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Can I Face Tax Penalties for Mistakes Made with Bitcoin?

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    The allure of Bitcoin as a potential next step in payment methods and systems can blind even sophisticated individuals to the tax obligations that might arise due to their use. Unfortunately, individuals who engage in financial and other transactions without first considering the tax implications and consequences of such actions are likely to make mistakes and errors. These mistakes and errors often open the door to an audit and facing significant new tax liability, fines, and penalties. In extreme situations, the taxpayer may be accused of committing tax crimes, like tax evasion, that carry a federal prison sentence.

    Failure to Handle Bitcoin Tax Obligations Can Result in Punishment

    The IRS is targeting Bitcoin transactions and assets due to the potential for abuse by taxpayers that is presented by this technology. In fact, the IRS is well aware that some taxpayers may be attempting to use Bitcoin to conceal income and assets thereby illegally reducing their tax liability. As such, the IRS has taken a particularly aggressive stance against potential Bitcoin-based tax fraud announcing that penalties can apply to all taxpayers – even those taxpayers who only engaged in noncompliance prior to the release of IRS guidance on March 25, 2014.

    Bitcoin Errors Can Result in Tax Accuracy Penalties under IRC 6662

    26 U.S. Code § 6662 – Imposition of accuracy-related penalty on underpayments, states that for certain underpayments of tax an additional penalty of up to 20 percent of the unpaid liability can be assessed. For instance taxpayer negligence, mistakes regarding valuation of property or liabilities, and undisclosed foreign financial assets are all grounds where § 6662 authorizes an additional penalty.

    Furthermore, a substantial underpayment of tax can also trigger additional penalties under Section 6662. A substantial understatement of tax occurs when there is an understatement of tax of exceeding the greater of exceeds the greater of 10 percent of the tax required to be shown on the return for the taxable year, or $5,000.

    Failure to Report Virtual Currency Transactions Can Also Result in Punishment

    Since Bitcoin is characterized as property for tax treatment purposes, it is possible to realize capital gains and losses. Therefore, making and maintaining adequate records that track the value of the asset over time are essential to any adequate tax handling. Taxpayers who fail to make and keep these records may be subject to punishment under IRC Sections 6721 and 6722.

    IRC § 6721 sets forth the penalties and punishments for taxpayers who fail to file correct and accurate informational returns.  Furthermore, §6722 sets forth the punishments that can be imposed when a taxpayer fails to furnish correct and accurate payee statements. While the foregoing penalties can be imposed for Bitcoin tax mistakes, the consequences faced can often be mitigated through a show of reasonable cause.

    The IRS May Advance Tax Evasion Charges for Bitcoin Errors

    If your activities and practices show a pattern of noncompliance, willfulness, or other signs of tax fraud it is possible that your matter may be referred to IRS Criminal Investigations. You may end up being charged with criminal tax evasion. As a felony, tax evasion carries a federal prison sentence along with harsh financial penalties. Even if you did not intend to commit tax evasion a series of unexplained transactions, misstatements, and other potential indicators of fraud may convince the auditor that a closer look is required.

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