DeFi Has 3 Options If IRS Rule Isn’t Rolled Back, Says Alex Thorn
The recent Internal Revenue Service (IRS) reporting rule designating decentralized finance (DeFi) front-ends as brokerages has sent shockwaves throughout the crypto industry. The impact of this rule change is far-reaching, and its implications for DeFi services and applications are multifaceted.
A Brief Overview of the IRS Reporting Rule
The final IRS reporting rule was issued on December 27, 2024, and it proposes to treat ‘Trading front-end service providers’ as brokerages. This definition includes decentralized exchanges (DEXs), which are a crucial component of DeFi ecosystems. If finalized, the change will take effect in 2027.
The Potential Consequences for DeFi
Alex Thorn, the head of research at Galaxy Digital, has outlined three potential options for DeFi services and applications in response to the IRS rule:
- Compliance with Reporting Requirements: DeFi services and applications can choose to comply with the IRS reporting requirements and accept the designation as a brokerage.
- Blocking US Users: Another option is for DeFi services and applications to block users from the United States, thus avoiding the need to comply with the reporting requirements.
- Abandoning Smart Contract Upgrades: DeFi services and applications could abandon smart contract upgrades and revenue generation, effectively opting out of the new regulations.
The Potential Exemptions
Thorn suggests that extremely decentralized applications (EDAs) may be exempt from being designated as ‘brokers’ under the proposal. He argues that EDAs with no front-end website, non-upgradeable contracts, and that receive no consideration from the disposition of digital assets —i.e., collect no fees — could avoid compliance with broker reporting requirements.
Thorn further elaborates on this point: "Said another way, extremely decentralized applications are not in a position to know and thus could not comply with broker reporting requirements." This observation highlights the complexities inherent in applying the IRS rule to DeFi services and applications.
The Industry Response
The crypto industry has been vocal in its criticism of the IRS reporting rule. Crypto industry advocacy groups, executives, and experts have mobilized against the proposed change, arguing that it constitutes government overreach.
On social media, Consensys attorney Bill Hughes criticized the timing of the rule: "This rule has been ready to go for a while now. They dump it on the last Friday of 2024, in the middle of a holiday stretch on purpose, obviously — as if we wouldn’t notice or make an absolute ruckus over it."
A joint lawsuit was filed against the Internal Revenue Service by Texas Blockchain Council, the Blockchain Association, and DeFi Education Fund on December 27. The lawsuit alleges that the Department of the Treasury and the IRS are engaging in unlawful and unconstitutional overreach.
The Wider Implications
The impact of the IRS reporting rule extends beyond the crypto industry to the broader financial landscape. If finalized, the change could have far-reaching consequences for DeFi services and applications, potentially limiting their adoption and usage.
As Thorn notes: "If DeFi is forced to become more centralized or structured in response to this regulation, it will fundamentally undermine the decentralized ethos that has driven its growth and success."
Conclusion
The IRS reporting rule poses significant challenges to the DeFi ecosystem. As the industry navigates this regulatory landscape, it is essential to consider the potential consequences of each option outlined by Thorn.
While compliance with reporting requirements may seem like a straightforward solution, it could lead to increased costs and administrative burdens for DeFi services and applications. Blocking US users or abandoning smart contract upgrades are more drastic measures that could have unintended consequences.
As the industry continues to grapple with this issue, one thing is clear: the IRS reporting rule has sent shockwaves through the crypto industry, highlighting the need for a more nuanced understanding of decentralized finance and its regulatory implications.
Recommendations
- Monitor Regulatory Developments: DeFi services and applications must stay abreast of regulatory developments to ensure compliance with changing requirements.
- Engage in Industry Dialogue: The crypto industry should engage in open dialogue with regulators to address concerns and advocate for fair treatment under the law.
- Explore Alternative Solutions: The industry should explore alternative solutions that balance regulatory requirements with the decentralized ethos driving DeFi’s growth.
By taking a proactive approach to addressing this issue, the DeFi ecosystem can mitigate the potential consequences of the IRS reporting rule and ensure continued innovation and adoption in the years to come.
