One of the proposals in Congress’ eclectic grab-bag of payfors in the bipartisan infrastructure package is an effort to curb tax evasion in cryptocurrency by imposing a series of reporting requirements on the industry. While it makes sense to ensure cryptocurrency transactions are treated similarly to other financial assets, the nature of these requirements as written are potentially unworkable. Striking the right balance between sensible reporting requirements and unworkable rules will be important as policymakers consider changes to the proposal.
Estimates of the cryptocurrency tax gap are hazy. In 2018, the IRS cited third-party analysis that suggested the tax gap (or the difference between taxes paid and taxes owed) on cryptocurrency capital gains was roughly $11.5 billion in 2017. Given the substantial increase in market cap of cryptocurrency since then, it’s reasonable to believe that number is much higher now. This past April, former IRS commissioner Charles Rossotti testified that the true annual tax gap could be over $1 trillion, and while that overall number does not stand up to scrutiny, he cited cryptocurrency as an underestimated source of tax evasion.
Neutrality is a foundational principle of good tax policy. In the context of cryptocurrency, that means it should be treated the same way more conventional or traditional investments, like stocks, are treated. As explained in Forbes, financial brokerages have to report information such as sales price and basis when an individual sells a stock. It would make sense to have similar reporting rules for cryptocurrency, which are treated by the IRS as assets like stock rather than currency.
Under original proposed regulations, cryptocurrency exchanges would have to report the same information to the IRS. However, the definition of “broker” in the original bill would be much broader than it is for traditional finance. The original proposal defines a broker as anyone responsible for regularly providing services that facilitate the transfers of digital assets, which could end up including people such as software developers and cryptocurrency miners that do not square with what we would conventionally define as brokerage services. The result could be substantially increased compliance costs for the industry, as well as offshoring, which certainly seems feasible for an industry as virtual as digital currency.
An amendment proposed by Senators Ron Wyden (D-OR), Cynthia Lummis (R-WY), and Pat Toomey (R-PA) would clarify that non-custodial firms, such as many decentralized exchanges, cryptocurrency miners, or even crypto platforms facilitating exchanges with users who own non-custodial wallets, would be exempt from the reporting requirements. Thursday, Senator Rob Portman (R-OH), the original designer of the cryptocurrency reporting requirements, also spoke positively about the amendment. This change would only lose about $5 billion in revenue compared to the original score of $28 billion, according to the Joint Committee on Taxation. Sen. Portman, along with Sen. Mark Warner (D-VA) and Sen. Krysten Sinema (D-AZ) also released a proposed amendment that would more narrowly exclude the validation of transactions through “proof of work” mining.
Some advocates of keeping the reporting requirements broad argue that exempting decentralized exchanges or cryptocurrency miners from reporting requirements may “create a two-tiered cryptocurrency market,” which could encourage an “unregulated shadow financial market.” However, it is unclear that effectively increasing government surveillance of cryptocurrency transactions would stop people from working offshore or illegally.
In fact, the people most hurt by the current design of the requirements would be decentralized, smaller players within cryptocurrency who are competing with larger firms. Others have argued that the original language would not target these types of people in the industry yet oppose language that would make this explicit in the bill.
It makes sense to integrate cryptocurrency transactions into the existing system of tax reporting. But policymakers should balance that goal with minimizing unintended consequences of new requirements and making the requirements administratively feasible in the context of how the technology works.