How to Prepare for a Tax Audit Involving Cryptocurrency

 Posted on December 23, 2024 in Tax Audits

As cryptocurrency continues to grow in popularity, the Internal Revenue Service (IRS) has increased its scrutiny of digital asset transactions. Because of this, taxpayers are more likely to face audits focusing on transactions involving virtual currencies. For those who have received notices from the IRS related to cryptocurrency or who are concerned that they could face an audit, preparing thoroughly can help reduce the potential financial impact. An experienced San Jose, CA tax attorney can provide invaluable assistance throughout the audit process, helping taxpayers comply with federal tax laws while avoiding or minimizing potential penalties.

Why the IRS May Audit Cryptocurrency Transactions

Because virtual currency transactions are decentralized, and the people or entities involved often have some level of anonymity, they may not be reported to the IRS. To address this issue, the IRS has implemented several enforcement efforts to ensure that taxpayers properly report income, gains, and other taxable events related to digital assets. Common reasons the IRS might initiate an audit include:

• Failure to Report Cryptocurrency Transactions: Not reporting the sale or exchange of cryptocurrency or digital assets received as income can trigger an audit.

• Discrepancies in Reported Income: If the income or gains a taxpayer has reported do not align with information from third parties like cryptocurrency exchanges, the IRS may decide to investigate.

• Use of Cryptocurrency for Large Purchases: High-value transactions or asset acquisitions using cryptocurrency can attract IRS attention.

• Suspicious Activity or Non-Compliance: Certain red flags, such as moving large amounts between wallets, may prompt a review by the IRS.

What to Expect During a Cryptocurrency Audit

When the IRS audits cryptocurrency-related activity, it will often request extensive documentation. Detailed questions may be asked to uncover unreported income or gains or address other forms of non-compliance.

Documentation That May Be Requested

During an audit, the IRS will most likely ask for comprehensive records that detail cryptocurrency holdings and transactions. This information may include:

• Blockchain Wallet Addresses: Documentation of all wallet addresses used for storing or transacting cryptocurrency.

• Wallet Identifications (IDs): Information about specific wallets, including whether they are hardware, software, or custodial.

• Exchange Records: Details from any cryptocurrency exchanges a taxpayer has used, including transaction history, deposits, and withdrawals.

• Transaction Receipts: Proof of purchase, sale, or transfer of cryptocurrency, including dates and amounts.

• Tax Forms and Statements: IRS forms such as Form 8949 (Sales and Other Dispositions of Capital Assets) or other tax filings related to digital assets.

• Bank Records: Statements showing deposits or withdrawals related to cryptocurrency transactions.

• Gift or Donation Records: Documentation related to any cryptocurrency that has been donated to charity or given to other parties as gifts, including the fair market value at the time.

Questions the IRS May Ask

The IRS will be looking to uncover any discrepancies or unreported taxable events through targeted questions. These may include:

• Have you used cryptocurrency to purchase goods or services?

• What are the blockchain addresses associated with your wallets?

• What exchanges have you used for cryptocurrency transactions?

• How have you calculated the cost basis and fair market value of your digital assets?

• Have you received cryptocurrency as payment for goods, services, or employment?

• Have you participated in any Initial Coin Offerings (ICOs) or received tokens through airdrops or hard forks?

Tips for Preparing for a Cryptocurrency Audit

Preparing in advance can make the audit process smoother. Here are some key steps to take:

• Organize Records: Ensure that all documentation related to cryptocurrency transactions is accurate, complete, and easily accessible.

• Review Tax Filings: Compare financial records involving digital asset transactions to past tax returns to identify and correct any potential errors.

• Consult with a Tax Attorney: An experienced tax lawyer can provide guidance throughout the audit process, make sure all information is prepared correctly, and help address any IRS concerns.

• Respond Promptly: Provide the requested information within the specified time frame, ensuring that it is accurate and complete.

• Avoid Providing Additional Information: Limit responses to what the IRS specifically requests to avoid unnecessary scrutiny.

Contact Our San Jose, CA Tax Attorney

Preparing effectively for a tax audit related to virtual currency is critical, since failure to address this issue correctly can lead to significant penalties. At John D. Teter Law Offices, our knowledgeable San Jose, CA tax audit lawyer can help taxpayers organize financial records, respond to IRS inquiries, and take steps to resolve tax-related concerns while minimizing potential financial losses. To learn how we can help you throughout the audit process and make sure you comply with federal tax laws while avoiding or minimizing potential penalties, contact us at 408-866-1810 and schedule a consultation.