Decrypting the Crypto Reporting Proposal in the Bipartisan Infrastructure Bill
The bipartisan amendment to the infrastructure bill now working its way through Congress includes a new information reporting requirement for some cryptocurrency market actors—one of the few payfors in the package that is not purely an accounting trick. The current legislative language is quite broad, but a spokesperson for Senator Rob Portman (R-Ohio)—one of the amendment’s co-sponsors—has suggested that the drafters’ intent was much narrower. If the provision that ultimately passes is as narrow as Portman’s office suggests, then it will probably have a modest but positive effect on cryptocurrency tax compliance. The limited benefits still will be worth the cost, but the hard problem of cryptocurrency tax compliance won’t have been solved.
A quick taxonomy of crypto market actors
Before delving into the details, it will be helpful to define a few terms.
A cryptocurrency exchange is a platform that allows customers to swap crypto “coins” for other assets. Centralized exchanges like Coinbase and Kraken act as intermediaries between transacting parties. Centralized exchanges in the United States allow users to trade dollars for coins and vice versa, and they are subject to know-your-customer requirements. For example, when I sign up for Coinbase, I need to provide my name, address, date of birth, last four digits of my Social Security number, and a driver’s license or other state-issued ID.
Decentralized exchanges like Uniswap and PancakeSwap facilitate “peer-to-peer” transactions without an intermediary. Decentralized exchanges are protocols, not entities: know-your-customer requirements don’t make much sense in an environment where everyone and no one is a customer. Typically, they facilitate coin-for-coin exchanges but not exchanges of coins for fiat money (e.g., U.S. dollars and euros).
Wallets are mechanisms for storing and sending coins. A wallet can be a piece of physical hardware, or it can be software installed on a desktop or mobile phone, or it can be an online-only app. To send coins from one wallet to another, you don’t need to go through a centralized exchange. Likewise, to trade on a centralized exchange, you don’t need a separate wallet (Coinbase and Kraken, for example, provide “exchange-hosted wallets” that keep custody of your coins). The general advice on cryptocurrency security, though, is to store coins in more secure wallets because exchanges are frequent targets for hackers.
Finally, miners are computers (or people who own computers) that use their computing power to verify blockchain transactions and, as a reward, receive newly minted coins. Miners don’t figure much into the information reporting equation, except for the fact that sloppily drafted language looked for a moment like it might accidentally loop in millions of miners around the world who have literally no possible way of complying.
What would the new crypto provision do?
The proposed provision begins with a “clarification” of the definition of “broker” in section 6045 of the Internal Revenue Code. It states that “broker” includes “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.”
Based on that language, centralized exchanges like Coinbase and Kraken would definitely be brokers. It’s less clear whether (and which) wallet providers might be brokers. Lots of software wallets are free—they effectuate transfers of digital assets, but not “for consideration.” But what if a software developer offers a free wallet but also runs a revenue-generating swap service? Hardware wallets aren’t free, but are they services? Meanwhile, miners facilitate transfers for everyone on the blockchain. One might read the draft text and think it applies to miners, except that requiring miners to file information reports would be a reductio ad absurdum.
Senator Portman’s office sought to answer some of these questions on Sunday. “This legislative language does not … force nonbrokers, such as software developers and crypto miners, to comply with I.R.S. reporting obligations,” a spokesperson for Portman said. “It simply clarifies that any person or entity acting as a broker by facilitating trades for clients and receiving cash must comply with a standard information-reporting obligation.”
So it sounds like senators meant to limit the provision to centralized exchanges. If the legislation passes, presumably Treasury will clarify via regulation what’s in and what’s out, with at least some view to what lawmakers thought they were doing.
The new provision goes on to say that digital assets will be considered “specified securities” for information reporting purposes. The upshot is that when a customer sells coins, the broker will have to file an information return reporting both the gross proceeds and the adjusted basis (in most cases, the price paid). Section 6045(a) gives the Treasury secretary authority to decide what else must be included in the information return.
