The two-pronged Eleventh Hour IRS squeeze on Bitcoin and crypto developers

Call it the 2024 Christmas Crypto Regulatory Shock.

In a manner of days, the Internal Revenue Service has provided clarity on two separate regulations that will have an intimidating impact on anyone who uses what the government deems digital assets.

Both of these proposals have been cooking within the bureaucratic chambers of the federal government and its rule-making process for some time, but the finalization and deadlines have caused understandable panic among those who hold Bitcoin and other crypto-offspring in the US, as well as developers and innovators who offer tools for us to use.

The two proposals in question are:

1. The KYC dealer-broker rule for DeFi front-ends
2. IRS Safe Harbor Transitional Relief

Though the former was only published to the Federal Register today, it will get plenty of attention and legal might thrown at it, considering the implications on most DeFi protocols, crypto tokens, and software developers. And they'll be aided by a formidable representation by industry groups well-placed and funded to challenge this rule in court and among lawmakers.

A deal breaker for noncustodial services

As explored here on The Rage, the IRS is continuing to widen the scope of who it believes should be required to comply with KYC/AML regulations like the Bank Secrecy Act, following similar proclamations from another branch of the Biden Administration.

As seen in the Samourai Wallet and Tornado Cash criminal complaints, the Department of Justice is deviating from established FinCEN rule-making, which still de jure considers that noncustodial software developers who do not take custody of funds are not liable to be licensed as money transmitters and are not required to implement KYC/AML programs.

In de facto terms, however, the high-profile indictments of software developers of noncustodial tools demonstrate the Biden Administration's hostility to both privacy and crypto innovation.

The dealer-broker rule is intended to come into force by 2027, but its looming effect will predictably lead to a decline in US innovation and crypto product offerings, as argued by Coin Center. For now, it will be up to the courts to determine whether the rule is legal and can withstand constitutional muster.

Last Friday, the Blockchain Association, DeFi Education Fund, and the Texas Blockchain Council filed a lawsuit against the IRS and the Treasury Department, seeking to have a federal judge strike down the final rule and provide an injunction prevent it from coming into force.

Considering their argument that the IRS rules are unconstitutional and contrary to federal laws on administrative procedure, the courts should resolve this matter rather quickly, especially in a post-Chevron era.

Beyond the courts, the incoming Trump Administration (headed by the literal "Chief Crypto Advocate" of a DeFi platform) and a somewhat more crypto-friendly GOP Congressional majority will have adequate time to change these rules within a new tax reform package.

Whether that actually happens, though, is anyone's guess.

The Dark and Stormy "Safe Harbor"

For the latter proposal regarding "safe harbor" and accounting practicing rules, despite the name, it is a squeeze on Bitcoin and crypto holders.

In the absence of a comprehensive digital assets framework from Congress, the IRS has continued to build upon its own guidance and regulations, using its own interpretation of recent legislation to create new laws for Americans to follow when they file their taxes.

The Infrastructure Investment and Jobs Act, signed into law by President Joe Biden in November 2021, created reporting requirements for customers of any entity "effectuating transfers of digital assets on behalf of another person," what we would traditionally call a custodial service or exchange.

This triggered the rule-making procedure by the IRS, which decided to add its own requirements beyond what the law required (something that should eventually be heard by a post-Chevron court and promptly scrutinized).

If you use an exchange to sell (not buy) your Bitcoin or other digital assets, that exchange will be required to send you a new tax form, called the 1099-DA, which tallies up your various "taxable" transactions. This file will be sent out to customers to be retained for up to 7 years, and also retained by exchanges and shared with the IRS if an audit demands it.

Finalized in July 2024, and later expanded upon, IRS Revenue Procedure 2024-28 also outlines the method for the "determination of amount realized and basis for certain digital asset sales and exchanges," opting for a wallet-by-wallet accounting method , rather than the "universal" accounting method.

Previously, when taxpayers reported their crypto capital gains to the IRS, they provided a broad "cost basis" as if all crypto came from a universal, single account. Now, the IRS wants that information on a per-wallet basis, understanding that tokens and UTXOs were acquired at different fiat prices, and thus should be taxed accordingly whenever they are sold or traded for goods.

What the IRS is offering, via the safe harbor provision, is protection from any liability if crypto holders provide a "snapshot" of their holdings on a wallet-by-wallet cost basis by January 1, 2025, which can be used to determine the level of capital taxation in the future.

Moving all of your Bitcoin and crypto tokens into a single wallet, or selling them all and repurchasing them to establish a consistent cost basis, is the aim.

The "safe harbor" element, so graciously offered by the nation's tax enforcers, is realistically a legal maneuver to coax as many taxpayers as possible to provide the cost basis for their crypto purchases, giving the government an adequate formula to follow for calculating how much tax you owe.

Put simply, the IRS wants to bring as many digital assets as possible into the taxed system and attach a cost-basis to every coin, token, or UTXO. If you can measure it, you can tax it. That's the aim.

The concept and application of this new rule is incredibly complicated, muddy, and provides plenty of new customers and business for crypto tax attorneys and accountants, who are seemingly the only people who can somewhat explain these rules.

What about those who have been DCAing Bitcoin purchases for years, making daily, weekly, or monthly purchases on several different platforms and websites? What about those who use Bitcoin for goods and services they need from different wallets and UTXOs?

Understanding the technical and legal implications of this accounting and safe harbor plan is beyond the scope of this article (for that, I'd recommend Crypto Tax Girl).

But it does mean that, without even thinking about it, potentially millions of Bitcoin and cryptocurrency holders will be non-compliant with IRS rules and risk future audits and penalties if they miscalculate the gains of their various crypto transactions over the years. Or they'll be forced to HODL forever until there is more clarity from federal legislation and guidance.

In the meantime, we'll have a nation of Bitcoin scofflaws.

This is obviously a juggernaut of epic proportions that will need fixing, and should more congruent to the promise of peer-to-peer digital cash intended to fix the money.

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