The proposed tax regulations on crypto reporting could play the most pivotal role in shaping the future of the crypto industry in the US and perhaps the world. Not only would they have a profound effect on every American crypto holder, but they would also deeply affect innovation in the industry.
Under the proposal, crypto exchanges servicing US taxpayers would have to disclose detailed information on their users’ transactions, sparking a host of questions about the timing and cost of compliance. There may be other options that Treasury and the IRS could consider that would allow decentralized finance, or DeFi, to survive and crypto innovation in the US to thrive.
The proposed regulations aim to reduce compliance gaps when calculating and reporting crypto gains. If taxpayers were to simply receive a tax form reporting their gains, a copy of which is also filed with tax authorities, then surely compliance and enforcement would be much easier. In theory, that would be the case after the regulations would take effect.
But the path to get there is full of questions and complexities. For example, taxpayers with high trading volume using multiple exchanges would struggle to apply a clean cutoff prior to the first tax year in which a 1099 is issued. Unless they’re using the same calculation system as their crypto exchange would use, gains and losses will be over or understated during the transition.
There’s also uncertainty regarding transfers between multiple exchanges, considering that we will have to wait until later phases for guidance on transfer reporting, something that won’t be an easy task considering the volume. As basis reporting wouldn’t be required until 2026, taxpayers would still have over three and a half years left to deal with transfers of basis and potentially incorrect reporting triggering IRS scrutiny.
Treasury and IRS have estimated that small crypto businesses would have to pay $81,000 to $216,000 in startup costs to comply with the new regulations. Having been in the crypto data industry for several years, that estimate seems vastly understated and doesn’t account for building a central reporting infrastructure.
Gaps within the data will make the implementation process much more costly, especially without a standard for the information. These startup and compliance costs would hurt countless small crypto businesses—and not the bad actors like FTX, but rather the good innovative small companies bringing new ideas to the market—many of which have struggled to stay alive given recent market conditions.
Implementing the reporting systems would be extremely costly for any broker and likely would cause even more exchanges to withdraw from the US or perhaps go out of business or sell. This would also have a domino effect for the crypto industry in other areas of the world as the US framework is coordinated with the OECD’s Crypto-Asset Reporting Framework. Given enough time, big exchanges would spend what is necessary and will be able to comply.
Future of DeFi
The biggest question lies with the many DeFi projects and their future. The proposed regulations say the definition of a broker would “ultimately require operators of some platforms generally referred to as decentralized exchanges to collect customer information and report sales information about their customers.”
Decentralized ownership can be similar to a partnership, as the governance tokenholders benefit from fees and can vote on decisions to modify a platform. But the operating model of these platforms is such that providing information under the proposed regulations would require substantial modifications to their operations.
Current DeFi projects weren’t designed with the capability to incorporate such reporting systems. The best case scenario would be that US customers would be disallowed from using DeFi (or perhaps cut off from the off ramps) and be left with more centralized versions of DeFi platforms, therefore eliminating a key advantage of DeFi—its decentralization and permissionless network offering financial inclusion where centralized finance hasn’t.
True DeFi can’t be stopped. Once the code has been released to the world, anyone is free to interact with these smart contracts—regulators can only hope to cut off the off ramps. There will always be a market for DeFi and for any crypto technologies that fall outside of the regulatory box, such as privacy coins like Monero.
The proposal itself asks, ”Are there alternative information reporting approaches that could be used by digital asset trading platforms that collect and retain no information or collect and retain limited information about the identity of their customers that would satisfy tax compliance objectives while reducing privacy concerns?” This shows that the Treasury and the IRS are open to alternative systems outside traditional information reporting.
Considering that all widely used blockchains are public and immutable transaction ledgers, surely there must be a better way to obtain the right information about a taxpayer’s obligations digitally. Coinbase has proposed the use of tax tokens, an innovative approach that might be worth considering. Such tokens would be attached to a taxpayer’s crypto addresses to provide the necessary tax information.
Conclusion
The upcoming two months will be critical for stakeholders in the industry to submit feedback prior to the Nov. 7 hearing. While the final regulations will ultimately simplify tax reporting for the everyday taxpayer, they also will determine whether DeFi will be pushed to the corners of the dark web or whether the web3 community will rally and find an innovative solution that will satisfy the US government and allow crypto and DeFi to grow.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
David Canedo, CPA, specializes in taxation of crypto assets. He is a product manager at CryptoTaxAudit, a professional services firm dedicated to assisting crypto traders and investors properly file US taxes.
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