Cryptocurrency Exchanges Information Reporting
The Inspector General recently issued its Treasury audit report as to virtual currency transactions. The report found that there is currently a large “tax gap” when it comes to US taxpayers reporting and paying taxes on virtual currency. The Inspector General recommended that the best way to close this tax gap is to issue clarifying information reporting guidance to virtual currency brokers, explicitly requiring Form 1099-B to be filed. The IRS agreed with the Inspector General’s recommendation and stated that it is currently working with the Treasury Department to develop guidance on third-party information reporting under Internal Revenue Code Section 6045, which focuses on Form 1099-B.
Based on the report, the number of Forms 1099-K issued has been decreasing since 2017 as more exchanges continue to move to Form 1099-B. Notably, the report acknowledges that Form 1099-K should only be issued when “the central organization [exchange] settles transactions for goods or services.” This misunderstanding has led to much heartache for exchanges’ users and tens of thousands of unnecessary IRS audits. In order to remedy this problem and provide users with tax reports that actually reflect the economic substance of their virtual currency use, the report acknowledges that Form 1099-B is the solution, and as one United States District Court noted, very well may already be required under existing guidance today.
The Office of the Inspector General is responsible for the identifying, auditing, and preventing mismanagement within executive departments. The Inspector General initiated a Treasury audit that focused on the IRS’ performance and efforts to enforce virtual currency tax compliance. The Inspector General initiated this audit due to the increase in popularity of virtual currency use - virtual currency is not going away, only continuing to grow. During the audit, the Inspector General noticed that there is currently a large tax gap when it comes to US taxpayers reporting and paying taxes on virtual currency. The report focuses on exchanges’ role in this problem, as “[exchanges] play an important role in the transferability and stability of virtual currency by facilitating the buying and selling of virtual currencies for customers.”
The Inspector General found that in reviewing the 1099 practices of cryptocurrency exchanges, many are taking inconsistent positions from each other on information reporting requirements. IRS officials commented that in many cases it is unclear under the current rules whether cryptocurrency is actually being exchanged for goods or services.
Upon finding that in the vast majority of cases exchanges are not settling virtual currency transactions in exchange for goods or services, the Inspector General noted that virtual currency trading activity should be reported under I.R.C. 6045, which focuses on Form 1099-B reporting. The report notes that “brokers who sell commodities are included in the requirement to issue Forms 1099-B to customers.” Federal courts have held that virtual currencies are commodities for the purpose of being subject to Commodity Futures Trading Commission regulations, meaning that exchanges should already be filing Form 1099-B.
(i) Clarifying Guidance
Upon reviewing the Inspector General’s recommendation that Form 1099-B is the appropriate form virtual currency brokers to issue, the IRS responded as follows:
The IRS acknowledges that it is already working on clarifying guidance that makes clear that exchanges are to comply with 1099-B reporting requirements. Although the exact timing of the guidance release is not public knowledge, it is anticipated to come soon.
(ii) Penalties, Back-filing and Back-up Withholding
It is currently unclear whether the IRS will require back filings and/or impose penalties for failure to issue proper 1099 forms for historical years. Many argue that exchanges should have begun complying with I.R.C. 6045 regulations when the IRS declared cryptocurrency property in 2014, or at least should have transitioned upon notice that courts were classifying cryptocurrency as a commodity. One thing is clear however, Form 1099-K was not ever intended to report virtual currency trading activities.
The IRS has not officially stated whether it will require back-filing or back-up withholding for historical transactions brokered by exchanges. The back-up withholding rate for failure to collect proper W-9’s is 24% of gross proceeds. Cryptocurrency exchanges typically collect far less than 24% of gross proceeds in the form of transaction fees, and therefore failure to implement W-9 collection practices can potentially create a massive liability. It is important that exchanges implement proper W-9 information collection, as the alternative of back-up withholding is not viable for most platforms.
As acknowledged in the Inspector General’s report, the IRS and Treasury are currently working on clarifying information reporting guidance to specify that cryptocurrency exchanges are required to comply with information reporting requirements pursuant to I.R.C. 6045, which is 1099-B reporting. Form 1099-K was never intended to report virtual currency trading activity. Penalties for failure to file a correct information return can exceed $550 per user with no maximum limitation. It is imperative that exchanges collect W-9 information and begin reporting virtual currency trading activity on Form 1099-B.