The IRS Should Heed This Warning

This op-ed is part of CoinDesk’s Tax Week, presented by TaxBit. Bill Hughes is senior counsel and director of global regulatory matters at Consensys.

The Internal Revenue Service (IRS) may overplay their hand and, as a result, cripple the blockchain software industry in the U.S. It should change course.

The digital asset broker reporting law passed in 2021 is straightforward and sensible. There are plenty of intermediaries in the crypto ecosystem that execute transactions on behalf of millions of American digital asset investors. Just like it does in the traditional finance (“TradFi”) context, it makes a lot of sense for such businesses to inform not only their customers about what they owe in taxes but also the IRS, so they can ensure people pay what they owe.

The IRS’s proposed regulations that fill in all the important gaps in this reporting requirement unfortunately go far beyond this, however. All the gritty legal details were proposed on Aug. 25, and the public’s opportunity to comment on those proposals concludes Nov. 13.

The crypto community has certainly not wasted this opportunity, given that there are over 120,000 comments submitted, and those comments reveal a public that is very concerned the IRS has overstepped its statutory authority by expanding the application of this rule to entities that Congress did not intend to cover. This overreach risks placing unduly burdensome and often unachievable requirements on many entities.

The IRS should heed these warnings.

Specifically, the IRS proposes a new and complex regulatory scheme on software developers not accounting for blockchain technology’s unique technical and operational features. Many if not most of these parties have no historical experience with, offerings built around, or support systems for such reporting and would need to build compliance programs from scratch.

Software developers, from larger players such as Consensys to garage-band projects with a few engineers and a razor-thin budget, would need to dramatically overhaul their products and business practices to come into compliance if the proposed amendments are finalized in their current form.

IRS should stick to Congress’s instructions

These concerns can be largely avoided if the final regulations track the unequivocal intent of Congress to simply cut and paste the tax reporting regime from traditional finance. In making clear that digital-asset brokers are just like TradFi brokers for tax reporting purposes, Congress did not intend to overhaul the fundamental concept of a “broker.”

Amendment sponsor Senator Rob Portman (R-OH) in fact clarified on the floor of the Senate that brokers sell “on behalf of someone else” and do not simply engage in ancillary services. But the proposed rule would bring such an overhaul by treating as brokers not just those who act directly as dealers or agents in digital-asset transactions, but an amorphous category of “digital asset middlemen” that encompasses “any person who provides a facilitative service with respect to a sale of digital assets” where the nature of the service 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 the gross proceeds from the sale.”

Congress said a broker “effectuates” (meaning “carry into effect” or “accomplish”) a transaction, but the IRS reads that word to mean “being in a position to know.” One should be forgiven for wondering, is there a different English dictionary that only the IRS knows about?  That is an impossible leap that the law does not permit an agency to make.

The proposal would require a massive change in the peer-to-peer blockchain software landscape in the U.S. Non-custodial entities would likely have to become custodians to satisfy tax withholding obligations, and offerings that scrupulously do not collect personally identifiable information about users of their software, a practice that MetaMask for instance takes very seriously, would be required to collect and store such sensitive data, even on non-U.S. users.

Operational impacts like these are wholly beyond the information reporting law that Congress passed. The IRS should not impose regulations that are so broad as to make policy decisions for digital assets in areas beyond the tax realm.

The IRS should also do what it can to reduce reporting burdens. It is therefore essential that the IRS adopt some form of a “multiple broker rule,” which reduces duplicative reporting by exempting certain parties more tangentially involved in a transaction. Yet the proposed rule dismisses this possibility, failing to recognize the tremendous inefficiency.

We should simply not accept duplicative reporting.  It would lead to multiple withholdings for a single transaction, or to taxpayers being hopelessly confused by receiving multiple payee statements reporting the same transaction. The purpose of this reporting law is to make it easier for taxpayers to decipher how much they owe, not harder.

The IRS, too, would be overburdened if it is inundated with multiple returns for each transaction, particularly because the IRS may not be able to identify when reporting is duplicative.

Exclude certain assets in certain situations

Further, serious consideration should be given to excluding digital assets outside of the investment context. .  For example, as the IRS itself recognizes, many non-fungible tokens (NFTs) simply offer “ownership or license interests in artwork or sports memorabilia” analogous to physical souvenirs. So the IRS should limit reporting requirements for non-investment NFTs, such as by requiring reporting only for transactions occurring on trading platforms. Currently, every NFT sale or swap would potentially be a reportable transaction, a rule that would severely hamper growth in new commercial applications for NFTs.

For the same reasons, the IRS should also exclude stablecoins credibly pegged to a fixed value of the U.S. dollar, as such stablecoins are designed to have a constant value and their disposition generally should give rise to no meaningful gain or loss in the vast majority of cases. An exclusion along these lines would track the IRS’s practice in other contexts. At most, the IRS could require stablecoin reporting where explicit trading activity around stablecoins is conducted, for instance in order to capture gains when a stablecoin deviates from its designated peg. No good reason exists to require stablecoin reporting more generally.

The IRS should similarly add a de minimis exception from reporting and backup withholding in instances where any gain or loss is likely to be marginal and/or for small value transactions. This would align with Congress’s intent that the IRS focus on transactions with meaningful realization potential, help lessen the administrative burdens of this new reporting regime and maintain consistency with the IRS’s approach in other areas of its regulations.

An unworkable regime would be unlawful

It is well-established that agency regulation is arbitrary and capricious, and thus unlawful, if compliance would be unworkable. And, for blockchain software developers, this rule is generally unworkable, requiring substantial changes to their operating models.

We at Consensys did some back of the envelope math on the work that redesigning our offerings, systems and business practices would entail. The results, which are undoubtedly a low estimate given that many of the regulatory specifications remain unknown today, are staggering. We would need scores of employees working not months but years on this, spending at least two orders of magnitude more money than what the IRS estimates it would cost the average digital asset broker. And despite all this effort, there are requirements that would remain beyond our control to satisfy.

But what about those developers that are not as heavily staffed or well resourced? You can expect many, if not most, to buckle under the weight of these requirements. That is a terrifying notion in light of the IRS’s own estimate that 98% of the new brokers under its rules would be small businesses. The rule would be akin to a persistent forest fire that immolates all of the newly sprouting plants, leaving only the scorched larger trees.

IRS may pare back this rule

Congress adopted a simple information reporting requirement. The IRS may not use that requirement to affect in ways well beyond the tax realm how peer-to-peer software is offered, or to set policy over digital assets generally. But that is very much what this rule would do in practice.

Despite the overreach with the initial proposal, I am somewhat optimistic that the IRS will work as carefully and diligently on revising it as they did during the two years it took to compose the first draft. This regime will be an important one for digital asset investors generally and for the national fisc, and the IRS has a difficult task balancing all of the competing concerns appropriately. That they do a good job is crucial to the further development of a new technological frontier that the U.S. should play a preeminent role in exploring.

I have hope that these issues will be corrected and a workable reporting regime will ultimately be what we get.  They deserve our continued input and support.

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