Narrowing the “Tax Gap”: Treasury & the IRS Target “High-Income Taxpayers” and Cryptocurrency Transactions
The Biden Administration has identified the “tax gap” as a priority issue for 2021 with the Treasury Department suggesting that the tax gap could total $7 trillion over the next ten years and noting that the beneficiaries of that tax gap are wealthy taxpayers and the corporations they own. During the Senate Finance Committee hearing on the Biden budget proposals, Chair Wyden (D-OR) expressed concern about the recent leak of confidential taxpayer information on certain wealthy taxpayers, but also said that the disclosures support efforts to ensure that wealthy individuals and large corporations do not avoid meeting their tax obligations.
The Biden Administration believes that the government can recoup much of the revenue represented by the “tax gap” through increased IRS enforcement and expanded information reporting paired with improved compliance rules. Thus, the Biden budget submission for Fiscal Year 2022 (“Biden Budget”) includes a 10.4% increase in IRS funding over current levels. It also includes specific compliance-related proposals such as additional reporting on financial accounts, expanded broker information reporting on cryptocurrency assets, and increased electronic return filing.
Due to the heightened focus in Congress on the “tax gap” and targeting high income individuals as a way to pay for the Biden agenda on infrastructure and other economic issues, the attention being paid to the efforts to target high net worth individuals and virtual currency has taken center stage. IRS enforcement is certain to continue to increase in 2021 with Congressional focus on narrowing the “tax gap” and the release of the Administration’s tax proposals. There are a number of areas of focus including TCJA-related audits, tax compliance by partnerships, stock-based compensation cost-sharing arrangements, targeting high net worth individuals, virtual currency (cryptocurrency), FATCA and FBAR compliance, and CARES Act/pandemic related matters.
This True Alert will detail the current enforcement initiatives by Treasury and the IRS as well as the new Biden proposals that are designed to support those initiatives which are being used to target high-net-worth taxpayers and cryptocurrency transactions.
- The Biden Budget Includes several proposals to address the problem of the “tax gap,” including coverage of cryptocurrency, a budget increase to the IRS to target the wealthy, expanded reporting by financial institutions, reporting and enforcement tools for the IRS, and regulation of tax preparers.
- On May 20, 2021, the Treasury Department issued a report on the Biden Administration’s tax compliance proposals that were included in the President’s American Families Tax Plan (“Treasury Report”). The Treasury Report calls for stricter enforcement of existing tax laws, additional funding for the IRS, and expanded information reporting requirements all designed to narrow the “tax gap,” which is the difference between the amount of tax owed to the government (including tax on underreported income) and the amount paid.
- The first step in the Biden Budget tax administration plan is a sustained, multi-year commitment to rebuilding the IRS, including nearly $80 billion in additional resources over the next decade.
- In Congressional testimony, the IRS Commissioner testified that if the increased IRS funding is approved, the IRS intends to hire agents with specialized experience in high-net-worth and global high-wealth tax issues, large passthrough returns, large and ultra-large corporate tax compliance issues, non-filer virtual currency issues, Bank Secrecy issues, and abusive transactions.
- The IRS has stepped up its focus on high net worth individuals in recent years including a global high-wealth program called the IRS “wealth squad”; a high-income non-filer compliance campaign that targets taxpayers who have not filed required tax returns; and a compliance campaign focused on expatriated individuals who have not complied with filing and payment requirements.
- In another example of the IRS enforcement efforts, the LB&I Division is targeting credit funds and other financial service entities through which foreigners invest into the US to determine whether they are engaged in a US trade or business.
- The President’s budget proposals include the creation of a comprehensive financial account information reporting regime that would require financial institutions to report information on account inflows and outflows designed to increase reporting on earnings from investments and business activity. There would also be new reporting requirements for crypto asset exchanges, custodians, and payment settlement entities, which represents a significant expansion of information reporting beyond what is currently required with traditional financial institutions.
- Through actions that started several years ago, Treasury and the IRS have made it clear that they believe that there is significant under-reporting and underpaying of tax obligations related to cryptocurrency transactions. They have made cryptocurrency tax evasion a major enforcement focus with a number of initiatives.
