President of Open Source Ventures: The IRS should provide free tax reporting tools for DeFi users

Author: TaxDAO

The IRS is moving towards providing free software services to taxpayers, as evidenced by the direct filing pilot program being implemented in 13 states starting in 2024. This program allows taxpayers to file directly with the IRS with the help of software similar to Turbo Tax.

For decentralized finance (DeFi), the IRS should use open, traceable, and tamper-proof public blockchain data to provide taxpayers with free tax assistance regarding their profit and loss and cost basis reporting information. This would eliminate the need for DeFi protocols to collect personal user data and submit 1099 forms to the IRS based on recently proposed cryptocurrency broker rules.

IRS Proposal

In August 2023, the U.S. Department of the Treasury and the IRS released a proposed rule defining the term "broker" in the context of digital assets. The classification of brokers includes not only centralized exchanges like Coinbase that directly execute trades but also individual software developers, self-hosted digital wallets with exchange connections, and decentralized software protocols that facilitate (directly or indirectly) the transfer or trading of digital assets.

As of the writing of this article, the proposal has received over 120,000 public comments, indicating the level of controversy surrounding the rule. "The rule creates a massive personal identifiable information honeypot."

The proposed rule identifies parties that facilitate (directly or indirectly) or effectuate (indirectly) the transfer and trading of digital assets. These parties include:

• Providing access to protocols

• Providing automated market maker systems

• Providing services to discover the best buy and sell prices

• Providing self-hosted wallets with exchange functionality, enabling access to decentralized blockchain trading platforms

• Providing internet access services, which may include web browsers and internet service providers.

As noted in Coinbase's comment letter regarding the proposed rule, these parties do not directly engage in digital asset trading within the authority granted by Congress.

Not Fit for Purpose

The Treasury and the IRS are attempting to "bolt on" IRS-1099 reporting requirements designed for another era, based on paper, to individuals and groups that are unorganized and do not operate like intermediaries or brokers. If a staggering number of parties that do not meet the definition of a broker (98% of which are small businesses, according to the Treasury and IRS data) are required to collect personal information, protect that information, and transmit it to the IRS, then the rule would create a massive personal identifiable information honeypot for malicious hackers.

The IRS does not have a good track record of protecting taxpayer information. In 2016, the IRS acknowledged that over 700,000 social security numbers and other sensitive personal data were stolen from the agency's systems.

Trader Ken Griffith's tax data was leaked by the IRS, and he pointed out in a lawsuit that the IRS had been warned for a decade by the Treasury Inspector General for Tax Administration that the agency's "number one major management and performance challenge area" is data security. According to The Wall Street Journal, "The Treasury and the IRS seek to improve paper IRS-1099 reporting requirements designed for another era." There is no better measure of the IRS's abuse of taxpayer funds than the expected volume of IRS-1099 forms to be processed.

According to Tax Notes, IRS Digital Asset Director Julie Foerster stated at the Electronic Income Communication Advancement Committee meeting on October 25, "Our current estimate is that we will process 8 billion information returns, and that is just the 1099-DA form that is being developed." Foerster added that 8 billion is more than the total of all other IRS-1099 forms currently processed, equating to the world's population.

Blockchain is Not the Problem, But the Solution

Taxpayers already have many cryptocurrency tax service providers to choose from when preparing their tax return information, such as Token Tax, Koinly, and Zen Ledger. Due to the transparency and traceability of public blockchain transactions, users can simply input their anonymous digital wallet address to receive complete, itemized, and tamper-proof taxable transaction records along with cost basis information from DeFi protocols.

Blockchain can record data without the need for intermediaries to report. Traditional finance cannot adopt this method due to its complete reliance on opaque private intermediaries (i.e., brokers), which necessitate these intermediaries for IRS-1099 reporting.

No Reasonable Justification

The Treasury and the IRS have no reasonable justification for labeling hypothetical intermediaries and forcing these hypothetical intermediaries to report DeFi transactions and cost-based tax information. DeFi protocols do not have intermediaries, making this new technology innovative.

DeFi users complete their own transactions using self-custodied digital wallets. The IRS can already access the foundational data related to transactions involving DeFi protocols through recorded public blockchain data. The solution I propose is not only possible but also available today, as evidenced by the providers offering this service.

This approach is far more cost-effective for society compared to processing 8 billion unnecessary duplicate IRS-1099 forms.

Unlike the proposed IRS rule, my approach will:

• Not eliminate DeFi protocols or self-custodied digital wallets that do not directly execute transactions (users execute their own transactions)
• Not exceed the powers granted by Congress, and
• Still achieve better tax information reporting, compliance, and increased tax revenue goals while alleviating public concerns about privacy issues.

Real intermediaries (such as Coinbase) will still be designated as brokers and will need to submit tax information reports to the IRS. All U.S. cryptocurrency users must use centralized exchanges like Coinbase for on-chain and off-chain transactions between dollars and digital assets. Platforms like Coinbase should be the focus of blockchain-based financial regulation, rather than self-sovereign software protocols that lack true intermediaries.