a cryptocurrency exchange, we feel your pain. This article will explain: 1) the intended purpose of Form 1099-K; 2) the problems with cryptocurrency exchanges issuing Form 1099-K; and 3) what you need to do to avoid being liable for the inflated amount of income reported.

  1. The Intended Purpose of Form 1099-K

Third party settlement organizations (TPSO’s) are required to issue Form 1099-K to sellers of goods and services on their platform. A TPSO is the central organization that has a contractual obligation to make payments to participating businesses. Generally, a TPSO serves as an intermediary by settling payments between businesses and purchasers. TPSO’s are required to issue 1099-K’s at year end summing the total monetary value their users received so that sellers of goods and services can report the stated amount as income on their tax return.

In defining a TPSO, the IRS lists an auction house as an example. An auction house connects buyers and sellers of services and in return takes a small fee. If an auction house processes more than $20,000 and more than 200 transactions for the same seller of goods or services then it must issue the seller a 1099-K listing the seller’s gross income from the sales. This ensures that the seller reports their income payments from selling goods or services on their tax return.

A modern-day example of a company that is classified as a TPSO is Etsy. Businesses who sell on Etsy who meet the threshold will be sent a 1099-K so that they can report their receiptsprofits as income on their tax return. This ensures that sellers include their income from Etsy when they file taxes. A seller on Etsy may be able to lessen their tax liability by subtracting expenses such as fees, refunds, shipping costs, and sales tax. However, it is not appropriate to lessen your income on the 1099-K by subtracting your cost basis. This is because 1099-K’s focus on income received, while 1099-B’s focus on capital gains/losses from the sale of capital assets. The income reported on the 1099-K gets added to the taxpayer’s ordinary income after deducting expenses. 1099-B’s on the other hand are designed to be transposed onto an IRS 8949 and gains are taxed pursuant to capital gains rates instead of ordinary income rates.

  1. The Problem with Cryptocurrency Exchanges Issuing Form 1099-K

The IRS treats the value reported on Form 1099-K as ordinary income. Trading cryptocurrency leads to capital gains and losses, not ordinary income. There within lies the problem. Because Form 1099-K fails to take into account cost basis, the IRS is led to believe that a taxpayer received monetary payments in return for providing goods or services. In reality, a taxpayer gave up monetary value to acquire cryptocurrency and is only profiting in the event that the cryptocurrency appreciates in value above that which they paid. As a result of this confusion, the IRS has been led to believe that many taxpayers failed to report income on their tax return, and as a result tens of thousands of cryptocurrency users have been and continue to be audited.

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Making matters worse, TaxBit has seen circumstances where taxpayers actually have net capital losses for the applicable year, but the exchange reported hundreds of thousands of dollars in income to the IRS. TaxBit has been able to help resolve many of these through response letters to the IRS, however, some cases have escalated to deficiency notices that can only be challenged in tax court. Filing a petition in tax court can be very costly to the taxpayer and oftentimes pits the taxpayer against the exchange who issued the tax form. As a result, many cryptocurrency exchanges are moving quickly to remedy this matter by adopting proper 1099-B tax reporting.

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  1. What you Need to do to Avoid Liability For the Amount Reported on Form 1099-K

If you received or receive Form 1099-K in the future, we feel your pain. Don’t panic, here is what you need to do. First, know that you will most likely receive an IRS audit notice two years from the time you received Form 1099-K. The IRS typically audits a couple years behind, meaning the IRS is currently auditing the 2017 tax year, which is the year that most cryptocurrency users began receiving Form 1099-K. In order to prepare for this audit, make sure that you report your capital gains and losses from your cryptocurrency activity on IRS Form 8949. At the time you are audited, the trick then becomes working with the IRS to explain to them that Form 8949 that you filed represents your taxable cryptocurrency activity, not Form 1099-K. This can be a delicate and complicated process. In addition to aggregating your cryptocurrency trading activity and properly preparing your Form 8949, select TaxBit plans also include IRS audit assistance. Please know that our CPAs and tax attorneys are experienced with helping in this regard.

It is important to note that many cryptocurrency exchanges are now moving away from Form 1099-K. Cryptocurrency exchanges are beginning to remedy the problem that Form 1099-K created by filing Form 1099-B, which is the tax form intended for capital asset transactions such as cryptocurrency and other commodities. Form 1099-B provides a taxpayer and the IRS with cost basis and capital gain and loss information that accurately reflects the economics of cryptocurrency trading. It may be wise for you as a cryptocurrency user to research and choose an exchange that issues your Form 1099-B, not Form 1099-K. This will save you going through the pain of an IRS audit - nobody wants that!

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