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How Congress Plans to Penalize DeFi Cryptocurrency Exchanges

DeFi [Decentralized finance] are financial instruments that do not rely on intermediaries such as brokerages, exchanges, or banks, by using blockchain.

A proposal waiting for a final vote in Congress would require everyone to report certain transactions to the government while criminalizing failure non-compliance.

The amendment to tax code section 6050I requires some recipients of digital assets of over $10,000 to disclose the sender’s name, address, and Social Security number to the government. The amendment is merely eight words long and includes digital assets under its definition of cash.

While the proposal’s impact will be harmful to all digital assets, it could end DeFi.

Based on the intricacies of DeFi, the proposed reporting requirements make compliance impossible and could end DeFi without outright banning it.

In 1984 lawmakers wrote the unusual Section 6050I as part of the tax code, although it is not a tax provision:

  • Written initially to legislate one-on-one physical currency transfers, it will now apply to digital assets. At the same time, a new law will define the same in the broadest terms possible – as any digital representation of value involving distributed ledger technology.
  • Violation of IRS reporting requirements is not a felony, BUT violations of Section 6050I, are.
  • The reporting burden falls on active intermediaries collecting and storing data and all businesses, including individuals, while exempting only banks and financial institutions.
  • Typically, businesses file reports with the government, but this law requires reports containing personal information of individual users of cash and digital currency
  • Section 6050I is merely an anti-crime law that will generate reports to help the government investigate what they consider to be suspicious activity.

Understanding Section 6050I

Individuals will be required to report the personal information of persons [third parties] to the government within fifteen days using IRS Form 8300 if these elements are present:

You received a receipt

  • Keep in mind that a receipt is unconnected to taxable income or revenue.
  • It does not imply a right to keep the asset.
  • It often merely indicates custody of an asset.

Digital assets

  • Includes any digital representation of value using distributed ledger technology.

More than $10,000 in value

  • Transactions are defined to include related transactions and all payments from related transactions.

In the course of your trade or business

  • Only businesses file reports; however, the trade or business classification is extensive. When an individual engages in trading, this could now be a business too.

Unless

Unless a federally regulated financial institution already reports the transaction and personal information under the Bank Secrecy Act and regulations.

When the duty to report is triggered, it requires the inclusion of the names, addresses, and tax ID numbers of all the people FROM WHOM the digital assets were received.

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EXAMPLE 1

DeFi Activity

Andre surrenders the LP tokens he acquired when he made his deposit and withdrew tokens from the liquidity pool.

Proposed Consequences

  • The tokens he withdrew are Andy’s receipt under the statute.
  • According to the definition of transactions in the Act, the receipts from repeated withdrawals aggregate to meet the $10,000 threshold.

EXAMPLE 2

DeFi Activity

Peter uses AMM DEX to swap token A for token B.

Proposed Consequences

  • His receipt of token B is a receipt under the statute.
  • As a result, the report must include the person’s personal information from whom the digital assets were received.
  • When physical cash is received from multiple persons, each person must be listed, and you must list each person on whose behalf the transactions were conducted.

The primary purpose of Section 6050I is not to capture information about the recipient of digital assets. Instead, the true goal is to collect information about the sender. Reporting that excludes the source of cash or digital assets would defeat the purpose of the Act.

The liquidity pool swap or withdrawal tokens cannot be traced to particular persons or accounts. The tokens could come from a smart contract instead of a person. If the DEX were a centralized exchange, it might be the sender of the B tokens. The person you have to report most likely will be the DEX, which is merely a collection of smart contracts instead of a legal person or entity. Recipients can argue that the non-existent person renders the transaction outside the statute’s reach.

Insiders agree that it would be reckless to conclude that the mere existence of a smart contract would exempt recipients from the requirement to report the sender’s personal information.

EXAMPLE 3

DeFi Activity

In 1983, imaginary artist Mallory a highly sought-after artist, sold his sculptures on an honor system. Buyers took the artwork from his front porch and left an envelope containing $11,000 in cash in his mailbox.

Proposed Consequences

  • Section 6050I became law in 1984.
  • Would Mallory be excused from reporting the buyer’s personal information to the government because his business model did not enable compliance?.
  • Could he argue that his business model exempted him entirely since he received the cash from a mailbox, not a person?.

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It is legal to sell artwork anonymously for $11,000 cash. However, section 6050I imposes civil and criminal sanctions for those who fail to report as required by the Act. Therefore, to report in compliance with the statute, you have to obtain the information required by the regulation. Like Mallory, you will not defeat the reporting requirement merely by substituting a smart contract for a mailbox.

EXAMPLE 4

DeFi Activity

  • Jesse likes an NFT and sends his cryptocurrency to a smart contract. Now Jesse owns the NFT.
  • Artist Dana makes and sells NFTs, and he received Charlie’s crypto as payment.
  • The same goes for other people who received digital assets due to Jessie’s crypto transaction.

Proposed Consequences

  • A digital asset’s receipt [NFT] imposes a reporting requirement on Charlie.

Dana received his cryptocurrency from a smart contract. He is not exempted from reporting Jesse’s personal information by this mere fact.

Section 6050I cannot be applied to digital assets nor DeFi transactions. It is an old law that does not fit the new technology. Furthermore, it is too hard to visualize how 6050I would apply to digital assets – that is why the media have more or less ignored the proposal.

If the amendment becomes law, everyone will have to take it seriously. Congress cannot wait for that. The amendment to 6050I is an affront to the rule of law and democratic legislation. It was deviously slipped into a 2,700-page spending bill as a tax measure to defray the bill’s trillion-dollar price tag, while it is really a costly criminal enforcement provision.

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.

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