Crypto Tax Reporting Becomes IRS Top Priority – The New 1040 For 2020

Discover what the IRS is doing with crypto tax reporting by understanding the upcoming changes to the form 1040.

crypto tax reporting

What is the IRS doing with crypto tax reporting?

The IRS has just released draft versions of the new Form 1040 for reporting personal income taxes. In the form, the IRS has moved their enforcement of cryptocurrency taxation to the most prominent position possible.

In 2019, the IRS had added a cryptocurrency question to an optional form called Schedule 1. The question asks, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency? YES or NO.” 

For 2020, this question moved to just after the address.  The question occurs before listing your kids in the dependents block.  Cryptos before kids! Cryptos before wages!

Highlighted in yellow below is the new question on the 1040 form.

What is the significance of this for crypto tax reporting?

crypto tax reporting

This prominent placement forces every taxpayer to admit whether they dealt in virtual currencies. It is a simple Yes or No question.  No taxpayer can claim they never saw the question.

Why is this question important? 

Because when you sign a tax return, you are swearing to the following statement from page 2 of the form, “Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete.” Under U.S. law, perjury is a felony punishable by three years in prison.

Why are crypto owners concerned?

2019 was the first year this question appeared on the tax form.  Many crypto traders who had never reported their crypto income before became nervous. Here’s why. When you report the sale of property like cryptocurrencies, you must report the purchase price and date. That purchase date might be in a previous year.  That could expose a taxpayer to an audit unless you go back and correct all previous returns.

Why should non-crypto owners be concerned?

The question asks about virtual currencies. What are virtual currencies? The IRS says, “Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. Cryptocurrencies are only one type of virtual currency. 

Other types of possible virtual currencies include frequent flyer miles, store loyalty card points which can be used like cash to buy store products, even purchase cards where you prove you bought nine pizzas, then the tenth one is free.  In short, virtually everyone has an interest in some virtual currency.  Perhaps everyone should answer yes to this question?

What is the legal issue for crypto tax reporting?

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The term virtual currency is not a part of the law or tax regulations. The IRS notice defining virtual currency and the 2019 FAQ on virtual currency are non-binding.  The National Taxpayer Advocate has called out the IRS for publishing non-binding FAQ, stating that they are a trap for the unwary.

The U.S. Government Accounting Office (GAO) published a report GAO-20-188 stating the IRS guidance in 2014 & 2019 was not clear as to which parts are authoritative and which parts were subject to change. IRS and the Financial Crimes Enforcement Network (FinCEN) have not clearly and publicly explained when, if at all, requirements for reporting financial assets held in foreign countries apply to virtual currencies (Forms 8938 and FBAR).

Will the statute of limitations protect me from IRS audits?

The statute of limitations protects taxpayers by limiting how much time the IRS has to audit returns. The IRS has three years from the due date for filing the return or two years from when the debt was paid whichever is longer. However, if there is a false return or tax evasion, there is no limitation.  If the unreported income relates to financial assets where the counterparty is not a U.S. person, then the statute is extended to six years. (This pretty much describes all exchanges with anonymous persons on a crypto exchange, U.S. or foreign.)

The IRS has already begun audits of non-criminal crypto returns fro 2017. I am currently defending two clients from IRS audits of their cryptocurrency income.

Is the IRS question even lawful?

Many have asked if this question represents a substantial and unconstitutional overreach on the part of the Internal Revenue Service, and it should be withdrawn. It is excessive for the IRS to require a taxpayer to declare on the new Schedule 1 if he has “any financial interest” in cryptocurrency. This question violates many of the taxpayer’s constitutional rights. Mandating that taxpayers declare whether they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency subjects taxpayers to an abridgment of numerous constitutional protections. 

Is the question overly broad?

The First Amendment overbreadth doctrine allows a challenge to the validity of a statute on its face only if the law is substantially overbroad. City Council of Los Angeles v. Taxpayers for Vincent, 466 U.S. 789, 799-801, 104 S. Ct. 2118, 80 L. Ed. 2d 772 (1984). A law is overbroad when, although it constitutionally regulates some conduct, it sweeps so broadly that it also covers a substantial amount of constitutionally protected conduct. MDK, Inc. v. Vill. of Grafton, 277 F. Supp. 2d 943, 948 (E.D. Wis. 2003).

The United States Supreme Court has stated that “[a] statute may be deemed unconstitutional only if it is ‘substantially’ overbroad ‘judged in relation to the statute’s plainly legitimate sweep.’” Broadrick v. Oklahoma, 413 U.S. 601, 615, 93 S. Ct. 2908, 37 L. Ed. 2d 830 (1973). A finding of substantial overbreadth “requires the court to find ‘a realistic danger that the [policies] will significantly compromise recognized First Amendment protections of parties not before the Court.’” N.Y. State Club Ass’n v. City of N.Y., 487 U.S. 1, 11, 108 S. Ct. 2225, 101 L. Ed. 2d 1 (1988) (quoting Taxpayers for Vincent, at 801).

