Crypto Trader Tax: What happens when Crypto gets Political?

*Written October 7th

Many are proclaiming 2022 the year of crypto and it’s hard to argue against it. What began with Bitcoin in 2009 has now evolved into a thriving ecosystem of decentralized currencies and applications. Along the way, users and investors of all backgrounds have explored the various ways blockchain technology can simplify daily transactions and create a smart economy using our IoT. The edge of this expanding universe has yet to be found, but its rapid expansion has pushed crypto into the public eye and now the political system is grappling with the changes needed to both accommodate and regulate this system. Because of this legislative push Congress is considering a potential crypto trader tax and many anticipate that 2022 will cement crypto’s place in the political landscape.

Infrastructure Bill

As you might have guessed, a completely decentralized financial system surprisingly does not mesh with the government’s very centralized vision. For this reason, Congress’ $1.2 trillion Infrastructure plan included a provision to enforce new tax rules on crypto transactions as well as expanding reporting standards for digital assets. Ironically, the crypto tax provision is intended to reduce tax evasion – implying that crypto users are evading approximately $28 billion in taxes. But crypto advocates took offense to this potential crypto trader tax for a very different reason.

Crypto Trader Tax: Defining a “Broker”

The updated definition of a broker as “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person” is too broad because the definition did not exclude members of the crypto economy like miners, software developers, and stakers. As a result, they would have to file with the IRS to provide transaction details such as users’ names and addresses. In most cases it is impossible for miners and developers to even gather this information and some are worried even more blockchain applications could be affected by the added legal complexity.

In response, groups like The Electronic Frontier Foundationthe Coin Center, Fight for the Future, and the Blockchain Association have led a coordinated lobbying effort to alter this definition. Their campaign helped motivate the Wyden-Lummis-Toomey Infrastructure Bill Amendment created by Senators Cynthia Lummis (R-WY), Ron Wyden (D-OR), and Pat Toomey (R-PA).

The amendment would explicitly eliminate validators, protocol developers, as well as hardware and software makers from the bill’s ramifications. Yet, the White House came out in support of its more restrictive competitor, put forward by Sens. Portman, Warner, and Sinema. Ultimately, even this amendment was rejected due to “politics” – more specifically opposition from Sen. Richard Shelby, R-Ala because his unrelated defense amendment had been rejected.

Although the definition could still be loosened, the bill has already passed the Senate. But after recent negotiations fell flat, House Speaker Nancy Pelosi pushed the deadline for passing Biden’s infrastructure spending bill to October 31st which could be a trick or treat for crypto users depending on the final verdict.

Still, the pay-for-provision is ultimately unlikely to severely impact the crypto market because the definition is so broad even internet or telecom service providers could be affected – almost guaranteeing a legal battle. While the infrastructure bill could pass the House without an amendment to the broker definition, it will likely be corrected in a secondary process like what happened earlier to the defense bill.

In the grand scheme, this political battle symbolizes how regulatory efforts could undermine huge tenets of the crypto community and even digital privacy with some going as far as describing the shift as a step towards “mass surveillance”. Unfortunately this debate will likely get a lot worse before it gets better; but on a positive note, the provision is an undeniable sign that the government is finally taking crypto seriously.

The Treasury

As a result, federal bodies like the Treasury Department are racing to regulate the exponentially increasing crypto market but are struggling with how to approach regulation. The department has been meeting with industry participants since Treasury Secretary Janet Yellen recommended the department establish a regulatory framework for stablecoins. Now the Treasury is on track to issue a report outlining its framework for potential regulation.

The report will likely recommend stablecoin firms hold enough liquid assets to back up their currency’s value while touching on processes for creating new stablecoins, consumer protection, and security systems. In light of Solana’s 17 hour blockchain outage, the report could also discuss software requirements to make sure all networks are capable of handling large, simultaneous transactions.

The SEC

Meanwhile, the most decisive voice – SEC Chair Gary Gensler – has tied his stance on crypto to that of investor protection saying, “we have a role as a nation to protect those investors against fraud.” Gensler is generally viewed as a hardliner when it comes to investor protection and market stability but has likened the $2.2 trillion crypto market to the wild west, rife with fraud, scams, and abuse.

During May’s Financial Industry Regulatory Authority’s annual conference, Gensler took it a step further saying that, “the investing public would benefit from more investor protection on the crypto exchanges”. Gensler has also brought Congress’ attention to his concerns saying, “these exchanges do not have a regulatory framework at the SEC or at our sister agency, the Commodity Futures Trading Commission” he added that without a market regulator for these crypto exchanges, there’s “no protection around fraud or manipulation”.

