The US income tax system relies upon voluntary compliance, meaning that you are expected to voluntarily report your income. This inevitably leads to the temptation to inaccurately report your income in order to reduce your tax burden. In the case of crytpocurrencies like bitcoin , which are untraceable in many respects, this temptation becomes almost overwhelming. However, you should be care to avoid the pitfall of thinking that you can get away with underreporting your income. Here are four way that the IRS can find out about your bitcoin transactions (others may exist).
First, your bitcoin exchange or payment processor may report your transactions to the IRS. This would be done with a Form 1099, which you’ve probably encountered at one time or another in a different context. However, it does not appear that bitcoin transactions are currently subject to the 1099 reporting requirements (although that will probably change). Thus, unless they voluntarily file a 1099 against you, it is unlikely that the IRS will receive a report of your bitcoin transactions. Note that they would need your social security number to file a 1099 in your name.
Second, your bank or bitcoin exchange might file a Suspicious Activity Report (“SAR”). US banks and bitcoin exchanges are required by FinCEN to file SARs for wire transfers that are “suspicious” and larger than $5,000 ($2,000 in the case of bitcoin exchanges). The meaning of “suspicious” is vague and highly discretionary. Out of an abundance of caution, many banks automatically treat all international transfer as “suspicious.” So, if you’ve sent or received a wire transfer of more than $5,000 to/from an international bitcoin exchange like Mt. Gox or BTC-e, you can be pretty sure that your bank has already filed a SAR against you (although they are prohibited from telling you if they did, so you’ll never know for sure). The larger and/or more frequent you SAR filings, the more likely they will become a legitimate red flag and trigger an investigation. Although FinCEN is generally concerned with money laundering activities, the IRS does have access to FinCEN filings and it is common for IRS special agents to participate in FinCEN investigations.
Third, someone can rat you out to the IRS, which happens far more often than you might think. The simple fact is that people get jealous, and if they’ve heard that you’ve made lots of tax-free money with bitcoin, they might get tempted to make sure justice is served. There’s also that nice reward the IRS will pay them for snitching.
Fourth, you voluntarily and accurately report your gains on your tax return. That might sound ridiculous to some people given the inherent anonymity of bitcoin, but there are some very rich people in prison right now who used to think the same thing about their Swiss bank accounts. The fact is that penalties for failing to report income are significant. This includes the possibility of criminal prosecution. You can also add to this the additional penalties for failing to report foreign financial accounts (discussed below), which can be even more severe.
At the end of the day, you have a decision to make. You can comply with the law and pay taxes just like everyone else, which is admittedly unpleasant. Alternatively, you can violate the law and hope that you don’t get caught. Maybe you will, maybe you won’t. If you are caught, though, the amount of money you’ll be forced to pay in penalties and interest will drastically exceed the amount you saved. That’s not to mention the possibility of a felony criminal conviction and a prolonged stay at Club Fed. Personally, I have seen the havoc wreaked on people’s lives by tax crimes and I would never want to be in their shoes. Neither should you.