In analyzing an overbreadth challenge, a court must first construe the challenged statute—or in this case, the question on IRS Form 1040 Schedule 1—because “it is impossible to determine whether a statute reaches too far without first knowing what the statute covers.” United States v. Williams, 553 U.S. 285, 293, 128 S. Ct. 1830, 170 L. Ed. 2d 650 (2008). Next, the court determines whether the statute, as construed, “criminalizes a substantial amount of protected expressive activity.” Williams, 553 U.S. at 297. If so, the Court must determine “whether the statute is ‘readily susceptible’ to a limiting construction which would render it constitutional.” Snider v. City of Cape Girardeau, 752 F.3d 1149, 1158 (8th Cir. 2014) (quoting Virginia v. Am. Booksellers Ass’n, 484 U.S. 383, 397, 108 S. Ct. 636, 98 L. Ed. 2d 782 (1988)).

Likewise, a governmental directive may be held unconstitutional if “it seeks to prohibit such a broad range of protected conduct that it is unconstitutionally overbroad.” Taxpayers for Vincent, at 796. 

Holding property—in this case, cryptocurrency—is not a taxable event. Reporting the fact that your own cryptocurrency is not a taxable event. As a result, the question is overbroad and should be withdrawn.

Does this crypto tax reporting question have a chilling effect on First Amendment Rights?

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“The aim of facial overbreadth analysis is to eliminate the deterrent or ‘chilling’ effect an overbroad law may have on those contemplating conduct protected by the First Amendment.” Turchick v. United States, 561 F.2d 719, 721 (8th Cir. 1977) (footnote omitted). 

The Supreme Court stated that “[a] statute may be unconstitutional if it is so overbroad as to “chill[] . . . individual thought and expression,” such that it would “effectively preclude or punish the expression of particular views.” Nat’l Endowment for the Arts v. Finley, 524 U.S. 569, 583, 118 S. Ct. 2168, 141 L. Ed. 2d 500 (1998) (citations omitted).

In 1968, the Supreme Court reasoned that “a government regulation is sufficiently justified if it is within the constitutional power of the Government; if it furthers an important or substantial governmental interest; if the governmental interest is unrelated to the suppression of free expression; and if the incidental restriction on alleged First Amendment freedoms is no greater than is essential to the furtherance of that interest.” United States v. O’Brien, 391 U.S. 367, 377 (1968).

The question on the proposed Schedule 1 does not survive intermediate scrutiny, as the Supreme Court has held that it must “further[] an important or substantial governmental interest; if the governmental interest is unrelated to the suppression of free expression; and if the incidental restriction on alleged First Amendment freedoms is no greater than is essential to the furtherance of that interest.” United States v. O’Brien, 391 U.S. 367, 376-77, 88 S. Ct. 1673, 20 L. Ed. 2d 672 (1968). This overbroad question chills free speech and should not be included in the tax form.

Does the IRS question violate taxpayers’ legal protections?

Mandating that taxpayers declare whether they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency subjects taxpayers to an excessive fine.

What is the Excessive Fines Clause of the Eighth Amendment?

“Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.” U.S. Const. amend. VIII. In analyzing an excessive fines claim, the court must first decide whether a penalty is a fine before determining if it is unconstitutionally excessive. Dewees v. United States, 272 F. Supp. 3d 96, 100-01 (D.D.C. 2017).

The Supreme Court has stated that a payment to the government is only considered a “fine” under the Eighth Amendment if it is “punishment for some offense.” Austin v. United States, 509 U.S. 602, 609-10, 113 S. Ct. 2801, 125 L. Ed. 2d 488 (1993). The purpose of the penalty must be primarily retributive or deterrent rather than remedial. Id. In the context of forfeiture, for example, a penalty that is solely “designed to punish the offender” is considered punishment and is thus limited by the Excessive Fines Clause. Id. at 333-34.

The question in which a taxpayer must declare whether he receives, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency is primarily retributive or deterrent. It is not remedial. Taypayers will experience this situation regularly. The mandate will not deter them from doing so. While tax penalties have in the past been held to fulfill a remedial purpose are not subject to the Excessive Fines Clause, cryptocurrency was not contemplated by the Court by the Supreme Court 80 years ago when the standard was announced in Helvering v. Mitchell, 303 U.S. 391, 58 S. Ct. 630, 82 L. Ed. 917, 1938-1 C.B. 317 (1938). The Supreme Court reasoned that tax penalties are remedial because they exist as “a safeguard for the protection  of the revenue and to reimburse the Government for the heavy expense of investigation and the loss resulting from the taxpayer’s fraud.” Id. at 401. There is no fraud in this circumstance where income is not realized. The question does not create a loss of revenue for the government.

What is the Due Process Clause of the Fifth Amendment?