The new provision also addresses cases in which taxpayers move coins from brokers to non-broker wallets:
Any broker, with respect to any transfer (which is not part of a sale or exchange executed by such broker) during a calendar year of a covered security which is a digital asset from an account maintained by such broker to an account which is not maintained by, or an address not associated with, a person that such broker knows or has reason to know is also a broker, shall make a return for such calendar year, in such form as determined by the Secretary, showing the information otherwise required to be furnished with respect to transfers subject to subsection (a).
In other words, if I move coins from a Coinbase account to a hardware or software wallet, Coinbase will send an information return to me and the IRS. This new information return doesn’t have a name yet—as a placeholder, let’s call it the “1099-CRYPTO.” The Form 1099-CRYPTO will presumably tell the IRS when and how much cryptocurrency I transferred to the wallet.
The provision comes with an applicable date of January 1, 2023 (i.e., pre-2023 sales, exchanges, and transfers won’t be covered).
Will it work?
The new provision will address some cases of cryptocurrency-related underreporting. For example, if an individual sells coins on Coinbase in 2023 or later, Coinbase will have to send an information return to the individual and to the IRS. If the individual bought the coins on Coinbase in 2023 or later, the information return will include the individual’s adjusted basis. (If the individual bought the coins on another exchange—e.g, Kraken—in 2023 or later and then transferred the coins to Coinbase, then Kraken will have to report basis to Coinbase.) If the coins have increased in value and the individual doesn’t report gain on her annual Form 1040, it should be reasonably easy for the IRS to figure that out, audit her, and assess extra taxes.
Coinbase, Kraken, and other centralized exchanges already have most of the information they need to generate information returns, and they should be able to do it reasonably cheaply. Applying the broker basis-reporting rules to centralized exchanges strikes me as an unambiguously good idea. Some taxpayers who otherwise might not have reported their on-exchange gains will be incentivized to do so. And if they don’t, the IRS will be able to catch them pretty easily.
But an information reporting requirement for centralized exchanges—and only centralized exchanges—still leaves a lot of room for sophisticated crypto users to skirt taxes. To be clear: I’m not suggesting that all sophisticated crypto users are skirting taxes (some are, some aren’t). But the potential for tax evasion remains quite high even after the new reporting requirements take effect.
For example, imagine that I exchange dollars for coins on Coinbase and then move the coins to a non-broker wallet. Coinbase will have to file a Form 1099-CRYPTO, but the Form 1099-CRYPTO won’t tell the IRS whether I have any income. Under current law, moving coins from an exchange to a wallet is not a realization event. From a substantive tax law perspective, it’s like you took a valuable asset and put it in a safe-deposit box. (Congress could—in theory—make an exchange-to-wallet transfer a realization event, but it’s unclear what that would accomplish if sophisticated users move coins off-exchange immediately after purchase.)
Now imagine in the future, I transfer those coins from my wallet to someone else’s wallet in exchange for goods or services (e.g., I pay my barber in Bitcoin). If I exchange coins and my coins have appreciated in value since I bought them, then I will owe tax on the gain. But the IRS won’t receive an information return revealing that fact. Coinbase has no idea what I do with the coins after I move them to a wallet, and—at least according to Senator Portman—the software developer who made the wallet doesn’t have any reporting obligations either.
Or perhaps I exchange coins for other coins on a decentralized exchange. Exchanging one type of coin for another is a realization event, but a decentralized exchange isn’t a person. Again, no one files an information return.
Or, even more simply, let’s say I buy Bitcoin on Coinbase in 2023, transfer my coins to a wallet immediately, and then sell the coins on Kraken in 2025. Coinbase will file a 1099-CRYPTO when I move the coins to a wallet. Kraken will know how much the coins were worth when I moved them onto the exchange and sold them. But the IRS won’t know whether the coins that I sold on Kraken are the same ones that I bought on Coinbase.
The IRS, meanwhile, will be receiving lots and lots of Form 1099-CRYPTOs. Coinbase reports that it has 56 million verified users in total and 6 million monthly transacting users in the first quarter of 2021. Not all of those users are in the United States—but a lot are. And not all of those users transfer their coins to off-exchange wallets—but a lot do. (Worldwide, 87 percent of Bitcoin and 82 percent of Ethereum is held off-exchange.)