- The current focus on cryptocurrency at Treasury and the IRS is very basic, they are targeting taxpayers who do not report transactions and do not pay any tax.
- The IRS sent a clear signal that they are prioritizing enforcement of virtual currency in July of 2018 when the LB&I Division launched a campaign targeting cryptocurrency. In July 2019, the IRS sent three types of letters to taxpayers related to potential non-reporting of virtual currency transactions, which caused some taxpayers to file amended returns.
- In the fall of 2019, a global effort to target virtual currency holders was made public with the Crypto Challenge of the Joint Chiefs of Global Tax Enforcement (the “J5”), which includes the revenue authorities of Australia, Canada, the Netherlands, the UK, and the US.
- In March of 2021, Damon Rowe, the Director of the Office of Fraud Enforcement at the IRS, announced information about an IRS initiative called “Operation Hidden Treasure,” which is comprised of agents who are trained in cryptocurrency and virtual currency tracking, and who are focused on taxpayers who omit cryptocurrency income from their tax returns.
- For the 2020 tax year filings, a question was included on the Form 1040 — “Did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
- The IRS has also started using the “John Doe summons” on cryptocurrency issues. The “John Doe summons” is used to obtain the names of all taxpayers in a certain group that may have failed to comply with their tax obligations.
- The new reporting regime outlined in the Treasury Report includes two new filing requirements related to cryptocurrency transactions.
- The Biden Administration has proposed requiring the collection of data on foreign cryptocurrency investors active in the US, which would broaden the scope of third-party information reporting by brokers to include reporting about certain beneficial owners.
The Biden Administration Proposals on IRS Enforcement and Cryptocurrency
The Biden Budget calls for $6 trillion in spending and significant tax increases for large corporations and high-income individuals. Spending initiatives cover new funding for traditional physical infrastructure projects and “human” infrastructure initiatives along with tax relief for lower- and middle-income taxpayers, all of which were outlined in the Biden Administration’s American Jobs Plan and the American Families Plan.
On May 28th, the Treasury Department issued its “General Explanations of the Administration’s Revenue Proposals,” informally known as the Green Book. The Green Book provides details of tax proposals included in the Administration’s Fiscal Year 2022 budget submission to Congress.
The Biden Budget includes proposals to address the “tax gap,” including coverage of cryptocurrency, a budget increase for the IRS to target wealthy individuals, expanded reporting requirements for financial institutions, reporting and enforcement tools for the IRS, and regulation of tax preparers.
On May 20, 2021, the Treasury Department issued a report on the Biden Administration’s tax compliance proposals that were included in the President’s American Families Tax Plan (“Treasury Report”). The Treasury Report calls for stricter enforcement of existing tax laws, additional funding for the IRS, and expanded information reporting requirements that are all designed to narrow the “tax gap,” which is the difference between the amount of tax owed to the government (including tax on underreported income) and the amount paid.
The Biden Administration asked Congress for $80 billion in new funding for the IRS over the next 10 years to support the enhanced enforcement. Treasury estimates that the policies outlined in their report would raise $700 billion over a 10-year period and an additional $1.6 trillion in the second 10-year period after enactment.
The Treasury Report explained the purpose of the proposals by stating:
“To raise revenue, improve efficiency, and build a more equitable tax system, investments in tax compliance are of first order importance. The compliance proposals in the American Families Plan provide the IRS with the resources and information it needs to overhaul and enhance tax administration. These policy changes are integral to addressing evasion, but they also prioritize improving taxpayer service and the experience of Americans as they navigate the tax system. Taxpayers would benefit from effective communication with the IRS, access to the tax credits to which they are entitled, and competent assistance as they file their taxes.”
The policies outlined in the Treasury Report include:
- Provide the IRS with the resources necessary to address sophisticated tax evasion
- Provide the IRS with more complete information
- Overhaul outdated technology to help the IRS identify tax evasion and serve customers
- Regulate paid tax preparers and increasing penalties for those who commit or abet evasion
Treasury Secretary Yellen recently testified before both the Senate Finance Committee and the House Ways & Means Committee on the Administration’s budget proposals. Not surprisingly, committee members were generally split along party lines on their support for the proposals aimed at increasing the IRS budget for enforcement operations as well as specific compliance proposals including the new reporting regime.
