Tax Refund

After a bit of a delay, Treasury has proposed regulations outlining who in the cryptocurrency industry is a “broker” and hence obligated to provide the IRS with information returns on customers’ cryptocurrency gains and losses.

The proposed rules appear to strike a good balance. There are many types of businesses involved in cryptocurrency, and not all are equipped to gather and report gross proceeds and basis information to determine gains and losses. However, the ecosystem is evolving quickly; narrow rules might force policymakers to quickly return to the drawing board and catch up to where the crypto market is going.

First, a quick refresher. In 2014, the IRS determined that cryptocurrencies that can be exchanged for real currency met the definition of property for tax purposes. That means each trade or transaction using a cryptocurrency token has tax consequences. The rapid growth in the crypto market prompted then-IRS Commissioner Charles Rettig to ask Congress for authorization to better target tax avoidance and evasion by crypto sellers and buyers.

Congress responded with language in the 2021 infrastructure law tasking Treasury to define which crypto firms should report customers’ gross proceeds and basis to the IRS, similar to how traditional brokers report stock sales on a Form 1099-B. The statutory language was admittedly broad, leaving industry concerned that Treasury and the IRS would cast too wide of a net.

So far, so good

At first glance, those major concerns have been avoided. Think of the crypto industry as having two important pieces: those who help customers make crypto trades, and those who keep the behind-the-scenes technology (blockchain) operating and approving appropriate trades. Concerned that Congress didn’t provide enough guardrails, industry worried that Treasury would target the latter.

Why would that have been a problem? Let’s look at crypto miners as an example. Most cryptocurrencies rely on mining, which requires a lot of computing power (and electricity) to put new tokens into circulation and validate transactions.

Despite their importance to the network, miners don’t have customer information available to them. Classifying them as brokers would have been a nonstarter. Treasury’s proposal recognizes that and instead focuses on the intermediaries that help customers navigate the budding crypto financial market.

Here comes the complicated part

The easiest thing for Treasury would be to focus on “centralized” exchanges, such as Coinbase. Because of the level of service and account management they provide, most everyone would agree they fit the bill as a broker and could handle 1099 information reporting for its users. Coinbase itself has already been adding tax compliance tools to its menu of services in anticipation of new regulatory requirements.

Although centralized exchanges are a good place to start, decentralized finance (DeFi) exchanges also allow users to conduct many of the same transactions, but with less help from the intermediary. Instead of managing trades more directly, DeFi platforms use built-in algorithms (e.g., automated market makers, or AMMs) to help individuals move crypto assets around.

Does DeFi make compliance more challenging? Absolutely. Impossible? No. The issue at hand is whether the government should require DeFi platforms to collect and report more information. Treasury decided that they should. As written, brokers required to assist with crypto tax compliance would include “an operator of a peer-to-peer or AMM trading platform.”

DeFi platforms will view this as a costly administrative burden. They’ll argue that their business model is inherently different than more centralized exchanges, so applying the same rules would be problematic.

It’s true that compliance would not be costless. But the counterargument is that centralized and decentralized platforms can both end up facilitating similar financial activities.

This isn’t a new problem in the tax world. The gig economy app DoorDash is not an employer like your favorite local pizza joint. But regardless of whether customers use the DoorDash app or place an order directly with the restaurant, someone needs to collect and remit sales taxes and track earnings of the people who make and deliver the pizza.

Policymakers should not ignore potential compliance costs, but they have to balance those with the benefits of having platforms provide information to improve compliance. If done right, the information helps both the taxpayer and the IRS.

There is another argument in favor of trying to answer the DeFi puzzle now instead of later. Last year saw the demise of several large crypto firms, prompting the value of the crypto market to nosedive. The total market value of cryptocurrencies has rebounded somewhat but remains well below its peak. And the biggest centralized exchange at the time, FTX, failed.

Could that make DeFi more attractive? It might. Either way, with continued innovation in crypto, it would be shortsighted to rely solely on centralized exchanges to provide informational returns. It makes sense to start mapping out how to handle compliance in the DeFi landscape now, rather than waiting until it becomes bigger and more diverse.

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