Yet, Gensler came under heavy criticism during a September Senate hearing, regarding the SEC’s ongoing battle with Coinbase. At the heart of the argument is a series of tweets from Coinbase’s CEO detailing how the SEC threatened to sue the exchange if it launched a product that allowed users to accrue interest by lending their coins.

Sen. John Kennedy: “The people and the companies that you regulate as chairman of the SEC, do you consider yourself to be their daddy?”

Gensler: “No”

https://www.c-span.org/video/?514606-1/senate-banking-hearing-oversight-securities-exchange-commission

During the hearing, Sen. Toomey criticized Gensler’s approach, claiming that he was trying to regulate digital tokens through “enforcement” while pointing out the SEC’s lack of transparency in its process of classifying digital assets as securities.

The Future of Regulation

Despite the tug of war between policymakers and crypto advocates, the crypto community has long advocated for appropriate regulation although a crypto trader tax was likely not one of their first ideas. The lobbying effort that has occurred throughout this session demonstrates how organized and effective it could be if put to the task. As Elon Musk shared, it doesn’t seem possible to destroy crypto at this point but it is possible for governments to slow down its advancement.

Because it is an organic market fundamentally driven by its users, even if regulation comes into play it will likely serve as an obstacle rather than a fatal blow. As regulation is taken more seriously, the likelihood that crypto will be required to meet higher reporting standards is likely inevitable. 

For example, President Biden’s proposed American Families Plan would require businesses’ cryptocurrency transactions valued at $10,000 or more be reported to the IRS. While this is only a small stab at government regulation, it’s worth noting that the IRS already considers crypto a form of property and is subject to taxation just like stocks or gold.

While the future of crypto is still unknown, the regulatory battle ahead is almost certain. However, crypto investors should not be worried. Even with regulation, the market will continue growing and the government’s interest in taxing crypto assets means it will be in the Fed’s best interest to keep crypto around. This is good news for crypto users who have been waiting for cryptocurrency to be taken seriously.

Yet the question remains, what impact regulation will have on cryptocurrency more generally. Overall, regulation could solve many of the problems associated with the decentralized system but on the other hand approaches like a crypto trader tax could easily stifle the creativity and growth that has allowed blockchain systems and cryptocurrencies to flourish. Finding the right balance is a process that will likely begin in earnest during 2022 but will take many years to perfect.

*Updated March 3rd

Now What?

The $1.2 trillion infrastructure bill including the un-amended crypto trader tax was signed into law on November 15th and has left many crypto traders scrambling – and they weren’t the only ones. After signing the infrastructure bill into law, Bitcoin and Ethereum fell sharply after reaching new all-time highs the days before. Overnight Bitcoin dropped below $59,000 while Ethereum sunk below $4,200 marking investors fear of what the new policies might bring.

Only three pages of the massive bill deal directly with cryptocurrency and the key takeaways are that transactions of over $10,000 involving cryptocurrencies NFTs will now be included under the traditional reporting requirements. NFTs could be subject to different reporting requirements depending on whether they are treated as collectibles or investments. If its the former, then they will be subject to a 28% top federal tax rate on long-term capital gains. Typically crypto investors were only required to declare cryptocurrency gains but starting in 2024 crypto brokers will have to report crypto transactions directly to the IRS using a 1099-B form which is used to report miscellaneous income. These newly defined “digital assets” are subject to IRS scrutiny but are treated the same as cash which is a grave misunderstanding of the digital ecosystem most crypto holders operate in.

In theory, this regulation could be simple like in cases where someone buys a product using ETH or converting USD into ETH using a crypto exchange. But overall, the responsibility for reporting will fall upon cryptocurrency exchanges which will issue a 1099-B form for each crypto transaction. Working the same as a broker for stocks, these exchanges would send both the IRS and their customer a 1099-B form recording their gains and if the individual’s reporting does not match that of the exchange then the IRS will alert them to the discrepancy. However, these exchanges have limited information about the users themselves and reporting personal information, such as sender’s names, addresses, and Social Security numbers in order to comply with the law, could wreak havoc on the current system. More than that, the peer-to-peer interoperability enabled by blockchains means there is no need for a third party to “validate” or “facilitate” the transaction and these wallet to wallet transfers happen millions of times every single day, making this traditional reporting style particularly unsuited for crypto.

Some believe that in order to avoid the civil and criminal penalties associated with non-reporting, crypto transactions will move towards unregulated services and private wallet transactions which is the complete opposite of the legislation’s underlying goals. But if there’s one thing everyone can agree on its that this crypto trader tax is largely open to interpretation and will need clarification otherwise the regulatory authorities involved will be overwhelmed with transactions as complex as corporations’.

