The IRS and the Rising Cost of Crypto Tax Compliance

January is coming to an end, and you recently received five different 1099s from the crypto brokers you used over the last year.

This post is part of CoinDesk’s Tax Week, presented by TaxBit. David Kemmerer is the CEO & co-founder of CoinLedger, a crypto tax software company.

Despite only trading $5,000 of cryptocurrencies, your 1099s are reporting $50,000 of realized taxable income! This number isn’t accurate. But, given that these same 1099s were sent to the IRS, Uncle Sam believes you earned that amount, and now he is demanding his $15,000 cut.

Naturally, you start to panic.

How can this be? You originally bought only $5,000 of Ethereum. You can’t owe $15,000 in taxes, can you?

Confused and stressed out, you take to the internet and quickly find someone online who calls himself a crypto tax expert.

“Due to increased demand,” the crypto tax expert’s website says, “we have stopped offering free tax consultations.”

Reluctantly, you pay $250 up front and schedule a 30 minute consultation.

You need to get this sorted out.

Why is my crypto tax bill so much higher?

Once on the phone, the expert explains that the 1099s you received likely reported the gross proceeds of your trades and transfers without a detailed account of the basis, essentially the amount you spent to acquire the crypto.

This discrepancy is a common issue that crypto investors face, resulting in over-reported income and inflated tax bills. The misleading 1099s are the result of broker reporting regulations put into place by the IRS and Treasury department back in 2023.

To resolve this, you’re advised to compile a comprehensive transaction history across all of your wallets to calculate the actual gains or losses incurred. Once calculated, you need to reconcile the actual gains with what’s reported on your 1099s, a process that is not only time-consuming but also requires a specialized understanding of both crypto transactions and tax laws.

The expert is quick to let you know he can handle all of this burdensome reporting for you for a one time payment of $4,000.

“People actually pay that?” you ask the expert.

With a smile on his face, the expert replies, “My firm will do 350 of these just this week!”

As you delve deeper into the maze of reconciling your trades, you start to see all of the cost basis gaps in your 1099s from when you moved crypto from exchanges to your self-custodied wallets. On many of your 1099s, simple transfers to your wallets were marked as proceeds, dramatically increasing your reported gains.

After two weeks of trying to reconcile and account for everything yourself, you come to the conclusion that you are in over your head.

You give the expert a call back and complete the $4,000 payment.

“Thank you!” says the tax expert. “We look forward to working with you again next year.”

Conclusion

While this is a fictitious story, it represents a reality that the crypto industry will soon face as a result of the square-peg-in-a-round-hole broker reporting regulations proposed by the U.S. Treasury.

Cryptocurrency technology is built on open protocols. Copy-pasting 1099 information reporting rules as they exist for equity brokers, as the proposed regulations say, simply doesn’t work due to this technological underpinning.

Any market participant can connect to the Bitcoin blockchain. Anyone can freely send bitcoins from a wallet they possess to any other wallet in the world. No matter what laws and regulations get passed, this fact remains true.

The rules coming from the Treasury, which are currently in a comment period, will not only increase compliance costs for brokers, but they will also have the unintended consequence of increasing compliance costs for everyday investors who must reconcile inaccurate 1099s with their transaction history each year.

Hopefully the IRS works collaboratively and thoughtfully with industry to make sure this doesn’t happen.

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