Will DeFi be taxed? The IRS holds a hearing

Author: Matthew Lee, OKLink Research Institute

On November 15, Beijing time, the U.S. Internal Revenue Service (IRS) held a highly anticipated hearing to discuss expanding the tax scope of cryptocurrency assets. The hearing covered several key topics, including user privacy, the scope of crypto entities required to report transaction information, the inclusion of stablecoins, the application of proposed regulations to participants in decentralized finance (DeFi), and the reporting of wallet addresses.

The rapid development of DeFi has made it a focal point for regulators. According to Barclays research, the cryptocurrency tax gap is at least $50 billion. This initiative targets the vague definitions surrounding DeFi projects, the lack of historical taxation, the absence of experience in addressing on-chain transactions, and the challenges posed by other entities impersonating DeFi entities, prompting the IRS to attempt to ensure tax transparency and integrity by incorporating it into the regulatory framework.**

The main focus of the hearing was on the definition of "broker." According to proposed regulations established in August, the definition of a broker could potentially be expanded to include "digital intermediaries that directly or indirectly affect the sale of digital assets," which would directly encompass DeFi, non-custodial wallets, and wallet developers within the broker category. Brokers would be required to be responsible for the following:

• The taxpayer's name, address, and taxpayer identification number;

• The name, type, quantity, date, and time of the digital assets sold;

• The total proceeds received by the seller from the sale (including exchange and on-chain earnings);

• The total proceeds from transaction fees paid to the broker;

• Knowledge of the wallet address from which the seller transferred digital assets;

• On-chain sales or transactions into accounts, along with transaction identifiers or hashes related to the sale.

In simple terms, the IRS requires decentralized projects that rely on code, such as Uniswap, Sushi, and Metamask, to conduct KYC for all users, including tracking exchanges and on-chain transactions, as well as on-chain addresses, and to have a clear understanding of users' on-chain transaction activities and earnings.

Although the hearing faced public criticism, there are existing issues in the current market: 1. The significant increase in trading volume on decentralized exchanges; 2. The inability to track fund transfers from non-custodial wallets; 3. The increase in illegal activities due to private wallets (lacking third-party reporting); leading many experts in the market to believe that expanding the tax scope is inevitable, with the formal bill expected to be introduced in 2025.

What Impact Will Expanding the Tax Scope Have?

Users

In addition to reducing certain revenues, users will also face complicated data processing and paperwork. The provisions in the 2021 Infrastructure Investment and Jobs Act had previously instructed the IRS to implement new rules for cryptocurrency brokers. If the tax scope is expanded, digital brokers must report the taxpayer's Cost Basis, and the complexity of Cost Basis will pose more challenges for brokers, taxpayers, and the IRS. Taxpayers have two options for calculating Cost Basis:

1. First in, First out (FIFO, default): If you purchased Bitcoin at prices of $1,000 and $2,000, and then sold it at $4,000, FIFO assumes you sold the portion of Bitcoin purchased at $1,000;

2. Specific Identification: The specific identification method allows taxpayers to choose which digital assets to sell, enabling selective minimization of tax burdens, but requires taxpayers to clearly identify and track each transaction.

Based on the specific identification aspect, taxpayers need to delve into not only exchange records but also on-chain transaction records that can be traced back several years, marking specific Bitcoins in their intended inventory for sale, even if entrusted to a broker, they must identify the specific assets they wish to sell within on-chain or exchange history.

Simple FIFO may lead to additional taxation because the U.S. tax rates apply both long-term and short-term. Short-term rates apply to holdings of less than one year and are taxed at progressive rates, while long-term rates apply to holdings of over one year, where even the highest tax bracket for long-term rates only requires a 20% payment, while short-term requires 37%.

The IRS also acknowledges that collecting crypto taxes will create a massive amount of paperwork for them, as the vast amount of on-chain data could increase the 1099-DA forms for 13 to 16 million taxpayers by 800 million. Currently, brokers do not have the capacity to support the identification of specific transactions, and users can only rely on systematic learning of basic tax knowledge and using on-chain data tools to track and record transactions, transfers, and holdings of digital assets for targeted tax reporting.

Industry

Taxation requires complete transaction records to calculate Cost Basis, capital gains, fair market value, etc., but tracking asset changes across exchanges, wallets, and decentralized protocols is a highly complex task, making it difficult for the IRS to directly produce tax reports. According to relevant agencies, there are over millions of cryptocurrency investors whose tax reports are inaccurate.

IRS discloses cryptocurrency tax investigation methods; Source: Cointracker

In the future, commercial institutions or tax authorities will rely on on-chain data and centralized data to establish more intelligent automated tax reporting systems similar to TurboTax and H&R Block, integrating on-chain records including buying, selling, airdrops, forks, minting, swaps, and gifts, while such a system's tax reporting mechanism would result in a significant amount of public information being disclosed, undermining the industry's ideal of "decentralization."

Public Opposition

Thousands of people have raised objections to the hearing. Most believe that such excessive regulation will infringe on personal privacy rights and harm individual freedoms. This concern also reflects public worries about government overreach, arguing that regulation should protect citizens' basic rights while maintaining social order. Congress has previously attempted to define intermediaries to include "any decentralized exchange or peer-to-peer market," but it was ultimately rejected. Now the IRS is reinterpreting the definition of "broker" using language similar to that of intermediaries, exceeding the statutory definition, leading to public skepticism about the potential violation of administrative law.

In my view, taxing DeFi is unrealistic, as over 95% of projects in the market do not generate positive cash flow and are in very early and fragile stages; taxation would impose an additional burden on DeFi projects. Expanding the tax scope (to non-custodial wallets) will also exert tremendous pressure on the market. After President Biden increased capital gains taxes for the wealthy in 2021, Bitcoin experienced a significant drop. If a new tax system is implemented, expanding the scope to on-chain assets will lead to more users engaging in tax-loss trading, selling for profit before officially paying taxes to reduce tax liabilities.

Taxation still has a long way to go, involving multiple government agencies, and there are currently many ambiguities: for example, whether stablecoin transactions need to be reported and how to confirm non-financial assets. The Vice President of Tax at Coinbase stated during the hearing that "reporting taxes without gains or losses (including stablecoins) will lead to a large number of low-value reports." A senior advisor at the Blockchain Association also stated that the proposal is too broad, leaving decentralized projects with two choices: 1. Abandon decentralized technology; 2. Move away from the U.S.

References

IRS Releases Proposed Regulations on Reporting And Income Taxation of Digital Assets:

https://www.forbes.com/sites/matthewerskine/2023/08/28/irs-releases-proposed-regulations-on-reporting--income-taxation-of-digital-assets/?sh=3cc1fccd3d70
The IRS Is Making Crypto Compliance Impossible：

https://www.coindesk.com/consensus-magazine/2023/11/13/the-irs-is-making-crypto-compliance-impossible/?gl=1*11hrgdu*up*MQ..*ga*MjA0MTAzNDMyOC4xNzAwMDEwNzI4*ga_VM3STRYVN8*MTcwMDAxMDcyNy4xLjAuMTcwMDAxMDcyNy4wLjAuMA..

A Comprehensive Overview of U.S. Cryptocurrency Taxation: https://www.ccvalue.cn/article/1240835.html
How to Prepare for Virtual Currency Tax Reporting in the U.S.:

https://8hut.com/581
Proposed tax laws will chase DeFi out of the US: https://www.dlnews.com/articles/regulation/proposed-us-tax-rules-unworkable-defi-and-nft-industry-says/