I have helped many taxpayers through cryptocurrency audits. In my experience, both the IRS and state taxing authorities tend to follow a relatively consistent process: an audit notice and interview request, a request for information and documentation, a review of selected transactions or an independent calculation, and a determination of any additional tax and penalties. Below, I describe each stage in detail along with the challenges taxpayers may encounter.
Notice of Audit & Request for Interview
The first step is the receipt of a notice of audit, typically in the mail. This will let you know who exactly is auditing you (either the IRS or a state taxing authority), the years they are auditing, the name and contact information for the auditor, and oftentimes some detail on what exactly is being audited. Either included with or shortly after receiving the Notice of Audit, the auditor will request an interview with the taxpayer. If you have an attorney, you can send the attorney in your place and do not need to talk to the auditor. I strongly advise my clients to always send an attorney rather than attend these interviews in person, because attending in person carries the risk of accidentally saying something that is going to hurt your case. One misstatement can totally change the outcome the case—so it’s best not to risk it if you don’t have to.
The interview questions vary, but they tend to focus on your cryptocurrency activity, number of wallets you have, number of exchanges you use, number of transactions, if you engage in any peer-to-peer trades, defi activity, etc.
Information & Document Request
After the interview the auditor will send a written request for information and documentation and give you time to respond, typically about 30 days.
The request is likely to include:
- A list of all exchanges used (Coinbase, Kraken, etc.) used during the audit period
- All wallet addresses used during the audit period
- Transaction data from the exchanges
- Any cryptocurrency accountant workpapers or reconciliations. If you used cryptocurrency accounting software like Coinledger, TokenTax, etc., or if you retained a cryptocurrency accountant, this would be the transaction report that includes a list of every transaction and its classification—for example buy, sell, income, self-transfer, cross-bridge, and others.
Analyze Transactions
After you submit the requested documents, the IRS or state taxing authority will generally verify your transaction classifications in one of two ways: either select transactions from your reports and ask you to substantiate your classifications, or prepare its own calculations from your transaction data and compare the results with yours. The distinction matters because the first approach focuses on select transactions, while the second can require you to review the auditor’s calculations transaction by transaction.
1. Auditor asks you to verify a handful of cryptocurrency transactions
One approach the IRS and state taxing authorities use is to send a list of transactions—typically a handful to a few dozen—and ask you to explain what happened and substantiate the reporting of each transaction. In my experience, auditors tend to select the highest-dollar transactions and the most complicated transactions from the reports. As a result, even a relatively short list can require substantial work to explain and document.
Our task is to make technical cryptocurrency transactions understandable to an auditor who may have limited experience with cryptocurrency accounting. Written explanations and data tables are often helpful to connect the transaction’s reported treatment to on-chain data from Etherscan or other blockchain explorers. Additional phone calls with the auditor are often helpful to walk them through the evidence.
While this tactic presents challenges for taxpayers, if you can successfully reconcile and tie out the transactions the auditor selects, you have a chance to end the audit quickly with no changes. On the other hand, if some of your calculations or tax treatment turn out to be wrong, it’s going to encourage the auditor to give you more and more transactions to tie out. Or, worse yet, the auditor may opt to prepare their own numbers from your transaction data (more on that later).
In my experience, this method tends to be more favorable to taxpayers especially when their calculations are at least moderately accurate. Adjustments tend to remain limited to the set of transactions the auditor selects, leaving the remaining transactions unchanged and limiting the overall adjustments. However, this is merely a tendency I have witnessed in my own experience rather than a guarantee that the auditor will leave the rest of the transactions alone.
2. Auditor prepares their own numbers
The most challenging approach, in my experience, is when auditors run your exchange and wallet data through third-party cryptocurrency accounting software and prepare their own calculations. I have seen initial versions of these calculations overstate capital gains and income by hundreds of thousands, millions, even tens of millions of dollars, or more. The taxpayer’s task when this happens is to review the transactions manually and submit evidence identifying the errors, starting with the highest-dollar transactions and working backward. In my experience, auditors are accommodating when I substantiate a correction, but reaching accurate figures can take several rounds of submissions and recalculations. Unlike a review of selected transactions from your reports, this approach uses the auditor’s calculations as the starting point, which tends to be less favorable to the taxpayer.
Calculate Understated Tax & Penalty
After the auditor settles on a final transaction report, it’s time to calculate any underpaid tax . The auditor will send a final report with final calculations along with a calculation of any tax, interest, and penalty. If tax was underreported, both the IRS and states typically decide between assessing a negligence penalty of around 20%-25%, or a fraud penalty of between 50% and 75%. If penalties are assessed you are allowed to submit a request for penalty abatement to the auditor, which must include a written statement of why your actions amounted to “reasonable cause” and deserve abatement.
When the auditor sends their report, review it carefully including the calculations, tax treatment, and penalty decision. Auditors are can be wrong, and just because their calculations or conclusions end up in a final report doesn’t mean you should assume they are correct. If you disagree with their numbers, both the IRS and state taxing authorities offer avenues for appeal, although the exact procedures will vary.
If you have received a Notice of Audit from the IRS or state and would like some help navigating the process, give me and my team a call. We look forward to hearing from you.