Perhaps the IRS will see a Form 1099-CRYPTO as an audit red flag. How much these audits will accomplish is unclear. A lot of people move coins off-exchange for innocuous reasons (e.g., because they don’t want to lose their coins in a hack). So some of these audits triggered by Form 1099-CRYPTO filings will yield quite disappointing results. Meanwhile, big-time tax evaders probably have moved lots of coins off-exchange already or will do so before January 1, 2023. They can continue to spend those coins or trade them on decentralized exchanges without triggering information returns.
Note also that in fiscal year 2019, IRS field audits yielded an average of $26,780 in recommended additional tax, with only 9 percent of audits resulting in no recommended change. On the whole—and outside a few areas like partnership entity-level audits where no-change rates are very high—the IRS appears to be pretty good at selecting returns for audit. Field audits triggered by Form 1099-CRYPTO filings will need to have a very high hit rate in order for this audit-selection strategy to be better than what the IRS is doing already. And the IRS will have to build up considerable crypto expertise in order for these audits to accomplish all that much.
The Joint Committee on Taxation estimates that the provision will raise $28 billion over the next decade. That’s an impressive figure. For comparison’s sake, the JCT estimated in 2008 that basis reporting for securities brokers and mutual funds would raise about $6.67 billion over 10 years (closer to $9 billion in current dollars after adjusting for inflation). The JCT’s estimate should be interpreted as very approximate—it’s essentially a guess that taxpayers will change their behavior significantly even if the IRS can’t yet use crypto information reports effectively. Moreover, the JCT estimate was based on a provision that could be read much more broadly than what Senator Portman now describes.
Improving compliance on the cheap?
A robust enforcement strategy for cryptocurrency will require more than just extending the basis reporting requirements to centralized exchanges and generating information returns whenever anyone moves coins off-exchange. As long as wallet-to-wallet transfers and trades on decentralized exchanges can remain under the radar, sophisticated cryptocurrency users will be able to evade tax and escape consequences.
At the same time, expanding information reporting beyond centralized exchanges raises really hard questions. Requiring Coinbase and Kraken to file Form 1099s should be no big deal for them, but requiring information returns from wallet providers would be an earthquake. The raison d'être of cryptocurrency is to provide a means of transferring value that doesn’t depend on financial institutions acting as intermediaries. With information reporting responsibilities, wallet providers (some of whom are now just networks of volunteer software developers) would start to look a lot like financial institutions—or would be unable to comply and might cease to exist.
Defining the content and scope of cryptocurrency information reporting raises tough tradeoffs. Cryptocurrency—like cash—can facilitate tax evasion. It can facilitate good things too. It can enable customers to make cashless purchases from vendors without giving a sizeable cut to payment-card processors. It can allow individuals in the United States to send remittances to family members in low-income countries without paying high transaction fees. Moreover, onerous reporting requirements for wallet providers and other non-exchange actors might cause large swaths of an innovative industry to leave the United States. In an ideal world, Congress would carefully construct an information reporting regime for cryptocurrency that balances costs and benefits—after hearing from market actors, consumer and privacy advocates, academics, IRS officials, etc. Instead, the Senate is rushing to do it all in a matter of days before leaving town on a monthlong summer recess.
Finally, note that the inclusion of the cryptocurrency reporting provision comes days after the Senate decided to ditch a proposal for $40 billion of additional IRS funding over the next decade—apparently because many Republicans were uncomfortable with the idea of more audits. Instead of giving the IRS billions of dollars that the agency desperately needs, Congress now wants to give the IRS millions of information returns that the agency will find only moderately useful. If the IRS can figure out which of these Form 1099-CRYPTO filings merit follow-up—and if it has the resources to conduct additional thorough audits—then the reporting requirement might live up to senators’ optimistic revenue expectations. But lawmakers should not deceive themselves into thinking that they can achieve substantial cryptocurrency tax compliance gains while keeping the IRS on a starvation diet.