Tax Compliance for Digital Assets: Strategies for Solving Digital Asset Audits and Investigations

During the last half of 2024, I was honored to facilitate and moderate panels at three Federation of Tax Administrators (FTA) conferences on the topic of “Digital Assets from A to Z.” Each conference’s panel included experts from the civil and criminal offices of the IRS, as well as crypto experts from private companies that are assisting tax authorities in establishing expertise in this fast-evolving field. As evidenced by the strong attendance and audience participation at these panels, it’s clear that this is a timely topic. In today’s blog, I’ll share panel highlights and key takeaways, including the milestones, strategies, challenges, and collaborative efforts that define the modern approach to digital asset compliance and enforcement.

The Current Digital Asset Compliance Landscape

The surge in digital asset adoption, particularly cryptocurrencies, has presented unique challenges for tax authorities around the world. With the rapid evolution of blockchain technology and increasing participation in cryptocurrency markets, tax administrators are finding themselves in uncharted territory. Ensuring compliance and transparency in this dynamic space requires innovative strategies, robust partnerships, and continuous adaptation. I was surprised that very few, if any, state tax authorities have a campaign, initiative, or even a working group to address digital asset non-compliance. Experience indicates that non-compliance exists at the federal IRS-level; therefore, it clearly exists at the state level.  

The journey into the digital asset realm has been marked by significant milestones, underscoring the urgency of addressing compliance challenges. First, way back in 2014, the IRS issued notice 2014-21, stating that cryptocurrency was to be treated as property rather than currency for US federal income tax purposes. Another pivotal development in the compliance landscape has been the introduction of the “check-the-box” digital asset question on IRS Form 1040. Since 2019, this question has required taxpayers to disclose whether they have engaged in certain digital asset transactions. By creating an upfront compliance checkpoint, this requirement has provided the IRS with a powerful tool to identify taxpayers with potential reporting obligations and has significantly enhanced the ability to track digital asset activity. The “check-the-box” also signals that the IRS is serious about digital asset tax compliance. Over the years, The IRS and DOJ have had substantial success in rooting out foreign bank account non-compliance, in part due to the “check-the-box” requirements for reporting foreign bank accounts and Foreign Bank Account Reporting (“FBAR”) obligations.  

In 2023, the IRS issued a Request for Information on digital assets and proposed regulations aimed at improving gross proceeds and basis reporting. These initiatives sought to create a foundation for tracking and taxing cryptocurrency transactions. By 2024, the release of Draft Form 1099-DA signaled a strong commitment to addressing digital asset compliance at scale. The 1099-DA, barring any last-minute changes, should bring much needed transparency to the digital asset space. The lack of information reporting (1099’s, 1098’s, W-2’s, etc.)  generally correlates to a higher level of non-compliance – on the simple premise that if your income and earnings are reported to your tax authority, you are much more likely to report those amounts on your tax return. While the 1099-DA goes into effect in January 2025, it won’t be until 2025 tax returns are filed in 2026 that the true impact of this form will be felt.

Another strong signal of commitment by the IRS regarding digital assets is the establishment of the Office of Digital Asset Initiative. This office now acts as a centralized hub for expertise, resources, and training, ensuring that the agency is prepared to navigate technological advancements and emerging challenges.

Civil and Criminal Compliance Efforts

Civil Compliance

Educating taxpayers and employees remains a cornerstone of civil compliance efforts. Training programs have been designed to clarify the tax implications of digital asset transactions, ensuring that taxpayers understand their responsibilities and that enforcement personnel are equipped with the necessary knowledge. Outreach is a critical component in addressing compliance, particularly with respect to digital assets. For example, what percentage of digital asset holders belong to the younger generation that may lack the experience in dealing with tax return obligations?

While outreach is a critical component to compliance, audits are necessary for any effective tax non-compliance campaign. The use of John Doe Summons on various cryptocurrency exchanges like Coinbase, Kraken, and SFOX since 2016, has clearly been a source of civil audit lead development by the IRS. Other methods of audit case development in the digital asset space are likely the product of the IRS’s enhanced investment in technology and data analytics since much needed funding was received as part of the Inflation Reduction Act.  

Criminal Compliance

On the criminal enforcement side, investigating agencies such as IRS Criminal Investigation (IRS-CI) have intensified their focus on combating tax evasion, money laundering, and other illicit activities involving cryptocurrencies and other digital assets. High-profile cases, such as the Binance investigation, highlight the success of these efforts. By targeting mixers, unregistered exchanges, and high-risk stablecoins, enforcement agencies have made notable progress in mitigating crypto-related financial crimes. These initiatives demonstrate the importance of collaboration and innovation in addressing the complex web of illicit crypto activities.

IRS-CI has a well-established history of investigating the most complex and complicated cryptocurrency fraud cases. This dates back to the first Silk Road investigation in 2013-2015, which has been featured in a number of articles and books. More recently, cases such as the child exploitation case known as “Welcome to Video” was led by IRS-CI and is another example of IRS-CI’s investigative skill in the cryptocurrency space.  However, noticeably lacking in digital asset criminal compliance is criminal tax cases. Although current and prior IRS Commissioners and IRS-CI Chiefs have warned of the dire circumstances of tax non-compliance, there has only been one “pure” criminal tax case involving digital assets: Frank Ahlgren III, who in December 2024 was sentenced to two years in prison for failing to report capital gains on the sales of Bitcoin.

