Cryptocurrency tax compliance has historically been poor, but the government is trying to get better at collection. A controversial section of the Infrastructure Bill, signed into law by President Biden on November 15h, requires “brokers” such as cryptocurrency exchanges to issue Form 1099-Bs to customers for the 2023 tax year.
Regulators believe that these 1099-Bs will improve third-party information reporting by exchanges, make it easier for taxpayers to file taxes and ultimately lead to improved compliance.
Unfortunately, lawmakers have overlooked several intricacies unique to crypto in drafting this provision. Not considering these crypto-specific situations —Decentralized finance, Transfers & Self-custody — could make 1099-Bs entirely ineffective and create unintended tax nightmares for taxpayers.
Key Concepts
What are 1099-Bs?
A Form 1099-B (Proceeds from Broker and Barter Exchange) is a form filled out by brokerages to summarize customers’ annual gains and losses subject to taxes. There are three copies to this form – Copy A, Copy 1 and Copy B. Copy A and Copy 1 are filed with the IRS and the state by the exchange. Copy B is sent out to the customer before he has to file his taxes.
For example, say you purchased one unit of $TSLA for $500 and sold it for $1,200 on Robinhood during 2021. By January 2022, Robinhood is required to fill out a Form 1099-B showing $700 ($1,200 – $500) of capital gains subject to taxes. Copy A and Copy 1 report this amount to the IRS and the state, respectively. You receive Copy B to help you file your taxes.
IRS Document Matching Program
Three copies of the same 1099-B exist to support what’s the IRS’ computerized document matching program. Going with the example above, if you somehow don’t report that $700 capital gain on your taxes, the program will automatically flag that return and send you a tax notice to correct the return. This is because the IRS believes that you underreported income by $700 since Robinhood reported to the IRS (Via Form 1099-B Copy A) that you had $700 worth of capital gains that don’t appear to be reflected on your tax return. This matching system combined with an independent third-party (in this case Robinhood) reporting your activity directly to the IRS is designed to ensure that taxpayers pay their taxes on capital gains.
The above reporting, which has been required for ordinary stockbrokers for a decade, is working extremely well for stocks and securities at the moment. For example, when a taxpayer receives a 1099-B showing capital gains, the non-compliance rate is only 17%. Regulators wanted to replicate the same system in the crypto space by mandating crypto exchanges to issue 1099-Bs starting January 1st, 2024 (2023 tax year). Unfortunately, the language included in the final bill didn’t take crucial crypto-specific intricacies into account.
How 1099-Bs Will Fail In The Crypto Space
Although 1099-Bs have been effective when it comes to improving non-crypto-related tax compliance, this system could fail in the crypto world and cause unfavorable second and third order consequences to taxpayers.
First, rapidly growing decentralized exchanges such as Uniswap & dYdX will be unable to issue any 1099-Bs because they are not collecting any Know-Your-Customer (KYC) information (Name, Address & Social security number) from users. This information is required to file 1099-Bs with the IRS and the state.
Second, asset transfers between wallets and exchanges are extremely common in the crypto space compared to the traditional securities world. These transfers between centralized exchanges to/from DeFi and non-complying overseas exchanges will lead to incomplete 1099-Bs causing more issues for taxpayers.
For example, say you purchased 1 ether (ETH) for $700 on Uniswap. You later moved this coin to Kraken and sold it for $1,000. Here, Kraken will issue a 1099-B showing you sold an ether for $1,000. It will not show the cost basis of $700 because it doesn’t know how much you paid for the coin in Uniswap. $1,000 reported to authorities (instead of $300) could cause problems to taxpayers down the road.
Third, self-custody is common in the crypto world to ensure privacy and security of assets. Self-custodied assets will also make it harder for exchanges to issue a complete 1099-B.
For example, say you purchased 1 bitcoin (BTC) for $30,000 several years ago. This is securely stored in your Ledger hardware wallet. In 2021, you sent this coin to Coinbase and sold it for $50,000. Here, you would rightfully owe taxes on $20,000 ($50,000 – $30,000) of capital gains. However, Coinbase would report $50,000 on 1099-B because it doesn’t know the cost basis of the bitcoin transferred in form your Ledger.
Unintended 2nd & 3rd Order Consequences For Taxpayers
Crypto 1099-Bs could pose additional challenges to taxpayers.
Incomplete 1099-Bs with missing cost basis will confuse taxpayers. Uninformed taxpayers will over report income and overpay taxes by relying on these incomplete 1099-Bs. They will also blame exchanges for reporting “incorrect” information.
As a solution, taxpayers will have to use third-party software tools to reconcile crypto activity across multiple exchanges & wallets and arrive at the correct capital gains (or losses). However, these reconciled capital gains (or losses) would be different from what has been reported to the IRS and the state by the exchanges through 1099-Bs. These mismatches could trigger the IRS Document matching system and lead to troublesome tax notices, which could be time consuming and expensive to resolve.
Still, A Possible Silver Lining?
Despite the downsides, it is important to note that there are some advantages to making crypto exchanges subject to 1099-B reporting. If you are using one exchange for all your crypto activity, you will get a complete 1099-B. This will make your yearend crypto tax filings so much easier than it is today. From the regulators point of view, 1099-Bs will lead to increased tax compliance through signaling. The idea is that a recipient who gets a “tax form” at the end of the year, will be more likely to report that income and pay taxes.
Next Steps
· If possible, try to use one cryptocurrency exchange to keep tax reporting simpler.
· If you use multiple cryptocurrency exchange and wallet, start using a third-party crypto tax software to track your basis and calculate accurate taxes.
-Read original article on Forbes