Democrats argued – and Secretary Yellen agreed – that the proposals would promote equity in the tax system by ensuring that taxpayers meet their tax obligations. Republicans argued that the proposals could potentially create a huge new bureaucracy within the IRS and privacy concerns for taxpayers. They specifically focused on the new proposal that would require financial institutions to report gross inflows and outflows of financial accounts (see discussion below).
IRS Enforcement Targeting “High-Income Taxpayers”
The first step in the Biden Budget tax administration plan is a sustained, multi-year commitment to rebuilding the IRS, including nearly $80 billion in additional resources over the next decade. The IRS would grow manageably (no more than approximately 10% annually) and have funding in place to make necessary investments with large, fixed costs – like modernizing information technology, improving data analytic approaches, and hiring and training agents dedicated to complex enforcement activities.
Treasury believes that the increased IRS enforcement funding would allow the agency to recover from the cuts to their budget over the last ten years, which has led to a decline in the workforce, particularly among specialized auditors who conduct examinations of high-income and global high-net-worth individuals as well as complex tax structures that include partnerships, tiered entities, and multinational corporations.
In Congressional testimony, the IRS Commissioner testified that if the increased IRS funding is approved, the IRS intends to hire agents who have specialized experience with issues that include high-net-worth and global high-wealth taxpayers, large passthrough returns, large and ultra-large corporate tax compliance, non-filer virtual currency, Bank Secrecy, and abusive transactions.
The IRS has stepped up its focus on high net worth individuals in recent years including a global high-wealth program called the IRS “wealth squad”; a high-income non-filer compliance campaign that targets taxpayers who have not filed required tax returns; and a compliance campaign focused on expatriated individuals who have not complied with filing and payment requirements.
In February 2020, the IRS announced its “Non-Filer program” through which it would increase efforts to contact high-income taxpayers (defined as earning $100,000 or more per year) who in prior years have failed to file one or more tax returns. Some of the strategies the IRS detailed include the Automated Substitute for Return program, the Campus Automated 6020(b) program, and the Delinquent Return Refund Hold program. Now, more than a year later, there are reports of an increase in non-filer inquiries and notices of tax and penalty obligations now due.
In another example of the IRS enforcement efforts, on June 10, 2021, the IRS’s Large Business and International Division (LB&I) announced a broad compliance campaign targeting “financial service entities in a US trade or business.” It appears that the LB&I Division is targeting credit funds and other financial service entities through which foreigners invest into the US to determine whether they are engaged in a US trade or business. The announcement explains that there is a safe harbor rule under section 864(b)(2) for foreign investors who only trade stocks and securities for their own accounts and are not engaged in a US trade or business. That safe harbor is not available to dealers in stocks or securities, including entities engaged in a lending business, or to foreign investors in partnerships engaged in these activities.
Comprehensive Financial Account Reporting
The President’s budget proposals include the creation of a comprehensive financial account information reporting regime that would require financial institutions to report information on account inflows and outflows designed to increase disclosures on earnings from investments and business activity. There would also be new reporting requirements for crypto asset exchanges, custodians, and payment settlement entities, which represents a significant expansion of information reporting beyond what is currently required with traditional financial institutions.
The IRS believes that when they can verify taxpayer filings with third-party information reports, such as the W-2 forms submitted by employers to report wages, compliance rates exceed 95%. Without third-party reporting, compliance rates fall below 50% that leads to an inequitable asymmetry in tax collections depending on the type of income an individual earns. The President’s proposal leverages the information that financial institutions already know about the accounts that they house. Financial institutions would add information about total account outflows and inflows to existing reporting on bank accounts. There are no added requirements for taxpayers.
The report notes that other accounts that are similarly situated to financial institution accounts would also be covered under this new reporting regime, e.g., payment settlement entities would also be required to report gross receipts and gross purchases. The reporting regime would also cover foreign financial institutions and crypto asset exchanges and custodians.
