Do you have undisclosed crypto? If so, it’s time to decide your future

When Bitcoin and other cryptocurrencies first burst onto the scene, one of the major claims was that crypto was “untraceable’’ and the “perfect tax haven.” Unfortunately, those who bought into this mythology are now finding themselves forced to make a decision about their future: Do they get onside and act smarter, or do they continue to stick their heads in the sand and try not to get caught by tax authorities?

THE DEATH OF SECRECY

Over the past year, any concept of secrecy in crypto evaporated. The most public example occurred when authorities disclosed that they had recovered the ransom paid in Bitcoin in the Colonial Pipeline ransomware case. When this occurred, the horrified cryptocurrency enthusiast community immediately started talking about ways of hiding their crypto activity with techniques such as “mixers” and more secure cryptocurrencies, such as Monero, Zcash, Dash, Horizen, Verge and Beam.

A crypto mixer or Bitcoin mixer is an online platform that will mix an owner’s coins with those of other owners or with previously cleaned coins.

The fantasy that mixers are a magic bullet imploded in August when Larry Dean Harmon of leading mixer Helix pleaded guilty to money laundering charges. Those who have used mixers should take note of the fact that Harmon has entered into a plea agreement. It doesn’t take much imagination to suspect his detailed records of Helix transactions are being used as a bargaining chip to try to reduce a potential 20-year prison sentence. Of course, Helix is not the only mixer that authorities are targeting.

Most of the other supposedly secure cryptocurrencies suffer from the fundamental flaw that “someone has a record of the transaction” and that someone can be put in the same position as Harmon. Monero tries to get around this problem by using “ring signatures” and stealth addresses. Advertising these features has turned it into the most popular of the secure cryptocurrencies. Many users believe that these features will bring back crypto’s promised “cloak of invisibility.” The problem is that Monero isn’t really that secure. Those who believed the hype and used the product need to understand that their prior transactions will be uncovered.

WHAT IF I PUT MY CRYPTO IN A COLD WALLET?

Then there are those who have decided to “go dark” by placing their cryptocurrency in cold wallets and hiding them. Aside from the inability to reap the benefit of their crypto holdings, let me point out a few fault lines in this approach.

First, remember that you bought your crypto from somewhere or were awarded it from mining activities. Each crypto coin is registered on the blockchain. While the owner of that specific coin may not be known, the question can be triangulated and then answered by tax authorities in a number of ways:

• If you purchased a Tesla or other product or service with crypto;

• If you purchased crypto from an exchange. That exchange is now giving tax authorities whatever information (such as an IP address) they have about that purchase under either a John Doe summons or new regulations;

• If you traded one crypto coin for another on an exchange, the exchange will also turn over information on that trade;

• If you ever bragged online, to a former partner or to a friend about your crypto activities, all of these people are now motivated to collect a large whistleblower award to turn you in;

• If you used your cryptocurrency as collateral for a loan. While the loan may not potentially be a taxable event, the identities of the borrower and the owner of the crypto collateral are recorded by the lender; and

• If you posted a TikTok showing off your ride or crib and can’t explain how you paid for these extravagances in a lifestyle audit!

WHAT DO I DO NOW?

With the myth of anonymity exploded, those with undisclosed cryptocurrency are face a serious decision, with two paths that can be taken.

Path A: Condemn yourself to playing hide and seek with a tax authority that has unlimited time and resources and is joined globally by other tax authorities who can also out you; or

Path B: Retain expert professional advice to:
            a) Prepare a tax-efficient disclosure to tax authorities to bring yourself in compliance; and
            b) Organize so as to minimize or eliminate future tax liability.

There are both domestic and international tax strategies worth exploring fully. Which strategy or combination of strategies is most appropriate will be determined by the crypto owner’s individual circumstances and approach.

HOW DO I EXECUTE PATH B?

The key to minimizing the tax paid to come into compliance is the fact that the taxation of cryptocurrency is still a relatively new concept both for taxpayers and tax authorities. This provides some opportunity to claim lower potential liability than may be available in the future when the tax rules become more mature.

The correct procedures relating to voluntary disclosures are complex and vary significantly between jurisdictions. However, complexity is not a reason to wait as the fiscal ramifications of not doing a timely voluntary disclosure properly can be significant. For both of these reasons, it’s critical that the individual seeks and follows the advice of expert tax counsel.

After becoming tax compliant, the correct domestic solution to become more tax efficient depends upon the jurisdiction to which you’re subject. Some jurisdictions, such as Portugal, currently don’t include cryptocurrency value increases in their definition of taxable income. Other jurisdictions look at how long you held the particular cryptocurrency before engaging in a taxable event, such as a sale or trade, or the frequency of your trading activity.

Domestic solutions depend upon taking advantage of applicable rules. This includes qualifying for the reduced rates applied to long-term capital gains, and avoiding being defined as a “trader” subject to ordinary rates. Other strategies, such as wash sales, may be possible, but it’s worth noting that both the U.S. and the UK are looking to ban this strategy. The changing rules on wash sales illustrate a fundamental problem with any domestic solution — the government often moves the goal posts without much notice.

As a result of this domestic legal volatility, having an international strategy either for immediate implementation or future insurance is increasingly attractive. This is especially true for those involved in the crypto space as their operations are completely location-independent. As with domestic solutions, an international strategy involves first putting together a backup plan of alternative citizenships and/or residences. An effective backup plan needs to take into account the individual and their family’s personal and business requirements and preferences. It also needs a “fire escape” component that allows the individual to escape their current high tax situation and migrate to a zero- or low-tax situation — all without sacrificing their quality of life.

As with voluntary disclosures and domestic planning, designing and building an international strategy is not a do-it-yourself project. Nor is it something that can be put together by a commission-driven salesperson flogging a particular citizenship or residence product. Success or failure will depend upon retaining advisers who are well-versed in:
            a) How best to leave your current tax jurisdiction;
            b) how best to enter your new country of residence in a tax-efficient manner; and
            c) how to select the appropriate residence and/or citizenship statuses that are necessary to implement your departure and relocation.

The requirement for expert guidance is especially important for U.S. citizens, who are subject to citizenship-based taxation. Despite a great deal of nonsense on Twitter and Reddit, U.S. liability doesn’t change simply through the acquisition of an alternative residence or even citizenship.

NOT DECIDING WHETHER TO ACT IS MAKING A DECISION

No matter which tax jurisdiction you’re currently in, it’s worth recognizing that the tax authorities are coming after you with guns blazing. The sooner you move beyond denial, the more actions you can take to make your future bright.

Those who have large undisclosed holdings need to get their house in order before the tax authorities are aware of them. Once the authorities have their name, their options narrow considerably. However, with proper planning, individuals can not only come onside, they can also legally organize themselves to reduce or even eliminate future tax liability on their crypto activity.

If you’ve read this far but still aren’t convinced that tax authorities are capable or motivated, I suggest that you take some time to review tax authority efforts. If you are still hesitant, then I wish you luck — because you’re going to need it.

[More: 3 steps to prepare wealthy clients for higher tax rates]

David Lesperance of Lesperance & Associates is an international tax and immigration adviser.