Why Cryptocurrency is So Difficult for the IRS to Regulate

3 Reasons Crypto Eludes Regulators

Cryptocurrency is all the rave right now, which is why tax authorities are aching to get their share of the revenue. This may prove to be a tricky proposition, though, as many members of the crypto community are against IRS regulation. Despite the challenges and discrepancies, however, the IRS clearly sees crypto as a lucrative enough source of revenue to continue to pursue regulation. And while policies and regulations will continue to shift and evolve, we should be preparing now for stricter cryptocurrency regulation.

Cryptocurrency was supposed to exist outside the watchful eye of government, with no central banks, no physical manifestation and no oversight from tax authorities. While central banks and metal coins are still nowhere to be found, tax authorities are onto crypto and want their share of the revenue from the emerging form of currency.

Getting that share, though, is proving to be complicated. There are three basic factors that make regulation and reporting of crypto transactions so difficult:

1. The resistance to regulation within the crypto community.
2. The fact that the IRS doesn’t see crypto coins as actual currency.
3. The highly fragmented and distributed nature of crypto transactions.

A Brief Review of Cryptocurrency and IRS Regulation

Cryptocurrencies flew under the taxation radar in the United States until 2014, when the IRS issued Notice 2014-21, which detailed regulations for how taxpayers should report cryptocurrency transactions. The notice made little impact until two years later, when the IRS successfully served a summons to popular trading exchange Coinbase in search of information about its customers. After a legal battle, a court ordered Coinbase to hand over a list of some of its users.

The Coinbase affair struck a hard blow from tax authorities in the battle to regulate cryptocurrencies. Earlier this year, another watershed event took place: The Tax Cuts and Jobs Act removed a loophole and effectively enforced a tax on crypto assets. Under the measure, cryptocurrency transactions are now defined as taxable events.

Resistance to Regulation in the Crypto Community

Following those developments, cryptocurrency is very much in the crosshairs of the IRS, which doesn’t sit well with many members of the crypto community. While some crypto investors and exchanges actually welcome regulation because they feel it will give cryptocurrency – often associated with illicit purchases on the “dark web” – an air of legitimacy, others prefer an unregulated approach.

For example, in late March, a contingent of executives and attorneys met with the SEC to request limited regulation of crypto coins. Specifically, they asked that initial coin offerings (ICOs) be exempt from SEC oversight. Currently, the SEC’s Division of Corporation Finance oversees ICOs, but with the numbers of exchanges, coins and investors in the crypto community constantly growing, regulation is becoming more and more difficult.

When Money Isn’t Money at All

The debate about crypto doesn’t just involve what crypto is; it also has to do with what it isn’t. In the eyes of the IRS, cryptocurrencies aren’t actually money. This distinction alone is a huge barrier toward crypto regulation. On this issue, looking at crypto regulation from the perspective of tax information reporting – how exchanges and investors notify the IRS about transactions – is revealing.

Individuals who invest in physical foreign currencies, such as the Pound or Yen, report their investments to the IRS with form 8938, Statement of Foreign Financial Assets. But the IRS treats cryptocurrencies as property, not currency, meaning they are subject to capital gains tax in a way standard foreign currencies are not. Individuals even have to pay taxes on items purchased with cryptocurrencies because, technically, they have converted an asset into a currency and “traded” it for something else, rather than making a purchase with standard money. The trade triggers a capital gains tax.

According to the precedent set by the IRS in the Coinbase case, exchanges should issue 1099-K forms to customers, although expressing regulation from the IRS on this issue still does not exist. The 1099-K is the same form companies in the sharing economy, such as rideshare or home-share businesses, send to the drivers and homeowners who use their platforms.

The 1099-K covers income individuals receive through third-party settlement organizations, or TPSOs, which process credit card payments online. In the case of crypto, exchanges are considered TPSOs and are responsible for sending 1099-K forms to payees and to the IRS.

But the 1099-K isn’t the only form potentially involved with crypto trading. Form 1099-B, used to report proceeds such as stock trades, could come into play for investors who trade one type of coin for another. For instance, if an investor trades Bitcoin for Ethereum, the transaction would trigger a reportable event, possibly a 1099-B. However, there is currently no formal guidance instructing exchanges to issue 1099-B forms the way brokers do for security trades.

So, what is the distinction between reporting form 1099-K vs 1099-B?

There are two distinguishing factors: the difference between reporting proceeds versus gross proceeds and the difference between short-term and long-term gains. Since 2011, the exchange of a security requires tracking of the seller’s cost so that proceeds can be adequately calculated and reported to the regulators. This is reported on form 1099-B.

Furthermore, the 1099-B also indicates whether the sale of a security was a short-term or long- term investment. This information will dictate how the payment for said security should be taxed. With these two data points being absent from form 1099-K, the taxpayer doesn’t have all the information necessary to accurately report income from crypto investments.

The complete difference in tax information reporting approaches and the IRS’s current reliance on form 1099-K over 1099-B for crypto transactions suggests that the IRS views cryptocurrency as an asset, not a form of currency. While the agency is likely still deciding exactly what crypto is, either way, though, the nature of cryptocurrencies make them tough for regulators to track.

A Brand New Model That’s Difficult to Regulate

The splintered, distributed nature of crypto is another major hurdle for regulators. No other investment has ever worked the way crypto does. There is no central bank. There are new coins cropping up constantly, as well as new exchanges. Nothing about crypto is centralized, meaning proceeds and cost basis are exceptionally difficult to track.

Investors can switch coins from one exchange to another at any time, and the exchanges don’t communicate. Some exchanges require investors to identify themselves. Others, however, promise complete anonymity, making tax information reporting, or tax collection, virtually impossible. So, it’s extremely difficult and often impossible for an exchange to accurately report how much an investor originally paid for a crypto coin on another exchange.

The burden of compliance falls on both exchanges and individual investors, both of which the IRS could potentially pursue for failure to comply. But the extremely fast-paced nature and high transaction volume of crypto investing makes tracking transactions extremely difficult, if not impossible, for individual investors.

The IRS is more likely to seek financial remedies from exchanges that fail to adequately or accurately report transactions, but pursuing exchanges operating in a distributed blockchain environment is not as cut-and-dried as going after traditional businesses. It is, in fact extremely difficult.

Regulation in Crypto’s Future

Despite the challenges involved, the IRS clearly sees crypto as a lucrative enough source of revenue to continue to pursue regulation. With cryptocurrencies gaining mainstream acceptance, some exchanges and investors are likely to comply with, and even possibly embrace, regulation. And while policies and regulations will continue to shift and evolve, crypto as a source for government revenue will not disappear, despite the significant challenges currently in place.