Treasury believes that the additional information would enable the IRS to better target enforcement activities so that it can increase scrutiny of high-income evaders and reduce the likelihood of subjecting fully compliant taxpayers to costly audits. They also believe this would lead to increased voluntary compliance by would-be evaders who would know that information on previously unreported income streams could now be identified.
If enacted, the proposals would give Treasury broad authority to issue regulations necessary to implement these initiatives.
Business income currently is subject to limited third-party information reporting (e.g., Form 1099-MISC, Miscellaneous Income, Form 1099-NEC, Nonemployee Compensation, and Form 1099-K, Payment Card and Third Party Network Transactions). Total deductible expenses are not subject to information reporting.
The Administration proposals would create a comprehensive financial account information reporting regime intended to increase transparency about gross receipts and deductible expenses, enhance the effectiveness of the enforcement measures, and encourage voluntary compliance. The current reporting on Form 1099-INT, Interest Income, and Form 1099-K would be expanded with the new rules effective for tax years beginning after December 31, 2022.
Financial institutions would be required to report additional data on financial accounts using Form 1099-INT reporting. The new data required includes gross account inflows and outflows, with a breakdown for physical cash, transactions with a foreign account, and transfers between multiple accounts of the same owner.
This new third-party information reporting regime would apply to all business and personal accounts maintained by financial institutions (e.g., bank, loan, and investment accounts) with gross inflows and outflows or fair market value of $600 or more. The new rules are not clearly limited to US financial institutions, so foreign financial institutions may be affected.
The new regime would also require reporting on accounts with characteristics similar to financial institution accounts, such as payment settlement entities. Those accounts would be required to collect taxpayer identification numbers (TINs) and file a revised Form 1099-K, which would be expanded to include all accounts (subject to the $600 de minimis threshold). The reporting would include not only gross receipts related to merchants, but also gross purchases, physical cash, payments to and from foreign accounts, and transfer inflows and outflows.
Finally, it would also apply similar reporting requirements to crypto asset exchanges as well as cases in which taxpayers purchase crypto assets from one broker and transfer them to another broker. The proposal would also require businesses to report the receipt of crypto assets in certain transactions with a fair market value of more than $10,000 (see discussion below).
Electronic Filing: Treasury and the IRS are permitted to require electronic filing of certain income tax and information returns, although they must consider the taxpayer’s ability to comply and allow taxpayers to seek a waiver. The Administration Proposal would expand electronic filing requirements to Form 1042, Annual Withholding Tax Return for US Source Income of Foreign Persons, and Form 8300, Report of Cash Payments Over $10,000.
Reportable Payments and Backup Withholding: Payees of reportable payments are allowed to provide their TIN in any manner, which includes providing a Form W-9, Request for Taxpayer Identification Number and Certification, to the payor before receiving payment in order to avoid backup withholding. This rule only applies to US non-exempt persons for transactions involving reportable interest, dividends, and proceeds from the sale of securities. Under the Administration Proposal and effective for payments made after December 31, 2021, all US payees receiving reportable payments would have to document their TIN by providing a Form W-9 to avoid the backup withholding.
Over the past several years, the global cryptocurrency market has grown to an estimated $2 trillion and availability and access has expanded to a wide group of investors. Through actions that started several years ago, Treasury and the IRS have stated their belief that there is significant under-reporting and underpaying of tax obligations related to cryptocurrency transactions. They have made cryptocurrency tax evasion a major enforcement focus with a number of initiatives.
At a Congressional hearing in April, IRS Commissioner Rettig told lawmakers that cryptocurrency tax underpayment is a key contributor to the government’s “tax gap,” which he said totals more than $1 trillion annually despite the fact that the latest published estimate is $441 billion for the years 2011-2013. White House officials have also stated that monitoring cryptocurrencies is one of the steps the Administration is taking to help curb cyber-attacks.
The Commissioner recently said in a Congressional hearing that the IRS needs more authority from Congress to regulate the cryptocurrency industry and to require more reporting on its users. Treasury Secretary Yellen echoed this position at a recent public event, explaining that there is an inadequate regulatory framework to deal with cryptocurrency issues. She said, “While there are several agencies that arguably have some ability to address this through regulation, I frankly don’t think we have a framework in the United States that is quite up to the task.”
