The Proposed IRS Broker Reporting Rules Would Effectively Kill DeFi

Historically, brokers in the traditional finance (TradFi) sector are obligated to issue 1099 forms detailing an individual's gains and losses, requiring knowledge of personal details for tax purposes. This model fits neatly within the TradFi framework, where transaction data is centralized.

However, as we pivot to the digital asset world, this model becomes increasingly problematic.

Explanation of new 1099-DA tax form

The introduction of the 1099-DA form, crypto’s equivalent to the traditional 1099, symbolizes an attempt to tether the wild expanse of crypto transactions to the IRS's tax scaffolding.

While seemingly a minor administrative update, the implications of this are far-reaching.

The two overreaching proposals from the Treasury Department

1. "Effectuate" Redefined: The term "effectuate" is expanded to include any entity that directly or indirectly facilitates digital asset transfers. This broad stroke potentially sweeps in a swath of participants in the DeFi space, from validators to wallet providers.
2. Revised Broker Definition: Under the new proposals, individuals and businesses "in a position to know" or that could've altered their operations to identify customers are now brokers. This redefinition could drastically expand the net of entities obligated to report under 1099 requirements.

What these changes would mean for DeFi

1. KYC for Everything: Know-your-customer (KYC) procedures would become pervasive in areas they haven’t been historically, like wallet providers, DeFi protocols, and decentralized exchanges. The mere interaction with blockchain technology might subject users and intermediaries to invasive personal data collection and reporting.
2. Universal 1099 Reporting: Every tokenized asset, whether it's a Non-Fungible Token (NFT), stablecoin, or tokenized real-world asset, would fall under the 1099 reporting umbrella. This mandate extends even to those assets without a traditional financial analog requiring such reporting.

The impossibility of accurate tax compliance under new rules

The proposed rules, far from streamlining tax reporting, seed chaos in several ways:

• Data Exchange Nightmares: The lack of interoperability and standardization among digital asset brokers means that compiling accurate, comprehensive tax reports is a fantasy. The resultant discrepancies and inaccuracies in cost-basis reporting will turn tax season into a nightmare of reconciliation.
• Non-Optimized Cost Basis Defaults: Brokers defaulting to the First-In, First-Out (FIFO) method for cost basis reporting – or worse, cost basis at zero for transfers in – can misrepresent an individual's actual financial activity, leading to potential overtaxation and a mess of records.
• Gross Proceeds Misrepresentation: Reporting gross proceeds without a clear picture of actual gains or losses distorts an individual's financial reality, leading to potentially misleading and harmful tax assessments.

The status of the proposed rules and industry pushback

The crypto community has not taken these developments lying down. A "treasury raid" of sorts has occurred, with over 124,000 comments submitted in response to the proposed rule, reflecting the community's vehement opposition and concern.

But, wait, what’s this about the $10K+ transaction reporting rule?

Not to be confused with proposed broker reporting regulations, there’s another piece of tax regulation that has the crypto community up in arms: 6050I.

The law says that, as of January 1, 2024, if you receive $10k or more in crypto in the course of a trade or business, you now must report the transaction (including names, addresses, SSN/ITIN numbers, amount paid, date, nature of transaction, etc.) to the IRS within 15 days under threat of a felony charge.

The rule actually isn’t new; it’s from an anti-money-laundering bill that’s been around since 1984, but the Infrastructure Bill signed into law by President Biden updated 6050I to include digital assets.

Traditionally, under Section 6050I of the Internal Revenue Code (IRC), any individual involved in a trade or business who gets over $10,000 in cash from a single transaction (or a series of related transactions) is mandated to declare this on Form 8300.

While the law was supposedly in effect as of January 1st, the IRS left lots of questions unanswered, like:

• What form should these transactions be reported on – Form 8300 or a new form?
• When will a transaction with a digital asset be considered a trade or business transaction versus an investment?
• How will the recipient of a digital asset file the form when they do not know the sender and have no way to obtain the required information (e.g., airdrops, hard forks, mining and staking rewards, decentralized exchange transactions)

To the relief of crypto and DeFi organizations, the IRS announced that “businesses do not have to report certain transactions involving digital assets until regulations are issued.”

What happens from here?

Positioned at the forefront of these transformative shifts, the future of DeFi teeters on a delicate fulcrum. The community must continue its vigorous discourse, advocating for regulations that recognize the unique nature of digital assets and DeFi. The proposed rules are not merely an inconvenience; they threaten the very ethos of decentralization and financial autonomy that crypto was built upon.

While the IRS's intent to modernize tax reporting for digital assets is understandable, the current approach is akin to fitting a square peg in a round hole. Without thoughtful revision, these regulations will stifle innovation, infringe on privacy, and complicate the tax landscape to the detriment of all stakeholders in the DeFi ecosystem.

Pat White is the co-founder and CEO of Bitwave, a leading digital asset finance platform for enterprises.