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A due process means that a person has been afforded an adequate “opportunity to be heard at a meaningful time and in a meaningful manner.” Mathews v. Eldridge, 424 U.S. 319, 333, 96 S. Ct. 893, 47 L. Ed. 2d 18 (1976), quoting Armstrong v. Manzo, 380 U.S. 545, 552, 85 S. Ct. 1187, 14 L. Ed. 2d 62 (1965). Courts judge procedural due process challenges to property deprivations by weighing (1) “the private interest that will be affected by the official action;” (2) “the risk of an erroneous deprivation of such interest through the procedures used, and the probable value, if any, of additional or substitute procedural safeguards;” and (3) “the Government’s interest, including the function involved and the fiscal and administrative burdens that the additional or substitute procedural requirement would entail.” Id. at 335.

Arguably due process is violated when this property right is deprived of a taxpayer, especially when there is no value recognized, that is, the cryptocurrency is not converted to a fiat currency or exchanged for another service or product of value. The fact that a taxpayer has cryptocurrency impacted a taxpayer’s privacy interest; there is significant the risk of an erroneous deprivation of the taxpayer’s property right; and it creates an undue burden in light of any governmental interest.

What is the Equal Protection Clause of the Fifth Amendment?

The threshold element of an equal protection claim is disparate treatment. Tippins v. Parish, 2019 U.S. Dist. LEXIS 177875, at *23 (W.D. Mich. Oct. 15, 2019), citing Scarbrough v. Morgan Cty. Bd. of Educ., 470 F.3d 250, 260 (6th Cir. 2006); Center for Bio-Ethical Reform, Inc. v. Napolitano, 648 F.3d 365, 379 (6th Cir. 2011) (“To state an equal protection claim, a plaintiff must adequately plead that the government treated the plaintiff ‘disparately as compared to similarly situated persons and that such disparate treatment either burdens a fundamental right, targets a suspect class, or has no rational basis.’”). 

An equal protection plaintiff must be similarly situated to his comparators “in all relevant respects…” Nordlinger v. Hahn, 505 U.S. 1, 10, 112 S. Ct. 2326, 120 L. Ed. 2d 1 (1992). Further, a sufficient injury in fact is concrete and particularized, and actual or imminent as opposed to merely hypothetical. Lujan v. Defenders of Wildlife, 504 U.S. 555, 560, 112 S. Ct. 2130, 119 L. Ed. 2d 351 (1992)). It is the plaintiff’s burden to demonstrate that his claim satisfies all of these elements. Id. at 561.

Here, it is clear that the owners of cryptocurrency are being treated differently than other taxpayers. As such, an equal protection claim can be argued as the government treats these taxpayers “disparately as compared to similarly situated persons and that such disparate treatment either burdens a fundamental right, targets a suspect class, or has no rational basis.” Ctr. for Bio-Ethical Reform, Inc. v. Napolitano, 648 F.3d 365, 379 (6th Cir. 2011), quoting Club Italia Soccer & Sports Org. v. Charter Twp. of Shelby, 470 F.3d 286, 298 (6th Cir. 2006), overruled on other grounds as recognized by Davis v. Prison Health Servs., 679 F.3d 433, 442 n.3 (6th Cir. 2012). Answering the question affirmatively singles out cryptocurrency owners for treatment unlike other taxpayers.

Does this crypto tax reporting question discriminate against commerce?

crypto tax reporting

The question is also discriminatory on a cryptocurrency owner’s commerce. “If a restriction on commerce is discriminatory, it is virtually per se invalid.” Oregon Waste Systems, Inc. v. Department of Environmental Quality of State of Or., 511 U.S. 93, 99, 114 S. Ct. 1345, 128 L. Ed. 2d 13 (1994).

Under Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279, 97 S. Ct. 1076, 51 L. Ed. 2d 326 (1977), a state tax will be sustained against a Commerce Clause challenge as long as the tax (1) is applied to an activity with a substantial nexus with the taxing state; (2) is fairly apportioned; (3) does not discriminate against interstate commerce; and (4) is fairly related to the services provided by the state. Id. The Complete Auto test emphasizes the importance of looking past the formal language of a tax statue to its practical effect. Direct Mktg. Ass’n v. Huber, 2011 U.S. Dist. LEXIS 9589, at *14 (D. Colo. Jan. 26, 2011), citing Quill, 504 U.S. at 310.

Applying this test to cryptocurrency, there is no substantial nexus, the action is not fairly apportioned, discriminates against interstate commerce; and is not fairly related to the services provided. 

Further, it is clear that the practical effect is to create a discriminatory environment for cryptocurrency owners.

Summary On The Latest Crypto Tax Reporting

crypto tax returns

The question on virtual currencies represents a substantial and unconstitutional overreach on the part of the Internal Revenue Service; it should be removed—especially until the laws and regulation of cryptocurrency is more definite and the courts have had an opportunity to determine the validity and constitutionality of these laws. 

Although IRS Commissioner Chuck Rettig has noted, “The IRS is committed to helping taxpayers understand their tax obligations in this emerging area,” and that the new guidance “will help taxpayers and tax professionals better understand how longstanding tax principles apply in this rapidly changing environment,” this question runs afoul of constitutional protections and should be withdrawn.

The choice by the IRS to elevate the importance of their question after significant legal issues have been raised, is troubling. 

Given the overly broad definition of virtual currency, if all taxpayers answered YES, then the question becomes trivialized and useless for data mining purposes.

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