How Americans Pay Their Taxes and How Crypto Could Change That
Every year, millions of Americans file and pay their taxes to the Internal Revenue Service (IRS), either by having their income tax deducted from their paychecks or by paying estimated taxes quarterly. But how does the IRS ensure that people report their income accurately and pay their fair share of taxes? And how could the rise of cryptocurrency, a new form of digital money that operates outside the traditional financial system, affect the tax system and the tax morale of Americans?
The IRS Relies on Information Reporting
One of the main ways that the IRS verifies the income and transactions of taxpayers is through information reporting by third parties, such as employers, banks, brokers, and other financial institutions. These entities are required to report certain payments and transactions to the IRS and to the taxpayers on forms such as W-2s, 1099s, and 1098s. This way, the IRS can match the information reported by the taxpayers on their tax returns with the information reported by the third parties.
Information reporting also helps to increase voluntary compliance by taxpayers, who know that their income and transactions are being reported to the IRS and that they could face penalties or audits if they underreport or omit them. According to a study by the IRS, in 2019, taxpayers reported 95% of their income when it was subject to substantial information reporting, compared with only 45% when it was subject to little or no information reporting.
Crypto Poses a Challenge to Information Reporting
Cryptocurrency, however, poses a challenge to the information reporting system because it is designed to enable peer-to-peer transactions without intermediaries. Cryptocurrency users can transfer digital assets such as Bitcoin, Ethereum, or NFTs (non-fungible tokens) directly to each other using a decentralized network of computers called a blockchain, which records and validates every transaction. This means that there is no central authority or institution that can report these transactions to the IRS or to the taxpayers.
Although some cryptocurrency platforms and exchanges do provide some information reporting to the IRS and to their users, such as Form 1099-K or Form 1099-B, this is not consistent or comprehensive across the industry. Moreover, some cryptocurrency users may use anonymous or offshore platforms or wallets that do not report anything at all. This makes it difficult for the IRS to track and verify the income and transactions of cryptocurrency users and for the taxpayers to report them accurately on their tax returns.
The IRS Has Issued Some Guidance on Crypto Taxes
The IRS has issued some guidance on how cryptocurrency should be taxed in general. The IRS treats cryptocurrency as property, not as currency, for tax purposes. This means that cryptocurrency transactions are subject to capital gains tax, just like stocks, bonds, or real estate. For example, if a taxpayer buys Bitcoin for $10,000 and sells it for $15,000, they have to pay capital gains tax on the $5,000 profit.
The IRS also requires taxpayers to report whether they have engaged in any cryptocurrency transactions during the year by answering a question on Form 1040. The IRS has also clarified some specific issues regarding crypto taxation, such as how to value cryptocurrency received as income, how to report cryptocurrency donations or gifts, and how to treat NFTs as collectibles.
But Many Questions Remain Unanswered
However, there are still many questions that remain unanswered about crypto taxation, especially regarding more complex or novel aspects of cryptocurrency. For example:
- 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 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. The lack of clear and consistent guidance from the IRS may create confusion and uncertainty for crypto taxpayers and may also create opportunities for tax evasion or avoidance.
Tax Morale and Compliance Among Americans
Some of the factors that influence tax morale and compliance among Americans are social norms, trust in government, and the belief that others in their community are paying their fair share of taxes. If people perceive that the tax system is fair, transparent, and effective, they are more likely to comply with their tax obligations voluntarily.
However, cryptocurrency may undermine some of these factors and erode tax morale and compliance. Cryptocurrency may create a perception of anonymity and secrecy among its users, who may feel less accountable or responsible for their tax obligations. Cryptocurrency may also create a sense of distrust or resentment toward the government, especially among those who view it as a threat to their financial freedom or sovereignty. Cryptocurrency may also create a sense of unfairness or inequality among taxpayers, who may feel that they are paying more taxes than others who are using crypto to evade or avoid taxes.
The IRS and Congress Need to Act
To address these challenges and risks posed by cryptocurrency, the IRS and Congress need to act swiftly and decisively. The IRS needs to provide more clear and comprehensive guidance on crypto taxation, as well as more resources and tools for crypto taxpayers and tax professionals. The IRS also needs to enhance its enforcement and audit capabilities to detect and deter crypto tax evasion and noncompliance.
Congress also needs to pass legislation that would improve the information reporting and disclosure requirements for cryptocurrency transactions. For example, Congress could expand the scope of Form 1099-INT to include interest income from crypto lending or staking, or create a new form specifically for crypto transactions. Congress could also require cryptocurrency platforms and exchanges to report the cost basis and holding period of crypto assets sold by their users, similar to what brokers do for stocks and mutual funds.
Crypto Is Here to Stay
Cryptocurrency is here to stay, and it is likely to grow and evolve in the future. It offers many benefits and opportunities for innovation, but it also poses many challenges and risks for taxation. The IRS and Congress need to keep up with the pace of change and ensure that the tax system can adapt to this new reality. This way, they can protect the integrity and fairness of the tax system, as well as the tax morale and compliance of Americans. 😊