Although there has been criticism about the lack of guidance on cryptocurrency issues, it appears that the primary focus of Treasury and the IRS currently is very basic in that they are targeting taxpayers who do not report transactions and do not pay tax at all. As early as 2013, there was a Government Accountability Office (GAO) report issued related to cryptocurrency-facilitated tax evasion, which identified multiple risks including the lack of third party reporting on the transactions and a lack of knowledge about how transactions and gains from cryptocurrency exchanged are taxed.
The IRS sent a clear signal of prioritized enforcement of virtual currency in July of 2018 when the LB&I Division launched a campaign targeting cryptocurrency. The IRS began an initiative to collect more data on cryptocurrency. In July 2019, they sent three types of letters to taxpayers related to potential non-reporting of virtual currency transactions (Letters 6173, 6174, and 6174A), which caused some taxpayers to file amended returns.
In the fall of 2019, a global effort to target virtual currency holders was made public with the Crypto Challenge of the Joint Chiefs of Global Tax Enforcement (the “J5”), which includes the revenue authorities of Australia, Canada, the Netherlands, the UK, and the US. There are several other information-sharing regimes in place to facilitate the sharing of data, including the US Foreign Account Tax Compliance Act (FATCA) and country-by-country reporting. In January of 2020, there was a Day of Action by the J5 with coordinated international enforcement actions against tax evaders. In the fall of 2020, James Lee, the new head of IRS Criminal Investigations, publicly stated his support for the J5 collaboration, saying that “the agency’s investment in cybercrimes and data analytics has positioned the IRS to be at the forefront of cases involving cryptocurrency.”
In March of 2021, Damon Rowe, the Director of the Office of Fraud Enforcement at the IRS, announced information about an IRS initiative called “Operation Hidden Treasure,” which is comprised of agents who are trained in cryptocurrency and virtual currency tracking, and who are focused on taxpayers who omit cryptocurrency income from their tax returns. It is a partnership between the civil office of fraud enforcement and the criminal investigations unit.
IRS Guidance on Cryptocurrency
The initial guidance from the IRS came in Notice 2014-21. The notice said that, for federal tax purposes, virtual currency is treated as property, not money, and that general tax principles applicable to property transactions apply to transactions using virtual currency. A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in US dollars, as of the date that the virtual currency was received. If virtual currency is used to pay for an item or otherwise exchanged for property the taxpayer has a taxable gain if the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis for the virtual currency.
Notice 2014-21 also provides that:
- Virtual currency received by an independent contractor for performing services constitutes self-employment income,
- A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property, and
- Payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property.
Despite the IRS focus on cryptocurrency, the 2014 guidance has not been updated.
IRS Form 1040 Questions on Cryptocurrency
Some routine tax forms now require information related to virtual currency. Tax returns are signed under penalty of perjury, and failure to disclose information on a tax return is punishable by up to five years in prison and a fine of up to $100,000 if convicted.
Filings for the 2019 tax year included questions on the 2019 Form 1040 Schedule 1 (used for reporting certain adjustments or additional income) that asked whether at any time during 2019, “Did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
For filings related to the 2020 tax year, the question was moved to the very first question on the Form 1040 after the taxpayer’s name and address. The existence of the question on the standard Form 1040 will prompt tax preparers to affirmatively ask the question of their clients, and an inaccurate answer could be used against a taxpayer by the IRS.
“John Doe” Summons
The IRS has also started using the “John Doe summons” on cryptocurrency issues. The “John Doe summons” is used to obtain the names of all taxpayers in a certain group that may have failed to comply with their tax obligations. For example, this type of summons was used in 2008 when the IRS initiated a program to find US taxpayers with Swiss bank accounts. A “John Doe summons” presents issues for affected taxpayers as well as cryptocurrency exchanges upon which the IRS serves the summons.
