Cryptocurrency Front And Center In Revised IRS Voluntary Disclosure Practice

The Internal Revenue Service announced today that the Voluntary Disclosure Practice Preclearance Request and Application has been revised. The IRS’s Voluntary Disclosure Practice has been around for years, and it is the best way for taxpayers who have potential criminal exposure for tax compliance issues to come forward. According to the IRS, “The updates reflect input from practitioners and stakeholders and take into account trends in the type of financial asset that taxpayers hold.” Private tax practitioners welcomed the revised application’s increased visibility into what kind of penalties would be assessed, but cautioned that some of the new requirements to disclose information, in particular disclosures that have to be made regarding cryptocurrency, require careful analysis.

Who Should Disclose and Why?

The IRS’s Voluntary Disclosure Practice is a way for people who fear criminal prosecution to come forward and disclose errors or omissions in tax reporting before the IRS gets to them. This is critically important, because if a taxpayer is already under audit, the taxpayer may not participate in the Voluntary Disclosure Practice. Taxpayers who made a mistake and don’t fear criminal prosecution should find a different way to come forward, because the Voluntary Disclosure Practice is quite onerous, it requires full cooperation and carries stiff penalties.

“This is an important form and process for people who recognize it’s better to step forward and address their tax situations head-on, before facing IRS enforcement action,” said Doug O’Donnell, Deputy Commissioner Services and Enforcement. “The revised form includes a number of updates, and we encourage people to review the guidelines and consult a trusted tax professional.” The IRS encourages taxpayers to consult with professional tax or legal advisors in determining which option is the most appropriate. (I echo this advice and cannot stress it enough.)

What is different about the form and process now?

Megan Brackney, a partner at Kostelantz & Fink, LLP in New York, who handles federal and state voluntary disclosures and other tax controversies, welcomed the new form and instructions because it provides a lot more clarity on what the penalties taxpayers will face will be. “We have been waiting for clarification on the penalty framework for situations other than taxpayers filing amended returns to report income tax and foreign assets. It is very welcome news to see the penalty framework for taxpayers who are using the voluntary disclosure to get caught up after years of not filing, and who have other compliance issues with tax other than income, such as estate, gift, and employment tax. The IRS’s penalty framework in these areas is consistent with its approach in income tax cases,”  explained Brackney.

She further explained, “This new guidance gives taxpayers much more certainty about their penalty exposure in estate, gift, and employment tax matters. I believe that this increased predictability will cause more taxpayers to make voluntary disclosures. However, the voluntary disclosure process has been very slow in the past few years, with some taxpayers waiting for more than a year to receive preclearance and other taxpayers waiting years to resolve their cases. Hopefully, the IRS will work through those issues so that the voluntary disclosure process can move more quickly, which is a benefit for the IRS and taxpayers.”

Brackney’s experience that the IRS disclosure practice is slow moving is not unique, and I have encountered the same frustrating slow moving process as well. This is another area in which taxpayer service would be improved by increasing IRS funding.

How does this impact me if I have unreported cryptocurrency?

John Colvin, a partner with Colvin + Hallett cautions taxpayers to think carefully before reporting cryptocurrency. According to Colvin:

“The new IRS voluntary disclosure form substantially increases the volume of information that tax cheats will have to provide about their cryptocurrency holdings upfront if they want absolution from the tax man. Not only are taxpayers required to list non-compliant cryptocurrency assets, but also are required to disclose whether they used `mixers’ or `tumblers’”, and explain why such devices (which obfuscate the origin of the funds) were used. As illegal source income does not qualify for the voluntary disclosure process, professionals will have to be very careful in evaluating whether the mixer or tumbler was employed to disguise illegal sourced income. 

With various mixers playing a prominent role in the recent Bitfinex theft complaint (US v Lichtenstein & Morgan, D.DC. Case No. 1:22-mj-00022), and in the Bitcoin Fog Mixer complaint (US v Sterlingov, D. DC Case No. 1:32-mj-0040), both of which were investigated by IRS-CI, the IRS is clearly targeting the providers of these services. What better way to identify mixer/tumbler providers than to have their former customers rat them out.”

Of particular concern to some practitioners and their clients may be the requirement to specifically tell the IRS where all of the cryptocurrency is located and the identifying information regarding that cryptocurrency. “The IRS has updated the form to include more specific focus on virtual currency. The IRS has expanded the information that a taxpayer has to provide in requesting preclearance, now requiring the taxpayer to state from the asset all noncompliant virtual currency that the taxpayer owned, controlled, acquired, or disposed during the disclosure period. Taxpayers may be surprised that they have to provide this much detailed information up front. From my experience, however, the IRS can be trusted to use this information only to determine whether the taxpayer is eligible to make a voluntary disclosure. It does require some faith, however,” explained Brackney.

The fact that cryptocurrency is specially mentioned on the form, however, is no surprise. “At this point I think we would be surprised not to see crypto specifically addressed in this expansion,” said Andrew Strelka, former Senior White House Tax Counsel in the Biden administration. “Whether its NFTs or Dogecoin, the blockchain is here and this Treasury Department understands that. This is an important step in bringing this industry out of the cold.”

What About NFT’s?

The Voluntary Disclosure Practice Form does not mention NFT, Fungible, or Token anywhere. The definition of what constitutes “Virtual Currency,” which is how the IRS refers to cryptocurrency, is broad: “Virtual Currency” is a dynamic area, and for purposes of this form the term encompasses assets beyond what many define as virtual currencies.”

Colvin doubts NFTs are required to be reported as virtual currency. “At least the NFTs that I am familiar with do not fall within the definition of “cryptocurrency” as they are unique assets and not fungible (like currency) in any real sense. I suppose at some point if someone were to offer 1,000 or 10,000 limited editions of an NFT that were absolutely identical, you might be moving towards fungibility/cryptocurrency status.”

However, if any taxpayer had unreported income from an NFT, that income would absolutely be required to be reported on a voluntary disclosure practice application. An application that fails to completely, truthfully and accurately disclose all unreported income would not only fail to accomplish the goal of coming clean to the IRS, it would constitute a new felony in and of itself.