There is a saying in law enforcement that you “can’t investigate your way” out of a problem. This means, there are simply not enough investigative and DOJ resources for every violation of a federal crime. The US investigative strategy involving economic crime relies heavily on the investigation of high-profile targets and then the publicity that accompanies these cases. Publicity is a cornerstone of the deterrence necessary to prevent similar crimes from occurring. With this principle in mind, we will no doubt continue to see high profile federal cases investigated and prosecuted in the years to come.

Challenges in Crypto Enforcement

Despite advancements, digital asset enforcement faces numerous challenges. Technical obstacles, such as incomplete records, inconsistent data formats, and the lack of a standardized framework for digital asset reporting, continue to hinder compliance efforts. Furthermore, many taxpayers lack a clear understanding of their reporting obligations, creating gaps in compliance. The rules and regulations differ across the world.

Operational challenges are equally significant. Resource constraints, including staffing shortages and limited budgets, place a strain on enforcement capabilities. Additionally, the need for collaboration across multiple agencies complicates the enforcement process. To address these issues, tax authorities and law enforcement are leveraging technological innovations and fostering inter-agency cooperation to develop scalable solutions.

Collaborative Solutions: Public and Private Sector Partnerships

Key Roles of the Private Sector

The private sector has emerged as an indispensable partner in the fight for digital asset compliance. Companies specializing in Open-Source Intelligence (OSINT), blockchain analytics and crypto tracing tools provide critical technological capabilities that enhance enforcement efforts. By offering expertise in areas such as crypto lead development which may include whale trades, digital asset swaps, DeFi tracing, smart contract analysis and general risk assessment, private firms enable regulators to tackle complex investigations with greater precision and efficiency.

Public-Private Synergy

The synergy between public and private sectors extends beyond technology. Private entities often serve as a sounding board for tax authority and law enforcement strategies, offering insights that refine enforcement approaches. This collaboration has proven invaluable in streamlining investigations, reducing resource demands, and uncovering illicit activities more effectively. By working together, public and private partners create a robust framework for addressing the complexities of the digital asset ecosystem.

Through these partnerships, tax authorities and law enforcement agencies have significantly enhanced their resource allocation, investigative reach, and technical capabilities. The result is a more adaptive and effective enforcement framework capable of keeping pace with the rapid evolution of digital assets. This collaborative model not only strengthens compliance but also fosters innovation in the broader regulatory landscape.

The days of “build your solution” are behind us. In the time that it takes for a tax authority to build their own in-house technological solution to address an issue like digital asset non-compliance, billions of dollars in tax revenue have been lost. The speed at which money moves now occurs almost instantly, thanks to current technology and digital assets. Expertise exists in the private sector to immediately assist tax authorities and law enforcement with this challenge, and many agencies, including IRS-CI, have already embraced the benefits of private-public partnerships in successfully combatting many cryptocurrency scams.

State tax authorities could immediately benefit from the same playbook by leveraging public-private partnerships to the benefit of their citizens.  

The Three Stages of Digital Asset Compliance

Addressing crypto compliance requires a structured and adaptable workflow. There are at least three phases to be considered when developing an approach to digital asset compliance.

The first challenge is finding the non-compliance cases, or lead generation. OSINT (Open-Source Intelligence) has been very successful in uncovering critical leads such as taxpayer identities, wallet addresses, and transaction histories. This foundational step ensures that investigations are guided by reliable data.

Second, blockchain intelligence and investigation is used to enhance the lead by completing the taxpayer profile. By detecting risk indicators, such as interactions with mixers or privacy-focused assets, dark web marketplaces, and analyzing transaction patterns, investigators can build a detailed understanding of the taxpayer’s digital asset activities. This phase combines manual investigation with automated analytics to maximize accuracy.

Third and finally, consolidated transaction data is transformed into actionable reports showing actual financial gain. These reports provide a clear narrative of digital asset activity, supported by detailed visualizations and documentation that can be used in audits, litigation, or further enforcement actions.

These three factors are not an either/or proposition: to conduct a complete and comprehensive audit or investigation, you must have all three components to be effective. This workflow model has been applied across a wide range of compliance scenarios. From investigating high-value NFT transactions to uncovering cross-chain asset swaps, the process ensures that compliance and enforcement efforts are comprehensive and targeted. By leveraging advanced analytics and collaborative insights, agencies can identify patterns of non-compliance, mitigate risks, and uphold the integrity of the financial system.

Takeaways

The evolving landscape of digital assets demands constant vigilance and innovation. Key takeaways include:

• Education: Continuous training for taxpayers and compliance personnel is essential to bridge knowledge gaps.
• Collaboration: Strengthening public-private partnerships fosters innovation and enhances enforcement capabilities.
• Technological Evolution: Leveraging advanced tools simplifies investigations, reduces resource demands, and improves outcomes.
• Valuation Methods: Establishing consistent and reliable methods for valuing digital assets enhances transparency and compliance.
• Adaptability: A flexible compliance and enforcement framework ensures that tax authorities can respond effectively to emerging trends and challenges in the digital asset space. 

Conclusion

As digital assets continue to grow in complexity and adoption, proactive measures and strategic collaborations offer a blueprint for effective compliance and enforcement. By embracing innovation, fostering partnerships, and maintaining a forward-looking approach, tax authorities and their partners are well-positioned to navigate the challenges of the digital asset landscape and ensure the integrity of this dynamic ecosystem. This journey underscores the importance of adaptability, collaboration, and technological expertise in building a resilient framework for digital asset compliance.

For more on this topic, you can watch the recording of our 2024 webinar, Bringing Crypto into Compliance, in which IRS-CI’s Jarod Koopman discusses compliance efforts, emerging trends, and what’s next.