Public Key Podcast

Navigating Complex Crypto and DeFi Taxes: Podcast Ep. 102

April 11, 2024 | by Chainalysis Team

Episode 102 of the Public Key podcast is here!  It’s that time of year in the USA where the trees are blossoming, the winter jackets are being packed away for the season and there is only one thing on everyone’s mind, Taxes.  But how do you report, DeFi transactions, crypto staking and lending abd stablecoin purchases? Well we brought in crypto tax generalist, Lorenz Haselberger (Partner at Shearman & Sterling LLP), who dives deep into the most complex tax implications facing the crypto industry.

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 102.

Public Key Episode 102: Unraveling the tax implications of crypto lending, staking, DeFi and smart contracts 


It’s that time of year in the USA where the trees are blossoming, the winter jackets are being packed away for the season and there is only one thing on everyone’s mind. Taxes.  

But how do you report DeFi transactions, crypto staking and lending and stablecoin purchases? Well Ian Andrews (CMO, Chainalysis) brings in crypto tax generalist, Lorenz Haselberger (Partner at Shearman & Sterling LLP) to dive deep into the most complex tax implications facing the crypto industry. 

Lorenz unfolds the nuances of reporting taxes within the dynamic and evolving world of cryptocurrencies and shares his journey into the crypto tax niche and unwraps the critical aspects of current tax considerations.

He discusses the tax challenges with DeFi protocols and underscores the  importance of understanding the tax implications for both individual and institutional investors and the need for the US Government to provide more clarity and guidance to the crypto industry 

Quote of the episode

“I think one of the most interesting kind of unsolved riddles in this space, and it’s both a kind of a question of how the ecosystem evolves and how the tax rules are crafted to address it.” – Lorenz Haselberger (Partner at Shearman & Sterling LLP)

Minute-by-minute episode breakdown

2 | Lawrence’s background in taxation and involvement in the crypto industry 

6 | Discussion on the complexity of reporting obligations for exotic cases like crypto and DeFi lending 

14 | Everything you need to know about staking and potential tax implications

22 | The debate on whether DeFi transactions should be treated as a taxable event

25 | The national and international tax implications for crypto investors vs traders

33 | Debate on expanding information reporting requirements for crypto 

36 | Does tax complexity and uncertainty deter some from participating in crypto?

39 | Differentiating stablecoins from cryptocurrencies for tax purposes

42 | The evolution of DeFi protocols and need for Government guidance for crypto tax implications 

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

Speakers on today’s episode

Transcript

Ian:

Hey everyone. Welcome to another episode of Public Key. This is your host, Ian Andrews. Today I’m joined by Lorenz Haselberger, who is a partner at Shearman & Sterling LLP. Welcome to the show.

Lorenz:

Thanks for having me, Ian. Great to be here.

Ian:

This is becoming a bit of an annual tradition on Public Key as we’re recording this in late March, I know that I’m personally thinking about filing my taxes, I’m sure many of our listeners may be the ones that are very proactive and on top of it have already filed. But income taxes probably on everyone’s mind. I’d love your LinkedIn bio, “I’m a tax generalist,” because I think you’re being pretty humble. When we got to first met a few months back, it was very clear to me that you’re deeper than almost anyone I’ve met in the world of digital assets and the implications for tax. So I’m super curious to hear your crypto origin story. How did you get started learning about the industry? Maybe tell us about the first time you encountered digital assets.

Lorenz:

Sure. And when I say I’m a tax generalist, I really just mean that I work on the tax aspects of all sorts of transactions a big international law firm might advise on, from M&A transactions to debt restructurings to cross border investments and derivatives. The tax lawyers that I’ve admired the most in my career were generalists that mastered the art of taking knowledge from one sub area of tax and making it useful in a different area. And I’ve tried to model my career on those predecessors, but if I have a major in the field of taxation, it’s in the taxation of financial products and financial institutions, because those topics are highly relevant to a significant portion of my firm’s client base.

