5 Things Not To Do As Crypto Investor
Cryptocurrency taxes and accounting are very complex. In fact, over 95% of the cryptocurrency portfolios and tax returns we review have errors, incorrect tax interpretations or missed opportunities. To worsen this issue, most CPAs do not even have a proper understanding of cryptocurrency transactions needed to adequately interpret tax code sections realted to your portfolio.
I speak with hundreds of new cryptocurrency investors each year and have observed some common mistakes made from a tax or accounting perspective that costs investors significant money and time. We’ll go over the most common mistakes the top 5 most common mistakes to avoid to ensure you do not overpay in taxes or expose yourself to audit risk.
There are many crypto investors that still believe they can get away with not reporting or underreporting their cryptocurrency transactions. As we have seen the proliferation of DeFi and NFTs, many anonymous twitter handles online have assured people that the IRS and other authorities will not be label to track the transactions or associate a taxpayer’s identity with the transactions or wallet.
This is incorrect. The blockchain is an immutable, public ledger. The only factor that tax authorities must address is associating an identity with a wallet or exchange. The IRS can use a combination of reporting from centralized exchanges, reporting from other counties via partnerships like the J5, software such as chain analysis and other methods to prove that a taxpayer is not reporting or underreporting their transaction activity. Individuals and businesses attempting to evade taxes by not reporting or underreporting their crypto transaction activity are low hanging fruit for IRS audits.
Hold Future Tax Liabilities in Crypto
Each bull/bear cycle I see in the crypto markets leads to millions of taxpayers needlessly increasing their tax liabilities due to the IRS by 2x, 3x, 4x or even more due to one error. They fail to protect their tax payments from the volatility risk associated with cryptocurrency. This can sometimes bankrupt businesses or cost an investor their whole portfolio. That’s because many investors will generate income from cryptocurrency or capital gains from selling cryptocurrency but then hold the full amount of the income or gain in the crypto asset.
It is important to consider you tax liabilities monthly or quarterly to avoid receiving BTC, ETH or another cryptocurrency at a high fair market value only to then have it drop significantly in price before you liquidate the crypto to pay your tax liability.
For example, let’s take a company that has generated $4 million in income that they received in ETH when ETH was $4,000 per coin from an NFT sale. The approximate tax liability would $1.6 million. If this company is properly planning for taxes, when they generate the $4 million in income, they will immediately trade at least $1.6 million from ETH to USD or a stable coin to avoid volatility risk. When it’s time to pay taxes, if ETH drops to $2,000 per coin this company would already have liquidated the $1.6 million to cover their taxes before the price drop. If this company neglected to do this, then they would have to liquate double the amount of ETH to over their taxes. That means they would liquidate 800 ETH rather than 400 ETH to cover the tax lability due to the IRS.
Inaccurate Cost Basis Tracking
Whether your portfolio has gains or losses this year depending on your entry points and cost basis one thing is sure when it comes to tax reporting: documentation is key. Reporting taxes based on inaccurate calculations could result in penalties of up to 40 percent and tax courts place the burden of proof on the individual rather than on the IRS. It is imperative to have sufficient documentation to support all transactions you report, including accurate gains or losses, as well as proper cost basis assignments. Be sure that you save your historical trade activity from all the exchanges and wallets you have ever used. We suggest that our clients do this at least on a quarterly basis to avoid any issues retrieving documentation at year end.
Often, we’ll speak with investors that have not tracked their cost basis for several years or have tracked it incorrectly. Although, we can help you fix this issue at Camuso CPA, it’s important to stay up to date and keep your cost basis calculations as accurate as possible. This will ensure that you avoid compliance issues and minimize your taxes by tracking your tax character, cost basis and fees appropriately. Read our article tracking and deducing gas fees to learn more about how this applies to your cost basis and taxes.
Incorrect or Unnecessary Entity Structures
It’s common to see people establish entity structures including LLCs, Partnerships and S-Corporations in order to buy and sell cryptocurrency for tax purposes. All too often, this is done with proper tax planning with an experienced crypto CPA, sometimes without consulting a CPA at all. This can lead to significant tax issues that can lead to overpaying in taxes and compliance issues.
In some cases, it may make sense to establish a business entity depending on the nature of your business activities but in most cases it’s not advisable to establish entity structures for personally trading cryptocurrency. In cases where it is practical to have a business entity, lack of proper tax planning can still lead to tax and compliance issues if you do not properly manage this entity throughout the year. Read our article on staking and our articles on mining to learn more about entity structure considerations for these types of activities.
Trading Company, Friends or Family Funds Under Personal Accounts
It’s common to see people take crypto assets from their company and trade them under personal exchanges or wallets. This can create accounting and tax nightmares. It will be challenging and cumbersome to manually separate your personal and business transactions for accounting purposes. For tax purposes, you may run into tax reporting issues related to the treatment of your transactions and also may have exchanges incorrectly report your transactions via 1099s to the IRS due to how your registered for the exchange.
Be very careful to avoid commingling funds between your personal accounts and business accounts. For exchanges, you should have accounts personally set up using your social security number and separate accounts set up for your company using your employer identification number. For decentralized wallets, you should have separate wallets dedicated to personal and business use.
It’s also common to see individuals take funds from family or friends to purchase cryptocurrency on their behalf for various reasons. This is something that you should avoid doing. This can create accounting and tax nightmares. It will be challenging and cumbersome to manually separate your respective transactions for accounting purposes. For tax purposes, you may run into tax reporting issues related to the treatment of your transactions and also may have exchanges incorrectly report your transactions via 1099s to the IRS due to how your registered for the exchange. This can lead to overpaying in taxes and significant compliance issues.
Cryptocurrency taxes and accounting are very complex. No one wants to overpay Uncle Sam at the cost of your business or family’s finances. It’s important to plan in advance with an experienced crypto CPA when it comes to managing your cryptocurrency taxes and accounting. The mistakes above are the top five that I see but there are countless other issues that we’ll cover in future articles that you need to beware of.
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