Much has been made of the ways that crypto investors have been able to skirt existing tax rules to reap massive financial gains tax free. The underlying premise is that because of loopholes in tax laws, crypto investors are able to legally avoid taxes — as opposed to illegal tax evasion — and that only by fixing our laws to close those loopholes can we ensure that crypto holders pay their taxes.
But as I’ve written previously, this simply isn’t true. The line between tax avoidance and tax evasion is much muddier than commonly portrayed due to the existence of the economic substance doctrine, which preemptively disallows tax benefits for transactions without economic substance beyond lowering tax liability. Although the doctrine primarily applies to corporations, it also affects individuals’ transactions when they are “in connection with a trade or business or an activity engaged in for the production of income.”
When crypto investors engage in strategies like tax-loss harvesting, the economic substance doctrine (when properly enforced) prevents them from getting off scot free. Tax-loss harvesting is one tax avoidance strategy that utilizes the advantages our tax code gives to capital income by selling assets at a loss and then using those frontloaded losses to offset gains. While investors and corporations can engage in tax-loss harvesting using traditional financial assets and investments, the relative lack of crypto asset rules allows for more aggressive tax-loss harvesting; unlike traditional investments, which are subject to wash-sale rules whereby traders are barred from repurchasing the same assets for 30 days after selling them, crypto assets can be sold during dips and then immediately repurchased to reap the gains once the assets’ prices recover. Further, because crypto assets can be traded 24/7, traders don’t even need to wait for markets to open to sell and rebuy those assets.
But such transactions clearly fall under the economic substance doctrine’s prohibition on tax benefits for actions in connection with a trade or business or done to produce income. While this may seem counterintuitive, there is precedent for this interpretation of the doctrine; in 1987, the Supreme Court ruled in Commissioner v. Groetzinger that full-time gamblers are engaged in a “trade or business” and that the same is true of active traders. This covers both the most invested crypto traders, who may be properly understood as engaging in a trade or business, and casual crypto traders, who are transacting to produce income.
With adequate funding, the IRS may finally be able to resume properly and consistently enforcing the economic substance doctrine and ensuring against crypto-related tax avoidance and evasion. The bipartisan infrastructure bill currently making its way through the Senate includes additional reporting requirements on crypto exchanges and businesses that receive at least $10,000 in cryptocurrencies, but the bill no longer contains IRS enforcement funding after Republican negotiators rejected it.
Congressional Democrats must ensure that significant IRS funding makes it into the reconciliation package. The economic substance doctrine is a mighty tool to combat tax avoidance, but it is worthless without an IRS sufficiently funded and staffed to wield it.