Shearman & Sterling has historically represented big financials, banks, broker dealers, hedge funds, the like, sovereign investors. And we’re in the process of actually merging with Allen & Overy, which is our UK counterpart in this space. They’re really big in this area in the UK, which is obviously a financial hub and also the rest of the world outside of the US. And also have a very substantial US presence.

Digital assets in some sense are just a new type of financial instrument. And so, when sophisticated investors and financials began to have questions about the taxation of crypto in the first half of the last decade, we were the natural people to approach about those questions. And in terms of how much of my work these days is crypto related, I’d say about 15 to 20% of my practice is crypto focused, which may not sound like much, but for a big firm tax partner is a lot, because so much of the work we do is on big transactions. And there are few tax partners at law firms these days that have a significant client base of their own and do a significant volume of tax advisory work for those clients.

I try to stay smart in this field, both by working for cutting edge clients that are active in the crypto field on their most cutting edge tax questions, but also I’m involved in various bar organizations including the New York State Bar Tax Section Executive Committee, which I have always viewed as the preeminent tax bar group in the country and maybe even the world. And so I’ve authored a couple of bar reports on the taxation of crypto for that organization. And so doing, those are very long and detailed reports and they deal with all the areas where there’s ambiguity. I got to talk to a lot of market participants and other prominent advisors in this field and learn a lot. So those are the two ways that I’ve gotten smart and stayed smart in this field.

Ian:

Yeah. I’m curious about the New York Bar Association as you’re producing that research, what’s the reception to it? Are other lawyers as enthusiastic about the space as you are or are they maybe a little more skeptical of the ecosystem?

Lorenz:

It’s a mixed bag, in the way that I always find that funny when people have a knee-jerk negative or super positive reaction to crypto because as a tax lawyer, I just view my role as figuring out how the tax rules work for the economic reality that we operate in. And digital assets are now clearly part of the economic reality that we operate in, and people need to know how to properly report their taxes and file their tax returns. And so that’s my job. And I don’t really spend a lot of time thinking about is crypto good or is crypto bad from a policy level. I think it can have good applications, it can have bad applications. And people say, “Well, crypto can be used for criminal activity and money laundering.” Well, the same thing happened with bearer bonds in the ’80s. So it’s there. People need to know how it’s taxed. And that’s my role and I think that that’s how most other reasonable advisors view this space.

And so I think to that end, the NYSBA Tax Section has done I think more than any other bar group in terms of providing clarity in this area because there are very few rules and taxpayers do need guidance. And if you read our reports, I think they’re the single best source of guidance out there in terms of what reasonable tax practitioners think the right answers are.

Ian:

Yeah, I love that perspective because it’s so practical, I guess. If we could somehow bottle that and deliver it to some of our policymakers and legislators in Washington, we might be able to make some meaningful progress in this area. But let’s talk about people who are preparing the return. So my perspective as a non-expert here is it seems like depending on how you might be participating in the digital asset ecosystem, some things have gotten better. There’s now a requirement, I think, for most exchanges to send 1099s to anybody that’s traded on their platform, which if you’re doing basic activities, probably makes things a lot easier than it was a few years ago where people were combing through individual blockchain transactions in order to calculate cost basis and things like that.

But if you’re doing anything off an exchange, it seems like it’s still really complex. So maybe we can walk through a couple of the more exotic cases and get your take on how and how people should think about their reporting obligations there. One that comes to mind specifically is smart contract lending. What’s your thinking in that area?

Lorenz:

Absolutely. Happy to talk about that. Before we launch into the nitty-gritty though, I just want to quickly give a disclaimer to say that the views that I express on this podcast are solely my own and don’t necessarily represent the viewpoint of my firm or any of my clients.

And this should be obvious, but this podcast is not tax advice. And all advice in this area is highly fact specific and context dependent. So if you have any questions about your specific circumstances, you should talk to your own tax advisor or tax accountant. Particularly in the area of crypto lending and crypto staking, people will often refer to crypto lending but mean very different things depending on the context. And so that just by way of disclaimer. And another point you mentioned-

Ian:

It’s super important disclaimer everybody, not advice and we’re not your lawyers and you should consult your own experts if you need actual advice on these topics. So please continue.

