How to Beat the Crypto Tax Crisis

Clinton Donnelly has a horror story that could keep many crypto investors awake at night.

The CPA, who specializes in calculating taxes on crypto profits, had a client who came to him after being arrested by the IRS. The client wasn’t a crypto trader. He hadn’t collected NFTs or bought and sold dogecoins. He’d just transacted with someone who’d paid him a lot of money in Bitcoin.

The payer had mined the Bitcoin himself and sent it to the client’s private wallet. The funds had never touched a public exchange but the client didn’t declare the revenue. He then used the Bitcoin to buy services over-the-counter.

“One day, two guys from the IRS showed up at his doorstep,” Donnelly told The Bad Crypto Podcast. “These are the guys with the guns and the badges.”

The IRS agents invited Donnelly’s future client to the tax office, which he attended with a couple of lawyers. The agents told him they thought he hadn’t been reporting all his income. But the man’s Bitcoins were in a private wallet. They weren’t on an exchange from which they could demand information or in a bank that has to follow Know Your Customer rules. And they hadn’t come from an exchange that could create a paper trail. Surely, there was no way the IRS could know that he’d received funds.

Over the next six months, the IRS investigated. There was no news. He thought nothing had happened. He worried, but the IRS wasn’t saying anything.

Until one day, he received a phone call from a US District Attorney informing him that he was about to receive a subpoena for tax fraud. The penalty would be $250,000 plus three years in prison for every year of infraction.

So how did the IRS know that Donnelly’s client had received crypto funds that he hadn’t declared but which had never touched a public exchange and were stored in a private wallet?

The IRS had dusted the wallet with satoshis. They’d sent a bunch of low-value satoshis to his wallet address and every time the client paid for something using his undeclared Bitcoin, the IRS was able to track the movement of those satoshis.

They were able to prove he’d received a significant amount of income—more than $10,000—which he hadn’t reported on his tax return.

“When he got the call from the District Attorney and a copy of the indictment, he went and spoke to two very experienced criminal tax attorneys,” explained Connelly. “They both gave him the same advice: you’re dead.”

His best hope was a good plea bargain. He paid $240,000 in cash, filed all his past tax returns, including penalties and interest, and accepted one year in jail. He served around seven to eight months and came out a convicted felon.

It’s a horror story that could be coming to a crypto trader near you soon. Tax season is upon us and the IRS are flush with cash and overloaded with resources. And they’re looking for crypto investors who have been slack with their tax filings.

“Congress has weaponized the IRS to go after crypto owners,” said Donnelly.

The IRS Commissioner told Congress last year that it could bring in another trillion dollars on top of the more than four trillion dollars it currently raises if it had the means to improve enforcement. When Congress approved the Infrastructure Act, in addition to paying for tens of thousands of additional IRS agents, it also provided $46 billion specifically for tax enforcement on the owners of digital assets.

“Let me put $46 billion in context for you,” Donnelly said. “That’s three times the annual budget of the FBI.”

They’re going to have plenty of use for that money. Donnelly quoted surveys and data from the IRS that suggested from tens of millions of active crypto investors, roughly 80 percent were not reporting their crypto income on their tax returns. They were either filing a tax return but not reporting their crypto profits or they weren’t filing a tax return at all.

“The IRS knows this,” warned Donnelly. “They know who all the crypto investors are. They can get the information from all the US exchanges.”

But filing crypto taxes isn’t easy. Companies offer gain calculation services to help investors measure their profits but when both the value of an asset and the value of the coin that measures that asset are volatile, results can very widely from service to service.

“I have a company of over twenty employees and half of them are crypto analysts,” said Donnelly. “What we’re finding is that there’s a lot that these services are not telling you.”

Even the best services come up with answers that are too high for NFT pricing, he explained. His own company at at cryptotaxaudit.com uses a service that does appraisal values on NFTs that come in at a quarter of major crypto gain calculation services. “These are defendable prices,” he added.

What the IRS are really interested in is fair market value in US dollars at the time of the transactions, whether that’s a loss or a profit.

Donnelly’s one word of advice is not to report on your tax return any crypto income amount that you don’t believe is correct, whether it’s too low or too high.

“If you do report something and it’s in the range that you believe that you generally made in terms of realized gain then you can sleep well knowing that you’re gonna pay a fair amount of tax on a gain number that you believe in.”
And at least you’ll be able to sleep.