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IRS Kills DeFi by Calling It a Broker (IRS Kills Crypto Part 2)

crypto tax Sep 28, 2023

Check out IRS Kills Crypto in 282 Page Broker Regs (Part I) to get the background.

The DeFi logic

After digesting Part I at least you understand some of the general background of the IRS’ logic and reasoning. Now let’s examine more specific logic for how the proposed regulations apply to DeFi. It should be obvious that centralized exchanges like Coinbase, Kraken and Gemini are akin to securities brokers and fit the digital asset broker definition. Therefore, taxpayers would expect to get a 1099-DA from these platforms.

What about decentralized exchanges (DEXs)?

Broker reporting for DEXs gets tricky and could be the death of DeFi. I’m also going to analyze the IRS logic for applying the proposed regs to DEXs and why it’s flawed and unnecessary.

Key Takeaway
The taxpayer burden will go way up not down, and the 1099-DA reporting will create more work for taxpayers not less. This is counterinitiative to the IRS assertions that the reporting will aid taxpayers. The reporting may help a small group of noobs, but not most of the crypto crowd. It may help close the tax gap, but taxpayer burden must be taken into consideration.

You’re probably seeing a theme in my Key Takeaways by now.

The death of DeFi and more troubling stuff

This section is an IRS statement followed by my response.

IRS “Thus, for example, a digital asset trading platform, including an operator of a peer-to-peer or AMM trading platform, that facilitates a digital asset sale on behalf of a customer should be required to file an information return…”

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DEXs are digital asset brokers

Decentralized exchanges (DEXs) are AMMs (automated market makers) these are not peer-to-peer platforms. If anything, a DEX is a peer-to-smart contract (P2SC) platform.  An AMM is a DEX and a DEX is DeFi, therefore all DEXs would be considered digital assets brokers.

IRS: “Further, digital asset payment processors who facilitate payments that are potentially subject to reporting under the existing section 6050W regulations should be required to report on the payor’s exchange of digital assets in those transactions as well.”

Killing a use case

No further comment on the ridiculousness of this requirement. How about kill an entire use case.

IRS “…However, the definition of effect under existing §1.6045-1(a)(10)(i) and (ii), which sets forth the various roles under which a broker may take actions on behalf of customers, has been revised to provide that any person that provides facilitative services that effectuate sales of digital assets by customers will be considered a broker, provided the nature of the person’s service arrangement with customers is such that the person ordinarily would know or be in a position to know the identity of the party that makes the sale and the nature of the transaction potentially giving rise to gross proceeds.”

In a position to know 

Basically, you’re a broker if you could know the identity of customers. This creates a clever inference that every platform “in a position to know identity” is therefore a digital asset broker.

Key Takeaway
The “in a position to know” thing goes back to my earlier statement where everyone is suddenly a digital asset broker because they “could know” who their customers are. In addition, every DEX and DeFi platform is “in a position to know” under this language and could therefore be a digital asset broker. Overreaching at its finest.

IRS: “The modified definition of effect takes into account whether a person is in a position to know information about the identity of a customer, rather than whether a person ordinarily would know such information, in recognition of the fact that some digital asset trading platforms that have a policy of not requesting customer information or requesting only limited information have the ability to obtain information about their customers by updating their protocols as they do with other upgrades to their platforms. The ability to modify the operation of a platform to obtain customer information is treated as being in a position to know that information.”

Ability to modify 

The clever language from above that turns every platform into a digital asset broker. As you will see “the ability to modify” automatically means you are “in a position to know.”

IRS “The Treasury Department and the IRS expect that this clarified proposed definition will ultimately require operators of some platforms generally referred to as decentralized exchanges to collect customer information and report sales information about their customers, if those operators otherwise qualify as brokers. This decision was made because the reasons for requiring information reporting on dispositions of digital assets do not depend on the manner by which a business operating a platform effects customers’ transactions.”

Where death occurs

This is where decentralized exchanges are specifically mentioned as obligated to file information returns. If DEXs and other DeFi platforms were forced to add in KYC procedures, it would fundamentally alter the Web3 value proposition. An automated market maker (AMM) like Uniswap would no longer be an AMM and would probably have to morph into a centralized exchange to create the infrastructure to track every trade, calculate gains and losses and issue a 1099-DA, thus killing DeFi in the process.

IRS “Moreover, if the way a digital asset trading platform operates reduces or eliminates its obligation to report information on customer transactions, digital asset trading platforms might modify their operations to avoid reporting or customers who wish to evade taxes might elect to use a nonreporting platform in order to reduce the IRS’s ability to identify them as non-compliant.”

A false migration 

Furthermore, the IRS asserts that if DEXs were excluded from information reporting all taxpayers would simply shift away from centralized exchanges to decentralized exchanges. The IRS concludes the hypothetical migration would therefore be thwarted if everyone’s a broker and must file information returns.

This is just plain FALSE. There’s a lot to unpack here so let’s dive in deeper….

The progression of noobs (newbies; people just starting in crypto) to degens (people who love all things DeFi) is not going to change regardless of information reporting requirements. Noobs start with a Coinbase account, set up other centralized exchange accounts and eventually start dabbling in DeFi. The progression from noob to degen moves from using centralized to decentralized platforms.

Key Takeaway
DeFi is more complicated and has more risk. Noobs must overcome all those obstacles and that is the foremost thing on their mind not information reporting. 

The toolbox

Even degens use centralized exchanges like Coinbase because they need at least one fiat off ramp to get back to USD. Savvy crypto investors (including those who may not identify as a degen) know successful investing requires many tools in the crypto toolbox. Many tools means 8 to 10 centralized exchange accounts, for example, and even more self-hosted Web3 wallets like Metamask to maximize investing strategies. I’ll spare the detail on why until another time, but if every platform turns into a digital asset reporting broker my crypto toolbox is not going to change. I’d assert that’s the same for most degens.

Change for a different reason

Carte blanche information reporting will change how savvy investors use all the tools in their crypto toolbox, but it has nothing to do with whether a DEX is going to file a 1099-DA or not.

The new 1090-DA information reporting scheme is going to increase the cost and burden of taxpayer compliance. The current current capital gains and losses calculations by taxpayers is a gigantic headache. The new regs are going to make this at least 2X more painful. The finer details of this conundrum are too deep and I’ve already discussed them. Trust me on this one.

Key Takeaway
Once people get educated on the reporting mistakes and deficiencies and the extra work triggered by 1099-DA returns, they are going to change their crypto and exchange behavior to reduce the cost tax compliance NOT to avoid tax compliance.

Stay tuned there is even more to come.

Good luck and remember your goal is always to get a Crypto Bullseye™.

Yours in Crypto, 

Kirk David Phillips, CPA, CMA, CFE, CBP 

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