The 2008 invention of bitcoin, the world’s first cryptocurrency, revolutionized not only the concept of money, but how it can be exchanged.
Bitcoin is a form of peer-to-peer electronic cash with no central authority or middleman. The technology that allows bitcoin to be decentralized is blockchain, a digital ledger in which a permanent and immutable record is made of each transaction. (If you’re not familiar with crypto basics, this primer provides a good introduction.)
Traditional fiat currencies can be produced in unlimited quantities and are thus inherently inflationary. But the supply of bitcoin is mathematically limited by its underlying algorithm to never exceed 21 million units. This self-limiting supply feature has made bitcoin a hot investment, with its value increasing from effectively zero when it was introduced in 2009 to more than $25,000 per unit today.
An offshoot of the crypto revolution is the booming decentralized finance (DeFi) industry, which uses cryptocurrency and blockchain technology to manage financial transactions. DeFi is a blanket term referring to automatically executing protocols called “smart contracts” that don’t require middlemen or a centralized authority to function.
As such, DeFi is every bit as revolutionary as bitcoin itself. It offers an alternative to virtually all traditional financial services, including borrowing, lending, investing, insurance, and more. DeFi eliminates the need for intermediaries and gatekeepers and empowers individuals to transact business peer-to-peer.
Here’s a simple example. American banks currently pay about 0.6% interest in savings accounts. They then lend out this money at an average interest rate of 8.5%, resulting in a net profit of 7.9%.
But what if you could cut out the middleman – the bank in this case – and lend your funds directly to someone else and pocket the full 8.5%? (In some cases, less a modest trading fee.) You can, by making a crypto loan on a decentralized exchange (DEX).
This example is an oversimplification, because the interest rate you’ll receive on the loan could be substantially more or less than 8.5%. The important point, though, is that no one is standing in between you and the borrower to take their cut.
Naturally, Big Brother doesn’t like it when citizens under its thumb threaten its supervision of the financial system. This is especially true in the crypto arena. We documented a recent example where we showed evidence that Uncle Sam deliberately staged the demise of crypto-friendly banks in March 2023 in an effort to crush this industry.
As well, US regulatory agencies have attacked DeFi. Just last week, the Commodity Futures Trading Commission (CFTC) announced that it had settled charges against three DeFi firms. They were accused of various “failure to register” charges along with violations of the Bank Secrecy Act’s “know your customer” (KYC) provisions for not requiring customers to prove their identity.
The CFTC’s actions demonstrate the fundamental hostility Uncle Sam has against DeFi. Since DeFi’s purpose is to facilitate peer-to-peer interaction, efforts to force companies to act as gatekeepers hobble the entire concept.
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Another effort to reign in cryptocurrencies came in November 2021, when President Biden signed a 1.2 trillion infrastructure bill which requires “brokers” of “digital assets” to report information for transactions above $10,000 to the IRS. Conceptually, this is similar to the rules requiring that financial institutions that pay interest or dividends to investors to report these payments on Form 1099 to the agency.
To comply with this rule, federal law requires brokers to obtain the name, address, and Social Security number of their US customers. This sounds simple enough, but in the context of crypto, it’s not. To begin with, the law defines a “broker” as “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” This definition is obviously intended to cover centralized crypto exchanges like Coinbase – but many cryptocurrency transactions take place peer-to-peer, in some cases on a DEX.
As with most laws, the infrastructure bill left it up to federal agencies – in this case the IRS and Treasury – to come up with regulations as to how these rules would be enforced. And on August 25, we got the answer, in the form of proposed reporting rules for the parts of the 2021 law dealing with “digital assets.”
The rules define who a “broker” is and set out the requirements they must follow to comply with tax reporting rules related to cryptocurrency transactions. Brokers must report gross proceeds from sales of digital assets beginning on January 1, 2025. Reporting of adjusted basis and character of gain or loss is required for sales beginning January 1, 2026.
The proposed rules define a broker as:
Any person that in the ordinary course of a trade or business stands ready to effect sales to be made by others.
But the rules make no distinction between whether a trading platform is centralized or decentralized:
The requirement for information reporting on digital assets does not depend on the manner by which a business operates a trading platform.
This is nonsense, since the entire point of DeFi is to allow individuals to trade peer-to-peer, without a middleman. Thus, users of a variety of DEXs will need to provide those platforms with information such as their name, address, and Social Security Number. In turn, both centralized and decentralized exchanges will need to report gains and losses to the IRS on newly created Form 1099-DA.
And that raises another problem. Most DeFi platforms aren’t set up to comply with these requirements. Setting up the infrastructure needed to comply with the new rules will be a time-consuming and expensive process for anyone defined as a broker. That reality will stifle innovation in the DeFi market. Many DeFi companies will need to set up internal tax compliance programs or simply withdraw from the US market. Naturally, that makes no difference to Uncle Sam.
The good news, if there is any, is that the proposed rules exempt broad categories of market participants from these rules. One exemption covers cryptocurrency miners, for instance, who generate income by using computers to perform complex mathematical calculations that verify transactions on a blockchain.
A comment period ending October 30 gives market participants the opportunity to provide feedback on the new rules. The easiest way to comment is through the Federal eRulemaking Portal at www.regulations.gov. Refer to IRS and REG-122793-19 if you post a comment.
We’re hoping that Congress acts to short-circuit the new rules by repealing the broker reporting provisions in the 2021 infrastructure bill. Texas Senator Ted Cruz has introduced a bill that would do just that.
In the meantime, if you’re a crypto investor, we suggest getting your house in order to avoid a possible confrontation with the IRS. The agency has ramped up investigations in this area as it believes that US taxpayers have evaded billions of dollars of tax by failing to report profits in crypto transactions. Protect yourself by hiring a crypto-savvy tax professional who can make certain you file all required forms and pay the correct amount of tax.
