Preparing for IRS exam

The lay of the land

IRS interest in crypto transactions
On September 8, 2023, the IRS announced that it would devote substantial additional attention to digital asset transactions. The reason? A 75% non-compliance rate among taxpayers it had identified through records retrieved from digital currency exchanges.¹ Moreover, the IRS expects that, beginning in fiscal year 2024, there will be significantly more digital asset audits and examinations of digital asset holders.

Some two weeks before the IRS announcement, on August 25, 2023, the US Department of the Treasury released proposed regulations regarding the sale and exchange of digital assets by brokers. Their intent? “To crack down on tax cheats while helping law-abiding taxpayers know how much they owe on the sale or exchange of digital assets.”²

According to the Treasury, “[The proposed regulations are] part of a broader effort at Treasury to close the tax gap, address the tax evasion risks posed by digital assets, and help ensure that everyone plays by the same set of rules.”³

This additional announcement may well seek to prepare the public for a potential wave of IRS activity around digital asset examinations. Nevertheless, these statements also seem to discount the multitude of transactions performednot by tax cheats and criminals, but by regular taxpayers operating with less than complete guidance provided by the current regulatory framework.⁴

And that brings us to the core question motivating this brief review of the tax landscape for digital assets: Have you or your company thought about how you’ve been reporting your digital asset holdings and transactions for tax purposes? If you haven’t received a Form 1099, the matter may have escaped your attention. But digital asset holders should be prepared for a potential IRS audit.

For those who transact in digital assets—individuals and corporate entities alike—you may want to consider preparing for an IRS examination. And that may well mean a deep dive into your digital wallets and, consequently, digital asset transactions. By taking a good hard and earnest look at your exposure today, you may save time and expenses in the form of representation fees and potentially stave off accuracy-related penalties.

Proposed regulations
On August 25, 2023, the US Department of the Treasury and the IRS released proposed regulations covering digital asset reporting. The proposed regulations represent a first draft, but the intent seems clear. The IRS and Treasury may well want to see all your on-chain activity and may expect that any facilitator of a digital asset transaction will report such activity. As currently drafted, effective January 1, 2025, the proposed regulations would require a broker to report the proceeds of digital asset transactions. More germane, however, is the proposed reg. § 1.6045–1(d)(2)(i)(B) that would require the broker to report:

• The transaction identification (transaction ID or transaction hash) associated with the digital asset sale, if any.
• The digital asset address (or digital asset addresses if multiple) from which the digital asset was transferred in connection with the sale, if any.

It’s worth underscoring that such information would likely not only provide the IRS not only with information about the specific transaction at issue but enable agents to observe current and past on-chain activity and possibly determine whether there are previously unreported transactions. That kind of visibility might well lead to significant exposure for taxpayers who are less than fully conversant with the complexities of the current and incomplete regulatory landscape.

Statute considerations
Typically, the IRS’s ability to make a tax assessment is limited to three years.⁵ However, in instances where the IRS can prove that the taxpayer failed to report income that constitutes part of the taxpayer’s gross income, the rules change. If the omitted income exceeded 25% of the gross income reported for the tax year, the IRS can then make an assessment for up to six years.⁶ Furthermore, if the IRS can prove the taxpayer engaged in fraud by under-reporting, then there is no time limit to the assessment. While fraudulent intent can be difficult to prove, take a moment to recall how you answered the check box question on your Form 1040 about any digital asset transactions. A simple misstatement could be interpreted as a justification for further investigation and possible assessment on an otherwise time-barred year.

Current state of IRS examinations involving digital assets

The silent investigation
It’s worth remembering that the IRS starts to gather information about your activities well before you receive your first written notification.

Individuals and companies alike are perhaps inadvertently becoming more transparent about their use of digital assets through social media and other channels. Unbeknown to most, however, one of their followers may well be an IRS examining agent.

It is common knowledge that people are sharing more information about themselves with broader audiences. But less frequently discussed is the amount and types of information businesses share. There’s a growing expectation that businesses will continue to share more about their use of customer information, internal operations, proprietary computer codes, and more. In such an environment, yesterday’s discreet press release becomes tomorrow’s widely viewed post or tweet. And the days of closely guarded code with its voluminous documentation to support each intentioned segment has given way to public cloud-based code repositories—such as Gitlab and Github. And these repositories can also provide pertinent commentary from the developers. CodeCommit is a version control service hosted by Amazon Web Services that enables users to privately store and manage assets such as documents, source code, and binary files in the cloud. So, those taxpayers engaged in such communities need to take into account how the IRS could interpret their social media posts, website disclosures, or any commentary about their developer community.

In areas of tax law that deal with your intent or business purpose, or areas that are simply legally ambiguous (as is sometimes the case with crypto), how the IRS interprets the facts is just as important as the facts themselves. It is difficult enough to manage the situation when the only facts on the table are those adduced during the examination itself. However, when you layer on a cornucopia of pithy statements and posts made for public consumption, it becomes all the more difficult to sustain a consistent narrative. That’s why a thoughtful analysis of all publicly available information that you may have generated or released is imperative in anticipation of an opening conference with the IRS. It can also help with an affirmative presentation that can limit the significance of inconsistencies and promote a strong and clear tax narrative.

Scrupulous examinations
Initial Information Document Requests (IDRs) made by the IRS may include questions related to digital asset transactions. The following are the types of information being gathered.

