The Ultimate Guide to IRS Audits

If you fail to adequately respond to the IRS’ letters or fail to amend improperly filed virtual currency earnings, it is likely that the IRS will initiate an audit.

Although audits may be conducted both via mail and in-person, it is likely that the IRS will conduct your virtual currency audit via mail. The audit process “officially” begins when the IRS issues you an audit request.

While audit requests can vary in content, there are several preliminary questions the IRS will ask about your virtual currency income. You can expect that they will ask you to disclose all accounts, including:

• Wallet ID and blockchain addresses; and
• any digital currency exchanges utilized, along with their respective user IDs, email addresses, IP addresses, and account numbers relating to those platforms.

In addition, the IRS will most likely require detailed information about any virtual currency transactions, including:

• The date and time each unit of virtual currency was acquired.
• The basis and FMV of each unit at time of acquisition.
• The date and time each unit was sold, exchanged, of otherwise disposed.
• The FMV of each unit at the time of sale, exchange, or disposition, and the amount of money or the FMV of property received for each unit, and;
• An explanation of the method used to compute basis relating to the sale or other disposition of virtual currency.

If you are unable to provide the IRS with specifics of when your cryptocurrency or NFTs were purchased or sold, the IRS will assume that you disposed of your virtual currency in chronological order, beginning with the earliest unit of cryptocurrency or NFTs purchased or acquired.

This default method is known as the first in, first out (“FIFO”) basis. See Internal Revenue Service Notice 2014-21. The FIFO method has several drawbacks, especially if you’re a high-volume cryptocurrency user.

The FIFO method isn’t recommended during times of inflation or fluctuation, as it does not accurately reflect production costs.

While the IRS will assume you sold your cryptocurrency or NFTs at an inflated rate, it will not take the same consideration into account when calculating your production costs.

The result? FIFO makes it appear as though you earned more than you actually did. For this reason, you will most likely incur larger tax liabilities- which is why the IRS prefers to utilize this particular method.

It is imperative that you maintain organized transaction records at all times. Organized records are the key to ensuring that you’re accurately reporting your virtual currency earnings.

It is also important that you respond by the date stated on your audit notification letter. Failure to do so may result in the IRS issuing you a tax penalty by default.

Generally, the IRS can include returns filed within the last three years in an audit.

However, it is highly unlikely that the IRS will review three years of records, especially since the IRS has only recently begun sending letters and issuing virtual currency tax directives.

WHAT HAPPENS WHEN I SEND MY RESPONSE TO THE IRS?