The multi-billion-dollar collapse of cryptocurrency exchange FTX has raised important questions about the framework government is relying on to collect taxes from crypto investors.
The IRS is planning to rely on exchanges such as FTX to report crypto transactions. But if the FTX crash drives users away from these exchanges, the IRS may have to rethink its approach to managing crypto tax avoidance. And crypto investors themselves may be burdened by massive amounts of paperwork.
For starters, it’s helpful to remember that at its core, crypto was designed to bypass the centralization, bureaucracy, and outdated features of the traditional financial services system.
But a lot of crypto activity has been quite centralized thus far. Major exchanges like Binance and Coinbase (and formerly FTX) made a name for themselves in part by providing a bit of old-school customer service. Custodial accounts that allow users to transition seamlessly among different cryptocurrency tokens and between tokens and traditional fiat currency greased the wheels and made crypto more accessible to a lot of users.
The exchanges also became an obvious starting point for Treasury and the IRS to facilitate the kind of information reporting it needs to collect taxes owed by account holders. However, the fallout from the impending FTX bankruptcy will amplify the call from purists for individuals to take their money off centralized exchanges and adopt the world of “decentralized finance,” or DeFi.
Without centralized exchanges, participating in crypto would be more like running your own webserver and foregoing the convenience of signing up with an Internet Service Provider to surf the web. The user takes on more risk and gets more control.
You don’t have to worry about an FTX bankruptcy freezing your assets, but you also can’t call for help if you make a mistake and send money to the wrong place. And critically for tax policy, no third party would report your crypto gains and losses to the IRS – at least not yet.
If DeFi does gain in popularity, can it coexist with the IRS and its mission to collect taxes? Although regulating DeFi wouldn’t be easy, it’s not as impossible as it sounds. It may also depend on what you mean by DeFi.
Crypto still wouldn’t be a purely peer-to-peer proposition. DeFi platforms exist to make transactions and other activity more readily available to users. Aptly named decentralized exchanges do so without collecting the same customer information as their centralized counterparts. Could the government mandate that decentralized exchanges collect enough customer information to provide the IRS with something similar to a Form 1099? What would happen if they couldn’t or wouldn’t?
We might soon find out. It won’t be useful for government to choke off US crypto operations as it seeks to protect consumers from the chaos of an FTX. But we also don’t want a regulatory environment that makes tax collections too difficult and evasion too easy. At this point, efforts to collect taxes and protect consumers won’t be as easily swayed by the “let us innovate” calls from the free market crowd.
For now, expect Treasury and the IRS to move forward on 1099 information reporting requirements that largely are built on the centralized exchanges serving as the crypto hub. And the IRS recently issued draft 1040 guidance on digital assets (see pg. 16) that could help crypto investors better understand their tax obligations.
If the FTX collapse prompts users to flee to a less centralized environment, those centralized exchanges will become less valuable as a tool to ensure tax compliance. Regulators will need to find a new touchpoint to best oversee the ecosystem. That could end up being decentralized exchanges or something entirely new as DeFi evolves. But without centralized exchanges facilitating compliance, we risk heading toward an antagonistic environment with one side eschewing regulation and the other ignoring the potential for innovation.