The concept is that the IRS knows, or highly suspects, that there is tax noncompliance related to cryptocurrency, but does not know specific names of taxpayers. They issue a “John Doe summons” to obtain the names of taxpayers who have accounts at the cryptocurrency exchanges. Once the IRS has the names of the taxpayers, they can then proceed with more traditional procedures, including initiating an audit or issuing a summons directly to the taxpayers for their returns.
This type of summons must be approved by a federal district court. On April 1, 2021, a federal court in Massachusetts did authorize the IRS to serve a John Doe summons on a digital currency exchange located in Boston. The IRS is also pursuing a similar action in California. These two cases show that the IRS is seeking broad information on taxpayers engaging in cryptocurrency transactions, and third party record keepers will have to comply. IRS Commissioner Rettig recently said,
“Tools like the John Doe summons authorized in the Circle case send the clear message to US taxpayers that the IRS is working to ensure that they are fully compliant in their use of virtual currency. The John Doe summons is a step to enable the IRS to uncover those who are failing to properly report their virtual currency transactions. We will enforce the law where we find systemic noncompliance or fraud.”
Cryptocurrency Tax Reporting
The new reporting regime outlined in the Treasury Report includes two new filings related to cryptocurrency transactions. The report states that the growth of virtual currency is a significant concern as it “already poses a significant detection problem by facilitating illegal activity broadly including tax evasion.”
The first proposed new filing uses the existing framework of Form 1099-INT, which requires financial institutions to report interest income paid to US persons in amounts of $10 or more. It expands the reported data to include “gross inflows and outflows on all business and personal accounts from financial institutions, including bank, loan and investment accounts.” The Treasury Report states that for purposes of the reporting regime, the term “account” includes those at “cryptoasset exchanges and custodians.” It should be noted that the IRS is already working on regulations to implement an information reporting regime for cryptocurrency exchanges under its existing statutory authority to require information reporting by brokers.
The second proposed new filing would expand the reporting of cash transactions to include cryptocurrency transactions. The proposal would require businesses to report the receipt of cryptoassets in certain transactions with a fair market value of more than $10,000.
In addition, the Biden Administration has proposed requiring the collection of data on foreign cryptocurrency investors active in the US. The Administration proposal would broaden the scope of third-party information reporting by brokers by including reporting on certain beneficial owners of entities holding accounts with the broker. Brokers, including entities such as US cryptoasset exchanges and hosted wallet providers, would be required to report information relating to certain passive entities and their substantial foreign owners when reporting on crypto assets held by those entities.
The proposal is intended to allow the US to share the information with other jurisdictions and to receive reciprocal information about US owners through a global automatic exchange of information regime. The effective date is for returns required to be filed after December 31, 2022, which suggests that brokers and crypto exchanges would have to track transactions starting on January 1, 2022.
The current Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, and FATCA reporting do not require reporting if the selling account holder is a non-US person, so this proposal to require reporting related to foreign owners of foreign passive entities is a major expansion of current reporting requirements.
The IRS still relies on Individual and Business File Systems that date back to the 1960s – the oldest in the federal government. Modernization funding would allow the IRS to address technology challenges and develop innovative machine learning that can be used to better identify suspect tax filings, for example, by comparing returns to similarly situated taxpayers and historical filings in a way that the current IRS system does not allow. These resources would also support efforts to meet threats to the security of the tax system, like the 1.4 billion cyberattacks the IRS experiences annually.
Regulation of Tax Preparers
In addition to the regulation of paid preparers and service improvements that would simplify tax filing, the President’s proposal includes additional sanctions for so-called “ghost preparers” who fail to identify themselves on the tax returns which they prepare.
Current Treasury and IRS enforcement efforts targeting high-net-worth individuals and cryptocurrency transactions are robust and will be continuously clarified as these issues remain a focus of the Biden Administration and Congress. The consequences of noncompliance for taxpayers can be serious, so it is important to understand the reporting obligations and the programs underway to ensure reporting and payment of tax obligations.
Taxpayers are advised to review this information about the Biden Administration proposals and the initiatives that have been undertaken by the IRS in order to ensure that they are aware of their compliance obligations and potential government actions related to meeting those obligations. If you have any questions about the information in this True Alert, please contact a member of your TPC engagement team.