Section 6050I

 “Except as otherwise provided by the Secretary, the term ‘digital asset’ means any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.”  Sec. 80603(b)(1)(B)

Section 6050I of the Act not only expanded the anti-money-laundering “cash reporting” requirements to include digital assets, but it officially expanded the definition of “broker” as well. Now the term includes businesses “responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” Without further clarification, this rule appears to apply to cryptocurrency exchanges, peer-to-peer money transmission services, and financial institutions that support cryptocurrency transactions. But its worth noting that in August the Treasury clarified that it would not be targeting miners and hardware developers as brokers.

Unless Congress works to limit this requirement to “cash like transactions” – which happens to be what the law was originally intended for – then parties in peer-to-peer cryptocurrency transactions and even the intermediaries taking part in the transaction could be impacted. This is why major players like Coinbase, Square, FTX, and Kraken have been speaking out. As is, crypto market participants and others within the DeFi space do not have the ability to report customer information via 1099’s to the government, yet this law could potentially require them to do so.

Furthermore, these exchanges have no way of knowing the cost basis of cryptocurrency transactions which is an essential part of a 1099 and any crypto trader tax. Reporting gains, losses, and income seems next to impossible without brokers like Coinbase and Kraken sharing this information between themselves, one aspect of this legislation requires cryptocurrency brokers to report the cost basis information to each other in an attempt to solve the problem. But this again overlooks transactions that were not affiliated with a 3rd-party. If someone transfers crypto from a self-custody wallet to a centralized crypto exchange wallet, then the exchange will report the full amount of the transaction without being able to account for however much the crypto had been worth when it was first purchased. The multitude of existing decentralized wallets, protocols, and NFT marketplaces basically ensures that this is not a full-proof solution.

This means the taxable gains could be largely inaccurate and factoring the number of transactions into the process would present major issues not only for the individuals and brokers but for the regulatory agencies themselves. In many ways, the higher reporting requirements are unfounded since the premise of this policy is that cryptocurrency is not transparent and could lead to money laundering. However, one of the most fundamental aspects of the blockchain is the radical transparency it brings to every transaction through a publicly available distributed ledger.

Future Implications of the Crypto Trader Tax

As many have already pointed out, an ineffective crypto trader tax could harm the crypto ecosystem overall which is fundamentally built on the values of privacy and decentralization. But it could also delay the adoption of blockchain technology and cryptocurrency too. Even worse, if entities within the crypto ecosystem choose to avoid US citizens due to the higher reporting requirement, then the entire country could be setback as the rest of the world races to adopt the new technology and advantages it brings.

But its important to note that there is still time. As with any piece of legislation, there are opportunities for additional legislation to amend the infrastructure bill. Currently, the Treasury Secretary and IRS are expected to clarify Section 6050I’s scope as it pertains to “digital assets” and the reporting requirements which might arise. Experts are hopeful that through education and lobbying, the final regulations will account for the private, traceable, and decentralized nature of cryptocurrency transactions and will not unduly affect online or peer-to-peer digital-asset transactions. Congress’ Blockchain Caucus and other members appear to be up for the fight, already stating the need for “amending this language” but clearly the battle is far from over.

“Digital assets are here to stay in our financial system and the decisions we make now will have impacts far into the future, […] We need to be fostering innovation, not stifling it, if we are going to maintain America’s position as the global financial leader.”

Senator Lummis during a joint press release with Senator Wyden

With the growing, widespread adoption of crypto across the country, more efforts are being launched to regulate and tax these digital assets. Another provision had been included in the Build Back Better Act that would impact crypto investors by closing a significant tax loophole using the “wash sale” rule. If it had passed, the legislation would have disqualified tax deductions for losses from the sale of a digital asset if the investor buys the same asset within 30 days before or after the sale.

In any case, uncertainty regarding how to regulate cryptocurrency transactions are further muddied by another question – who is supposed to regulate them? As Daniel Gouldman, co-founder of Unbanked, described it: 

“The regulatory expectations for cryptocurrencies are a bit blurred. Different regulators claim to regulate it; the SEC uses a Supreme Court ruling from 1946 (SEC vs. Howey) to determine what does and does not qualify as a security. The [Commodity Futures Trading Commission] has said cryptocurrencies should be regulated more like a commodity. The IRS taxes it as property, and an advisor at FinCEN recently called crypto ‘just another means of payment.'”

Crypto activists and lobbyists are no doubt gearing up for many years of back and forth with Congress as the government struggles to adopt effective financial regulation of cryptocurrencies without stifling the ecosystem’s growth. The opportunities for dialogue to align the goals of state and federal governments with those of their constituents will be many and – with time – the resulting financial regulatory structures will hopefully fairly answer many of the hard questions regulators and investors are facing today.

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