One of the many questions raised by cryptocurrency is how to tax this new world of digital assets. It poses real tax evasion concerns.
Crypto was explicitly developed to allow people to transfer currency to one another directly, circumventing the oversight of financial institutions. The Internal Revenue Service relies on information shared by these financial institutions to ensure tax compliance — a system cryptocurrency defies. The crypto space has well-documented anarchist roots, and it has largely been averse to government regulation. Cryptocurrency and blockchain — complex and novel technologies — were not designed with tax returns in mind.
The IRS has made some things clear about crypto taxes. As of now, individual taxpayers must answer a question about whether they have participated in digital asset transactions. If I buy a token, it doubles in value and then I sell it, I must pay capital gains tax. Last month, the IRS issued a reminder that income from digital asset transactions has to be reported. And it recently released much-needed guidance on when NFTs, or non-fungible tokens, should be taxed as collectibles. Congress passed new crypto broker-dealer reporting requirements in 2021, and the Treasury Department is expected to release regulations on these requirements soon.
But the federal government has yet to answer very real questions from crypto investors and participants about how they should report their income. When is crypto mining a hobby and when is it a business? Does a taxpayer realize gain or loss when they lend cryptocurrency? If a U.S. resident stakes cryptocurrency (meaning it’s pooled with other crypto in a system to validate the blockchain, from which rewards are collected) via an offshore server, which country gets to tax the resulting income? Tax bills will look very different depending on the answers to these questions.
If crypto income is not taxed fully and appropriately, the ramifications could extend far beyond the blockchain. Effective crypto taxation promises substantial revenues: The new broker-dealer reporting requirements alone could raise an estimated $28 billion within the next decade.
Moreover, the IRS depends on high levels of voluntary compliance from Americans. Given the extremely low risk of audit (IRS data from the 2019 tax year indicate that just 0.25% of taxpayers are audited) and low penalties for those who do underpay, tax evasion should be rampant. Why isn’t it? One explanation is tax morale: the nonrational reasons that people choose to file and pay, including social norms and the belief that others in their community are paying as well.
Unfortunately, tax morale is a precarious enforcer of tax law. Once people start to see others not paying taxes, or they start to view the tax system as illegitimate, they are less likely to comply themselves. This can set off a nasty feedback cycle, creating havoc for the already overextended IRS and draining essential government revenue.
This is why the stakes are so high for crypto taxation. Getting it right is about the legitimacy and effectiveness of our entire tax system.
In a vacuum of government guidance, two specific tax morale problems emerge for crypto. First, the lack of clarity gives crypto interest groups opportunities for legal arbitrage. They can take advantage of uncertainties surrounding this new technology, and the complexities of our tax system, to seek tax outcomes through the courts that flout the intent of existing law or policy. This in turn can harm tax morale.
Second, the confusion could deter crypto investors and participants who genuinely want to pay their taxes from doing so. Reading through conversations on the r/CryptoTax subreddit reveals that many people who are trying to comply with tax law can’t figure out how to do it. If this confusion ultimately discourages taxpayers from paying on their crypto income, it will create more examples of people successfully dodging taxes, and tax morale may suffer.
The Treasury and the IRS should provide timely guidance on the open questions for crypto taxation, building on the recent guidance for NFTs. Congress should consider whether new or updated laws are also needed to ensure a comprehensive and coherent system for digital assets.
By April 18, most Americans will have voluntarily filed and paid their taxes (though Californians affected by this winter’s storms have until October). Voluntary tax compliance is essential — and fragile. We shouldn’t let crypto upend the belief that (most) others are paying their fair share as well.
Amanda Parsons is an associate professor at the University of Colorado Law School. She writes about the intersection of tax law and emerging technologies.
