In May 2024 the IRS added a section to its Fraud Handbook devoted to digital assets: IRM 25.1.2.11, “Digital Asset Fraud.” It is written for IRS employees. It tells them what to look for in a crypto case that might be more than a mistake.

It is also public. Anyone can read it. If you have crypto history you are worried about, this is the list the examiner will be holding.

The framing: crypto is not itself suspicious

The section starts with a sentence worth quoting: “While the use of digital assets is not itself an indicator of fraud, there are indicators of fraud that are specific to digital asset cases.” It also says the general indicators of fraud in IRM 25.1.2.3 apply to digital asset cases, because digital assets can be used in many of the same ways as other assets.

And it notes that digital asset subject matter resources are available to help IRS personnel with blockchain analysis and digital asset tracing.

And at the end of the list, the IRM cautions that an indicator “serves as a sign or symptom,” and that “no one indicator of fraud is determinative that fraud is indeed present.” If an examiner identifies indicators, the IRM directs a referral request for a consultation with a Fraud Enforcement Advisor.

Unreported income indicators

IRM 25.1.2.11.1 lists these examples relating to unreported income:

  • Intentional failure to report a substantial portion of digital asset transactions over multiple years despite knowledge of a reporting requirement.
  • Reporting digital asset activity reflected on an information return but intentionally failing to report transactions for which no information return was received or filed.
  • Reporting activity at some exchanges but intentionally failing to report activity at others.
  • Claiming income tax treaty positions with no real connection in order to exempt gains.
  • Soliciting payment in digital assets to evade reporting requirements.
  • Using un-hosted wallets to store digital assets in order to avoid reporting requirements.
  • Intentionally answering “No” to the digital asset question despite knowing the true answer.

The second and third items deserve attention in the 1099-DA era. Reporting only what a broker reported, and leaving off the self-custody trades and the offshore exchange, is exactly the pattern the IRM describes. See Form 1099-DA effective dates and the digital asset question.

Expense and deduction indicators

Examples relating to expenses or deductions:

  • Overstating digital asset cost basis to reduce gain or increase loss.
  • Overstating digital asset valuation to increase charitable deductions.
  • NFT wash trading or self-dealing to generate artificial losses.
  • Fictitious or substantially overstated mining business expenses.
  • Intentionally miscategorizing personal digital asset expenditures as business expenses.

Overstated basis is the big one for most investors, because the IRS often cannot see basis on information returns. It also extends the statute of limitations: IRC 6501(e)(1)(B)(ii) treats a basis overstatement as an omission from gross income for the six-year rule. See transferred-in crypto and basis.

Books and records indicators

Examples relating to books and records:

  • Intentional failure or refusal to provide complete digital asset records to a preparer or compliance employee after repeated requests.
  • Submitting altered or false digital asset records.
  • Keeping multiple sets of books for a business that accepts digital assets, or keeping no records at all of digital asset activity.
  • Using fictitious valuation methods for digital asset income or expenses.
  • Intentionally omitting digital asset transactions from books and records.

IRC 6001 requires every person liable for tax to keep the records the IRS prescribes. In a crypto exam, records are the whole case. See the crypto IDR guide.

Conduct indicators

Examples relating to taxpayer conduct:

  • Owning or using an address with direct receiving exposure from a scam, darknet market or other high-risk address or entity.
  • Using digital asset kiosks to convert significant cash into digital assets, or digital assets into cash.
  • Converting physical assets to digital assets in anticipation of, or in response to, IRS actions.
  • False statements about the location or use of digital assets to preparers or compliance employees.
  • Peel chain transactions.
  • Chain hopping to rapidly move assets between blockchains to obscure their source and use.

Concealment indicators

Methods of concealment specific to digital assets:

  • Direct sending or receiving exposure to mixers or tumblers.
  • Use of Monero, Dash, Zcash or other privacy coins.
  • Use of exchanges or services with inadequate or no KYC and AML procedures.
  • Holding exchange accounts in nominees’ names where the taxpayer is the beneficial owner.
  • Use of CoinJoin or other obfuscation techniques to avoid reporting requirements.

FinCEN data is part of the toolkit

IRM 25.1.2.11.3 tells IRS personnel developing a fraud case to use research through the Financial Crimes Enforcement Network Query system. It says reports may show a taxpayer purchasing physical assets with digital assets or conducting suspicious digital asset transactions identified on Suspicious Activity Reports, and that SAR narratives may contain wallet addresses or transaction hashes that can be used to trace activity.

In plain terms: if a financial institution flagged your activity, an examiner developing fraud may see it.

How examiners find these indicators

The IRM is direct about sources. After listing the unreported income indicators, it notes that evidence can be obtained “through an interview with the taxpayer and/or return preparer, blockchain analysis, internal research, or review of taxpayer-provided (or summonsed) financial records.” See IRM 25.1.2.11.1.

Notice the first item. Interviews. Many indicators, such as false statements about where assets are, or knowledge of the reporting requirement, are established by what taxpayers say. That is one reason I do not let clients with any exposure sit for an unprepared interview.

Notice the second item too. Blockchain analysis. Activity on public blockchains can be traced, and the IRM points examiners to internal resources for exactly that. The idea that self-custody makes activity invisible is not one the IRS shares.

Innocent explanations, documented

Many people with crypto history will recognize one or two items on this list in their own past for reasons that have nothing to do with taxes. A hardware wallet bought after an exchange hack. A privacy coin bought as a speculative investment. A kiosk used once because it was convenient. An account at an offshore exchange opened because a token was only listed there.

Explanations like those carry weight when they are specific, consistent, and supported by documents created at the time. They carry much less weight when they first appear in the middle of an examination. If an item on the list describes something you did, write down why now, gather what supports it, and keep it with your tax records.

And remember the list is a starting point for the IRS, not a conclusion. An examiner who sees an indicator still has to develop facts, consult a Fraud Enforcement Advisor, and, if fraud is asserted, prove it by clear and convincing evidence under IRC 7454(a) and Tax Court Rule 142(b).

What to do with this list

Read it honestly against your own history. Most crypto taxpayers will find nothing on it, or find an item with an innocent explanation, such as a privacy-focused wallet used for security rather than concealment. Document that explanation now.

Then check the reporting side. Most of the indicators only matter when paired with unreported income or inflated deductions. If every year was reported correctly, an unusual wallet or a privacy coin purchase is a curiosity, not a case.

If you find several items that describe your conduct, especially alongside unreported income, stop and talk to a lawyer before you file, amend or talk to the IRS. Indicators are how civil cases become fraud cases, and fraud cases carry the 75 percent penalty under IRC 6663 and an unlimited assessment period under IRC 6501(c)(1). See the civil fraud penalty. Those conversations should be privileged.