Crypto exchanges face new reporting requirements and stiff penalties under Senate infrastructure bill

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The Senate released 2,702 pages of the latest version of the bipartisan infrastructure bill early Sunday evening. Funding for increased IRS enforcement is particularly lacking, but it notably includes an increase in reporting of information for cryptocurrency exchanges or cryptocurrency transaction brokers. Increased disclosure of information necessarily includes increased penalties for disclosure of information. And these particular penalties for providing information are incredibly severe.

PARIS, FRANCE – JANUARY 15: In this photo illustration a visual representation of digital … [+] Cryptocurrencies, Bitcoin and Litecoin are displayed on January 15, 2018 in Paris, France. Bitcoin and Litecoin are fully paperless and decentralized electronic currencies that experienced an incredible increase in 2017. Cryptocurrencies, including Bitcoin, Ethereum, Ripple, and Litetcoin, experienced unprecedented growth in 2017, while remaining extremely volatile. (Photo by Chesnot / Getty Images)

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New reporting requirements

The pending bill does not create new reporting requirements for individuals, create new penalties for individuals, or impose any new obligations on individual cryptocurrency holders. Instead, if passed, the proposed law would require cryptocurrency exchanges – defined as anyone who (as consideration) is responsible for regularly providing any service performing digital asset transfers on behalf of another person to file an information return reporting the transaction. While the form has not yet been created – indeed, the law requiring it to be filed has not yet been passed – the form would likely be created quickly. The proposed legislation would come into effect in 2023, giving exchanges a year and a half to prepare to meet the requirements.

While the words cryptocurrency, virtual currency, bitcoin or the like never appear in the nearly 3,000 pages of proposed legislation, a digital asset is defined as any digital representation of value that is recorded on a cryptographically distributed ledger. secure or similar technology as specified. by the secretary. The definition is designed to include cryptocurrency and any other representation of value that may change in the future.

What is the information report?

Reporting information is not the same as filing income tax. Tax returns are reports of income earned, the amount of tax owed, and the amount of tax paid. Everyone in the United States who earns more than a certain amount * is required to file income tax returns. If a tax return is a cake, then the information return is the ingredients of that cake. Employers have information reporting requirements, such as a requirement to file W-2 forms that report wages and taxes withheld from their employees. Banks have information reporting requirements and must report how much interest is earned and paid to account holders. If the legislation proposed in the latest version of the Senate Infrastructure Bill is enacted, crypto exchanges will have increased information reporting requirements.

How are information reports used?

The IRS matches the reported information to taxpayer tax returns. For every W-2, 1099, and 1098-T you receive, the IRS also receives a copy. When the IRS receives a tax return, a computer checks that each W-2, 1099, and 1098-T that the IRS received matches the taxpayer’s tax return, for the same tax ID and for the same amount. Match failures usually lead to IRS matching error audits.

When it comes to items such as stocks, which are only taxable on gain, inconsistencies in reporting information can create real problems. I wrote previously about how, when a taxpayer does not file a tax return, the IRS will prepare a substitute for the return, or SFR. Imagine you bought 10 Amazon stocks for $ 3,000 a share and sold them for $ 3,327 a share. Your gain is $ 3,270 (327 * 10) and your tax is calculated based on that gain, not the total sale of 10 shares for $ 33,327. The purchase price of the shares is your basis. But for taxpayers who never file a tax return, the IRS has no information on the purchase price of the shares or on the taxpayer basis. If no tax return is filed, the IRS will calculate the gain on the sale as the full sale price, or $ 33,327, because information is required when assets are sold but not acquired.

Does this proposed rule impact crypto investors or just exchanges?

The proposed legislation, if passed, would have a significant impact on both investors and stock exchanges. Exchanges will need to put in considerable effort to comply with the reporting regime. Investors, on the other hand, will have nothing to do. But under the new law, all information the IRS would normally receive when an investor sells Amazon stock will now be sent to the IRS when an investor sells Bitcoin, Ethereum, or whatever. There are a lot of things to work out: what will happen to cryptos stored in cold rooms, un-traded wallets, so-called stand-alone custody. The bill does not deal with this self-guarding cryptocurrency, as it is analogous to cash under a mattress. It is difficult to trace and even more difficult to design an information reporting system that would encompass such an asset. However, individual cryptocurrency owners and investors should still be careful, as the IRS is even more likely to be aware of their transactions and expect them to be reported on a tax return.

What are the potential penalties?

Information reporting penalties are the most onerous and costly in the Internal Revenue Code. As a tax litigator, I can say this unequivocally, without any hesitation. They are costly both in terms of the sanction imposed and the extraordinarily difficult path to challenge them in court. The bill does not expressly say anything about penalties other than to state that Section 6724 of the Internal Revenue Code is amended to include digital assets in the definition of what is included in a return. information subject to penalty.

Failure to file a required information return is subject to a multi-part penalty. Under Section 6721, the IRS may impose a penalty for failure to file a required information return with the IRS. Under Section 6722, the IRS may impose a penalty for failure to provide the recipient with an appropriate disclosure statement. The penalty is $ 250 for each return for which a default occurs, without exceeding $ 3,000,000 in one year.

Think back to the example of a W-2. An employer who is supposed to file a W-2 will be assessed a penalty under Section 6721 for failing to file that W-2 with the IRS, and under Section 6722 for failing to provide the W-2 to the employee. In my experience, the IRS always offers to assess both penalties, never one or the other. To put it in perspective, Coinbase, the first major cryptocurrency exchange to go public, has over 56 million customers. That’s $ 250 for each client who would be required to receive the form but did not.

Worse yet, these penalties are significantly increased if the IRS determines that a required reporter has committed intentional contempt. Penalties assessed under the general rule are capped at $ 3,000,000 per filer and tax year (for a combined cap of $ 6,000,000 per year under 6721 and 6722), but the penalty is not capped if the IRS determines that the rules were not followed due to intentional disregard. And in my experience defending these disclosure penalty cases, the IRS almost always initially asserts that intentional disregard was present, even in cases where taxpayers hired professionals to help them. determine and comply with their disclosure requirements.

Put it all together

If the proposed legislation is enacted as it is currently drafted, cryptocurrency exchanges will have to work hard to ensure they meet stringent information reporting requirements to avoid information reporting penalties. . And cryptocurrency holders will need to be even more vigilant to ensure their cryptocurrency transactions are properly reported.

** For readers looking to dig deeper into the technical requirements, last year I wrote a more detailed and technical article on information reporting requirements and penalties here.

*** I recently announced a Top 10 Crypto Tax Mistakes to Avoid series and was unable to immediately post the series. It’s coming.

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