DeFi's Regulatory Reckoning (IRS Kills Crypto Part 4)
Dec 31, 2024In my analysis of the IRS's impact on crypto and DeFi, I've detailed how regulatory changes are reshaping the crypto landscape. This blog builds on my previous three-part series focusing on the December 2024 developments that significantly affect DeFi protocols.
Background: The journey to current regulations
The regulatory journey began with proposed digital asset broker regulations in 2023, followed by final regulations in July 2024. While DeFi protocol applications were initially deferred, December 2024 brought significant changes.
Previous coverage in this series
- The IRS Kills Crypto with Definitions (IRS Kills Crypto Part 1)
- IRS Kills DeFi by Calling It a Broker (IRS Kills Crypto Part 2)
- The IRS Tripled Your Crypto Tax Prep Cost (The IRS Kills Crypto Part 3)
Latest developments: Treasury's new requirements
The U.S. Department of the Treasury issued a press release for tax reporting requirements for brokers of digital assets. While implementation begins in 2027 and excludes protocol operators and developers as brokers, the broader implications remain concerning.
Treasury's claims vs. reality
The press release states:
"By collecting more information from brokers, the owner of a digital asset who engages in DeFi transactions will receive a Form 1099 from brokers and be reminded that those transactions are taxable, thereby reducing the number of inadvertent errors or noncompliance on the taxpayer's federal income tax returns and saving taxpayers time and money during the filing process."
Key Takeaway
DeFi broker regs (and the centralized exchange regs) will INCREASE the inadvertent errors and SKYROCKET the taxpayers time and money in the crypto tax calculation and filing process. This is the opposite of what the US Treasury claims.
The DeFi-CEX reporting dilemma
I've stated this many times, but by adding DeFi reporting on top of CEX reporting the errors and other misreporting of information will be exponential. Decentralized exchanges (DEXs) are a part of decentralized finance (DeFi) which allow users to engage with digital assets via smart contracts without third party intermediaries. Centralized exchanges (CEXs) on the other hand are akin to traditional financial institutions (TradFi).
The role of traditional reporting
CEX broker reporting is already going to create nightmares; however, these entities are best poised to implement onerous taxpayer reporting because they are a third party. The IRS already tasks third parties with reporting such as employers who issue W-2s and also 1099-NECs for contractors. TradFi brokers issue 1099-Bs which are ironically helpful in tax reporting.
Key Takeaway
DEXs on the other hand are the opposite of CEXs. Customer information gathering is a mutually exclusive activity of decentralized exchanges. The DeFi broker rules would force DEXs to become a centralized version of themselves which defeats the value proposition of the technology in the first place.
Technical limitations and market impact
Decentralized identify may be able to come in and save the day at some point, but DEXs are not designed to be modified for information gathering. The technological limitation is a trigger for turning a decentralized exchange into a centralized exchange. DEXs are not going to do that because they can't. Instead, they will block US taxpayers and more Web3 companies will go offshore. The list of blocked dApps for US DeFi power users will get even bigger. (You can thank the SEC and Gary Gensler for starting this frustration.)
The withholding requirement challenge
In some circumstances brokers have to make backup withholding from certain customers, which means they have to escrow funds and pay the IRS. Again, DEXs are not designed to do this. A DEX would have to scrape funds from a transaction, reserve it, off-ramp it to USD and pay the US Treasury. DEXs don't want to be CEXs so they will move offshore and not service US customers. It will be interesting to see if some DEXs make a centralized version of themselves just for US customers.
Industry response and fighting back
Fortunately, the the DeFi Education Fund, the Blockchain Association, and the Texas Blockchain Council filed a lawsuit against the IRS and US Treasury. This Blockchain Association posted this in their press release:
“The IRS and Treasury have gone beyond their statutory authority in expanding the definition of “broker” to include providers of DeFi trading front-ends even though they do not effectuate transactions,” said Marisa Coppel, Head of Legal, Blockchain Association. “Not only is this an infringement on the privacy rights of individuals using decentralized technology, it would push this entire, burgeoning technology offshore."
If you feel like knocking yourself out with another IRS 115-pager then read the final regs: Gross Proceeds Reporting by Brokers that Regularly Provide Services Effectuating Digital Asset Sales.
These new IRS regulations represent a fundamental misunderstanding of DeFi's technological architecture and could effectively ban DeFi by proxy in the US. While intended to increase tax compliance, these rules will push innovation offshore and limit US users' access to decentralized financial services. The crypto industry is hanging in the balance as these regulations take effect in 2027. Fight back and write your members of Congress.
