In 2018, Coinbase, a company handling cryptocurrency transactions, released the data of 14,000 of its users to the IRS after the information was subpoenaed, and cryptocurrency traders held their breath as to what was to come next, which turned out to be a wave of correspondence which boded some serious enforcement actions, which are outlined below under the "IRS Compliance Program" subheading.

More recently, the IRS updated the cryptocurrency question on Form 1040 to apply to all taxpayers.

Furthermore, the legal compliance of specific crypto players came into play when accounting firm Mazars dropped all of its cryptocurrency clients, including Binance.

The IRS sent letters to taxpayers about their cryptocurrency activity; by the end of August 2019, more than 10,000 taxpayers received one of three varieties of letters. A taxpayer receiving one of these letters, should not ignore it! The IRS compiled this list of taxpayers that it feels has not been reporting their cryptocurrency transactions from various ongoing IRS compliance efforts. The following is a synopsis of the types of letters:

Letter 6173 – Requires a response from the taxpayer, either by the taxpayer providing a statement to the IRS that they have already complied with the required reporting or by filing a return that reports their cryptocurrency transactions. For situations where the taxpayer had already filed a return but had left off the cryptocurrency transactions, an amended return (Form 1040X) will need to be filed. Taxpayers who ignore this letter may face a full-blown audit by the IRS and could be subject to penalties.

Letter 6174 – This is a “soft notice” that does not require a response, and the IRS says it won’t be following up on it. However, the notice also warns that if the taxpayer had cryptocurrency gains and fails to amend their return or continues to be noncompliant on future returns despite receiving the letter, the taxpayer will be in hot water.

Letter 6174-A – The taxpayer isn’t required to respond to the letter but does need to correct their prior returns in which cryptocurrency transactions have been omitted. The IRS warns of future enforcement action if the taxpayer doesn’t amend their return(s) or file their delinquent returns. After receiving the letter, the taxpayer can’t use an excuse of not knowing the law for failing to report their cryptocurrency gains.

The IRS also successfully used a subpoena approved by the U.S. district court in Northern California to request information on the clients of another crypto exchange, Kraken, based in San Francisco (and parent company Payward Ventures). The company was ordered to hand over to the IRS the names, addresses, taxpayer ID numbers and other records of users who conducted at least $20,000 worth of transactions on the platform between 2016 and 2020. According to Kraken, this order applies to over 59,000 of its users.

In addition to trying to root out tax cheats through crypto exchanges, the IRS has been engaged in a virtual cryptocurrency compliance campaign to address tax noncompliance related to virtual currency use through outreach and examinations of taxpayers and plans to remain actively engaged in addressing non-compliance related to virtual currency transactions through a variety of efforts, ranging from taxpayer education to audits and criminal investigations.

Taxpayers who do not properly report the income tax consequences of virtual currency transactions are liable for the tax, penalties, and interest. In some cases, taxpayers could be subject to criminal prosecution.

So, if your clients receive one of the above letters, especially letter 6173, be sure your clients (or you if tasked to do so by your clients) respond timely. For anyone receiving a letter be sure to counsel them on the need to report the transactions and amend any return where reporting was omitted.

To further the IRS’ efforts to flush out taxpayers who may have cryptocurrency reporting requirements, as of the 2019 tax return, taxpayers need to answer a question about their cryptocurrency activity. The location on the forms and wording of the question have varied, and starting with the 2021 tax return the virtual currency question is prominently at the top of Form 1040, Form 1040-SR and Form 1040-NR - just under the filing status section.  All taxpayers filing these forms must check one box, answering either “Yes” or “No” to the virtual currency question.

Starting with the 2022 Form 1040, IRS is using the term “digital assets” in lieu of virtual currency in the question which reads: “At any time during 2022 (2023, 2024), did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?” The question must be answered “yes” or “no”. The 1040 instructions provide this explanation:

Digital assets are any digital representations of value that are recorded on a cryptographically secured distributed ledger or any similar technology. For example, digital assets include non-fungible tokens (NFTs) and virtual currencies, such as cryptocurrencies and stablecoins. If a particular asset has the characteristics of a digital asset, it will be treated as a digital asset for federal income tax purposes.

When taxpayers can check “No” - Taxpayers who merely owned digital assets at any time in 2022 (2023, 2024) can check the “No” box when they have not engaged in any transactions involving digital assets during the year, or when their activities were limited to:

When taxpayers must check “Yes” - Below are the most common virtual currency transactions that require checking the “Yes” box if at any time in 2022 (2023, 2024) the taxpayer:

Of course, taxpayers who disposed of any virtual currency (digital asset) held as a capital asset through a sale, exchange or transfer must check “Yes,” and use Form 8949 to figure their capital gain or loss and report it on Schedule D, while taxpayers who received virtual currency as compensation for services, or who disposed of virtual currency that they held for sale to customers in a trade or business, must report the income as they would report other income of the same type.