IRS and Tax Authorities Are Hunting Crypto Tax Evaders — And They Want Better Tech to Do It

Governments are becoming increasingly impatient as many people are not paying taxes on their cryptocurrency holdings, and as a result they have been spending serious amounts of money trying to stop this trend from continuing. In just the past couple of months alone, tax agencies from countries such as the USA, UK, and Australia have issued public requests for contractors to develop surveillance and analytics tools that will assist them in locating individuals who own cryptocurrencies and are not reporting their corresponding income.

The amount of money being allocated for these contracts is substantial, and the agencies' intent is clear: they want their respective agencies to develop a better understanding of who owns what properties in an effort to identify gains made by each person. Over the last several years, there has been a shift in the overall number of individuals who have been able to maintain control of their assets without having to go through traditional banks or brokers and therefore, there has been virtually no issuance of any type of income tax forms at the end of each calendar year.

In certain cases, enforcement has been so weak that there have been numerous instances of people simply choosing not to report the income they have earned from crypto trade. Some individuals were not even aware that the income needed to be reported. Others made a calculation that it was a low risk for them not to report. As the enforcement agencies begin to strengthen their enforcement measures, the above-mentioned calculations will begin to change.

What These Tools Actually Do

Tax authorities have been purchasing blockchain analytical solutions from companies like Chainalysis, Elliptic, and TRM Labs since before the industry began. The nature and speed of their purchasing decisions have changed in that they no longer just want generic reports on what the technologies can do but rather very specific tools with defined capabilities; examples include the ability to trace transactions across varied blockchains, associate a given wallet address with individual identity, identify unusual transaction behaviors, and extract data from centralized exchanges.

Ultimately, they aim to associate each wallet with taxpayer identities (as you now associate brokerage account numbers with tax id numbers using the forms being issued).

It's tough to pin down what's going on in crypto because the community doesn't always follow the rules when it comes to keeping records. But, as a rule of thumb, any kind of crypto activity requires some sort of proof of identity (KYC) even if the transaction doesn't happen on a centralized exchange. Like KYC and transaction reporting, once there is an identity associated with a wallet, you can easily locate the wallet's activities both before and after KYC was completed at a centralized exchange.

Analyzing DeFi or self-custody wallets still represents a significantly smaller volume of crypto activity than investors are led to believe; therefore, there would be fewer examples to track than with centralized exchanges.

Privacy coins and mixing, forensics analysis tools are available and occasionally successful at uncovering identities from transaction data.

Why Now

A convergence of factors is occurring. In recent cycles, there has been a massive increase in the value of cryptocurrencies resulting in the largest amount of taxable gains to date. Governments find themselves under more fiscal pressure than they did five years ago and are urgently looking to address the tax gap (the difference between what taxes should be owed and what has actually been paid). Cryptocurrencies are generally accepted to be a significant contributor to that gap.

At the same time, the regulatory landscape continues to develop. The EU's DAC8 directive requires that crypto exchanges report to tax authorities on user transactions made on those exchanges. In the U.S., 1099 reporting requirements for brokers have been amended to include crypto platforms. As a result of both of these developments, there are significantly more data points being sent to government agencies that need to be put through new tools for analyzing that data efficiently.

In addition, there has been a shift in the public narrative surrounding cryptocurrencies. At the time of their inception as a currency alternative to government-backed currency, many users viewed tax minimization as one of the products of using that currency. That view has changed as the use of cryptocurrencies becomes more commonplace, and businesses including institutional investors and publicly traded companies, and, soon, ETF holders view it as a business practice — not an alternate currency.

What This Means for Ordinary Crypto Holders

If you've been ignoring your crypto gains and thus lulled into complacency, you are in good company as most surveys show that tax compliance rates for digital currencies are shockingly low. Just because so many are ignoring the law however doesn't mean there will be a permanent reprieve from it and unfortunately your opportunity to rectify your situation will likely narrow rapidly.

While many governments have some method of voluntarily correcting mistakes through a Disclosure Program, which allows taxpayers an opportunity to come forward to pay their tax and interest owed, by simply not doing anything with respect to your taxes, you run the risk of losing your eligibility if an audit is initiated.

The crypto tax software is also improving markedly with tools like Koinly, CoinTracker, and TaxBit being capable of ingesting your transaction histories from the majority of the major exchanges and providing you with required forms for submitting your tax returns. While record keeping may be laborious it is not hopeless.

For those involved in DeFi, NFT, and/or Cross-Chain activity the rules governing these activities can be very confusing and they continue to evolve on a daily (if not hourly) basis. Therefore it is essential that anyone in need of a tax professional that understands crypto finds one who actually has experience and knowledge regarding crypto, as many of the accountants who provide this service to clients have made the statement "I handle crypto" without being able to back it up with sound understanding and experience.

The Bottom Line

Governments aren't going to get perfect visibility into crypto overnight. But they're investing in better tools, reporting requirements are expanding, and the assumption that crypto activity is invisible to tax authorities was always partly wrong. The people who treated crypto gains as untaxable income are exactly who these new tools are built to find.