A recently conducted audit by Treasury Inspector General For Tax Administration (TIGTA) has found that the IRS is struggling to identify taxpayers with virtual currency transactions due to poor third-party information reporting. As the number of crypto tax non-reporting cases are increasing, the administration has asked the IRS to reduce this information gap by enforcing more stricter rules on crypto exchanges.
Third-party information reporting is a smart mechanism used by the IRS to ensure tax compliance. This is the reason why you receive tax forms such as Wage and Tax Statement (Form W-2), Proceeds from Broker and Barter Exchange Transactions (Form 1099-B), Interest Income (Form 1099-INT), etc. at year-end. Issuers such as your employer or the bank send these forms to both you and the IRS. When you file your tax return, the IRS system matches what’s been reported to them by the issuers with what you have reported on your tax forms. If there’s a mismatch, the IRS automatically sends you a tax notice inquiring about the discrepancy.
This information reporting regime is very effective. As the audit report points out, the IRS estimates that tax compliance is approximately 95% when there is substantial information reporting. This percentage goes up to 99% when information reporting is combined with withholding (ex:- W-2). However, tax compliance drops to a staggering 45% where there is little to no information reporting or withholdings, which is the crypto world.
Problem With Crypto Exchanges
Unfortunately, US crypto tax compliance is so poor due to poor information reporting by the crypto exchanges. Tax rules around information reporting related to crypto are murky and written way before the invention of cryptocurrency. Therefore, exchanges are interpreting rules in different ways and issue different forms. Some prominent crypto exchanges issue Form 1099-Ks when users have more than 200 transactions and $20,000 in volume.