How can a trusted advisor assist you?

There are a number of steps—both preemptive and remedial—with which an adviser, such as Deloitte Tax LLP, can assist you. A brief, albeit incomplete, list could include:

• Compliance engagements. Advisers can help:
  
  • Provide accuracy in reporting in tax returns. Reconcile input and output transactions associated with digital wallets to the books and records that a taxpayer uses to support a tax return.
  • Complete Form 8275 to document to the IRS the reasonable basis for your position, and in a way that reduces the risk for accuracy-related penalties.
• Preparation for your first IDR before receipt of any formal request. Advisers can help:
  • Leverage their knowledge of your business and your online identity to help you assess your exposure to any risk
  • Conduct mock crypto audits by assembling a team of Deloitte professionals that can deliver to you or your company a depth of knowledge in terms of digital asset transactions and the ways in which the IRS might assess an individual’s or entity’s possible overall tax exposure; and furnish pertinent guidance on how to prepare for a potential IRS examination. Mock audit sessions typically include:
    • Examination of public statements on social media including cloud-based repositories activity that may exist in public repositories to determine how your tax narrative might be affected
    • Assistance with maintaining clean books and records as they relate to digital asset transactions with an emphasis on:
      • Basis tracking methodology and application.
      • Character determination of property (i.e., capital vs. ordinary).
    • Where necessary, document justifications for positions taken contemporaneously regarding:
      • Staking.
      • DeFi activity.
      • Token warrants.
      • Market making agreements.
      • Token loans.
• IRS exam/appeals representation is likely to be of value to individual taxpayers and corporations alike given both the complexity and incompleteness of the regulatory framework governing digital assets. Advisers can:
  • Help pull together documentation and supporting evidence for the tax positions that you or your company may have taken on your return.
  • Assist with flagging the facts to consider as you frame your broader tax narrative and address any apparent inconsistencies.
  • Share with IRS agents some of the leading business and operations practices that are currently being implemented in different industries with regard to the use, accounting, tracking, and tax preparation for digital assets.
  • Analyze and work with relevant regulatory interpretations for purposes of a return position that can be articulated clearly to the IRS.
  • Create efficiencies as the result of IRS audits when/if they occur.
  • When appropriate, help to develop remediation road maps for prior years’ filings.

Where are we headed?

It is quite clear that tax authorities—both federal and state—are interested in uncovering any discrepancies or shortcomings between the tax rules to which typical law-abiding citizens adhere and those to which the holders of digital assets (law-abiding or otherwise) are asked to adhere. In that broader context, the new proposed regulations regarding digital assets are only a single point of reference in a broader universe of complexity.

That said, in the last few years, it is clear that the IRS has had unprecedented recourse to the use of the John Doe Summons (i.e., a summons that does not identify the person with respect to whose liability the summons was actually issued).

To support the issuance of this sweeping summons, the government has cited various studies that indicate the potential for abuse in digital asset transactions and related tax matters.

Although the number of taxpayers reporting cryptocurrency transactions has increased in recent years, the crypto tax reporting rates still fall far short of what would be expected given the information about number of users, transactions, and value that the virtual currency exchanges publish on an annual basis.

Anecdotally, too, Deloitte has noted increased IRS interest in digital asset holdings in the course of broader-focused IRS examinations of a host of clients in various industries. And it’s not uncommon for the first set of Information Document Requests to focus on any transactions involving digital assets. To the extent that such transactions took place, the IRS has not hesitated to examine meticulously the tax treatment of those transactions. Those efforts cover a wide range of matters including delving into issues related to basis tracking, the specific identification of the assets being traded, etc.
Despite the noticeably heightened governmental focus on digital assets, there is agreement among many users that the lack of comprehensive guidance on the tax treatment of digital asset transactions is a matter of both concern and confusion.

Where do all these different strands of inquiry and complexity leave us? For those who transact in digital assets—individuals and entities alike—they should be prepared for a potential IRS digital asset audit, one that will likely uncover the full history of their digital asset holdings and transactions. And since the use of digital assets has become more accepted and less of a novelty among traditional businesses, these assets have increasingly come under scrutiny by the IRS. So, if you hold or transact in digital assets of any kind, consider taking the time and making the effort to conduct a thoughtful analysis and to maintain contemporaneous and robust documentation of all holdings and transactions.

About Blockchain & Digital Assets at Deloitte

At Deloitte, our people work globally with clients, regulators, and policymakers to understand how blockchain and digital assets are changing the face of business and government today. New ecosystems are developing blockchain-based infrastructure and solutions to create innovative business models and disrupt traditional ones. This is occurring in virtually every industry and in most jurisdictions globally. Our deep business acumen and global industry-leading Audit & Assurance, Consulting, Tax, and Risk and Financial Advisory services help organizations across industries achieve their various blockchain aspirations. Learn more at Blockchain & Digital Assets

About Deloitte Tax Controversy Services

Deloitte Tax Controversy Services provide assistance spanning the various stages of IRS, state, and local examinations, from dispute avoidance to issue resolution and post-exam improvements. Through decades of working with clients on a broad range of tax issues, we have fine-tuned our technology, analytical procedures, and planning methodologies to offer a broad-based, scalable solution that we can tailor to the specific circumstances of each client and each tax controversy. Learn more at Deloitte Tax Controversy Services.

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