How the IRS’s proposed rule affects U.S. crypto tax compliance

On August 25, 2023, the U.S. Department of Treasury and the Internal Revenue Service issued a proposed rule in response to the Biden Administration’s directive to develop a cryptocurrency tax regime. 

This proposal has sparked significant concern within the industry, as its wording will inarguably stifle blockchain innovation in the U.S.

As experts in crypto tax compliance in the U.S., we will break down this proposed rule and discuss how it affects U.S. taxpayers in the crypto community and token projects that issue token grants.

Background

‍The IIJA is passed - November 2021‍

On November 15, 2021, Congress passed the Infrastructure Investment and Jobs Act (IIJA). This law regulates reporting requirements for ‘brokers’ of digital currencies, bringing the blockchain industry closer in line with traditional finance. 

From a tax compliance perspective, the IIJA was a necessary step in the right direction, but implementation remained a key point of concern. 

‍The proposed rule is published - August 202

‍The U.S. Department of Treasury and the Internal Revenue Service proposed a new rule in August 2023 that stipulates reporting requirements for specific types of entities. 

This proposed rule, if passed, would impose reporting requirements on ‘brokers’. It defines a broker as any business that ‘effectuates transfers of digital assets’. The rule cites examples such as centralized exchanges, decentralized exchanges and payment processors. This means platforms like Coinbase, Uniswap and Stripe would be affected. 

The reporting requirements necessitate these platforms to collect their users’ names, addresses, gross proceeds, types and amounts of digital assets transacted in, and the wallet address from which deposits were made. This information would then be reported to both the customer and the IRS.

Backlash from the Community

The response from the digital asset community has been overwhelmingly negative. The primary concerns include:

• Operability Issues: The ability of decentralized exchanges or decentralized finance platforms (DeFi) to collect personally identifiable information (PII) is questionable, as many are not able to do so.
• Privacy Concerns: The proposal raises significant privacy issues for both users and exchanges, as it will give the IRS unprecedented access to sensitive user data.
• Stifling Innovation from Burdensome Reporting: Due to the broadness of the proposed rule, many different service providers (and even smart contracts) would likely be required to perform tax reporting functions, which create an undue burden on innovation in the space.
• Inclusion of Stablecoin Transactions: Including stablecoin transactions, which theoretically result in no gain or loss, would exponentially increase reporting requirements without a corresponding benefit.

Coinbase’s Brian Armstrong said,“Coinbase is happy to help customers fulfill tax obligations”, but criticized the IRS proposal as it “defines ‘brokers’... [as] almost anyone in the crypto ecosystem.”

Sarah Millby from The Blockchain Association highlighted this issue, arguing “The proposal would create unworkable reporting requirements for a wide array of participants in the digital asset ecosystem and would cause projects to shut down operations or move offshore, inhibiting U.S. innovation in blockchain technology.”

‍The proposal has undergone a public comment period, receiving over 120,000 comments, including a 29-page comment by famed VC firm a16z.

What does this mean for U.S. projects issuing token grants?

In brief, if this proposed rule were to pass, U.S. token projects issuing token grants and transferring tokens to their employees would not be defined as a ‘broker’ under the current proposed rule.

However, under this proposed rule, token projects will have severely limited options to operate, liquidate and rebalance their treasury, as their options will be limited to compliant brokers. For example, if your token is new and not currently listed on any brokers, you will have no way to buy or sell your tokens publicly in the U.S. until you go through the listing process with a broker.

Additionally, smart-contract-based payroll solutions would automatically become non-compliant.

This will greatly impact tax compliance operations (i.e. sell-to-cover transactions), as decentralized exchanges would no longer be able to provide any liquidity for your tokens.

Additionally, projects should not offer to redeem or buyback token grants with cash, as such an action would designate the project as a ‘broker’, requiring the project to comply with burdensome reporting requirements.

Aside from tax compliance issues, one key concern of this proposed rule is how it will likely make transacting with smart contracts non-compliant with tax laws. This means U.S. users will fundamentally not be able to participate in any decentralized protocols.

In the event that this proposed rule does pass, we would expect to see an exodus of crypto projects offshore to avoid these stringent reporting requirements.

What does this mean for you as a U.S. taxpayer?

This proposed rule, if passed, would mean that individual U.S. citizens would not be able to utilize the functionality of any decentralized protocol or application, as the smart contracts underlying these products are not able to be altered to comply and would thus fall afoul of this rule.

This would also affect other applications like non-custodial wallet apps (i.e. MetaMask, TrustWallet and Edge Wallet), as these wallets allow users to connect to trading platforms such as decentralized exchanges.

These reporting requirements would enable the IRS to link your crypto wallet addresses to your real identity. As the blockchain contains records of all transactions from any wallet address, this effectively means the IRS will have full access of your private economic activities on the blockchain. This would constitute an unprecedented infringement of privacy, and worse, if a data breach were to occur.

Moreover, this rule will create a situation where a U.S. taxpayer executing one blockchain transaction may end up receiving multiple data collection requests and tax information reports from multiple entities at the same time. This creates significant friction and confusion for any U.S. taxpayer transacting in cryptocurrencies.

Overall, this proposed rule would harm the user experience, infringe privacy rights and limit the selection of platforms U.S. taxpayers are able to compliantly onboard to. 

Conclusion

The proposed Treasury and IRS regulations on digital assets is an unprecedented rule that would violate privacy rights, limit operability, and stifle innovation in the crypto industry. 

Toku believes in and agrees with the importance of third-party tax reporting, which is present in the world of traditional finance. However, this proposed rule has far-reaching real-world implications that go beyond regulations in traditional finance.