Lorenz:

And then you mentioned another interesting point before we get into the smart contract lending question, which I think is really interesting, which is that if you’re transacting through centralized exchanges, you’re now getting reporting. So that is true in certain circumstances. There’s certain reporting requirements that already apply to exchanges, and then some of the more forward-thinking is changes are voluntarily reporting, broker reporting type 1099-B information. But the regulations for broker reporting are still in proposed form and are not effective until they are finalized. And so this is still a space where even if you’re trading through a centralized exchange, you cannot rely on the fact that transactions will always be reported to you correctly. You still need to keep track of all of your transactions, especially if you’re trading with high frequency, keeping track of your basis on your own because the exchange may not be retaining that information or reporting it properly to you, or at least you shouldn’t rely on that.

I mean theoretically even in the securities context, the exchange has an obligation to report transactions to you, but if they fail in that obligation, you still need to report it on your tax return. So I think taxpayers that are active in this space would be well advised to continue to keep careful track of their own transactions for the time being, until we get final information reporting regulations.

And then the lending question is really an interesting one. I think lots of crypto investors are lending their crypto to generate yields, either through traditional bilateral loan agreements or through DeFi protocols, which I think DeFi protocol lending is more of what you were referring to. And I think although most investors are aware that crypto lending fees have to be reported as taxable income, they may be less aware that there’s a risk that when you lend your crypto, depending on the specific facts of the arrangement, that may actually trigger tax realization of any embedded gain in the crypto at the time you’re lending it out.

So if you bought a lot of Bitcoin in this last crash at $18,000 a Bitcoin, and now you’re lending it out on a DeFi protocol when it’s worth 70,000, before you go ahead and do that, you would be well advised to talk to a tax advisor about mitigating the risk that lending transaction in itself triggers the embedded gain in the Bitcoin, because you could end up with a lot of phantom taxable income in that Bitcoin and potentially also, I mean if you required it less than a year ago, you might not get capital gain preferential rates on that. So that is something to look out for.

Ian:

I think that’s probably a big surprise to most people, because what I’ve observed is folks who think about lending as a mechanism to not have to take the capital gain tax treatment, maintain the low cost basis, but yet still earn some sort of a return on the asset. What would be the conditions that would trigger one treatment versus the other? If you can explain that for us.

Lorenz:

Sure. So in the context of securities lending, there’s a specific non-recognition rule in the Internal Revenue Code Section 1058 that turns off gain realization provided that the securities loan meets certain requirements, which are generally designed to put the securities lender in the same position as if it owned the security outright. So pass through of dividends, interests, other income items generated by the security, you have to have a right to get the security back, meet certain other conditions. Those rules do not by their terms apply to crypto. Because for these tax purposes, for 1058 purposes, crypto is not a security regardless of what the SEC may be doing for securities law purposes.

And so there is no clarity on whether and under what circumstances crypto loans are taxable, except general background tax principles on when exchanging one piece of property for a different piece of property is or is not taxable. And that general standard is the property you’re getting back in exchange, in this case, your rights in the loan agreement, materially different in kind or extent than owning the underlying crypto outright?

And so, we have gotten reasonably comfortable in the context of bilateral traditional legal form loans of crypto that if you have the rights to demand the crypto back within a short period of time, generally something like one to five days, and you have the right to all hard forks and airdrops, digital assets can under certain circumstances generate income items for tax purposes, including when the blockchain splits and there’s a hard fork, like the 2017 hard fork of Bitcoin into Legacy Bitcoin and Bitcoin Cash, or when there’s an airdrop of a new digital asset in respect of an existing digital asset. So those need to be passed through.

And without getting into the weeds, we’ve come up with certain reasonable guardrails for when those need to be passed through automatically when they’re sufficiently material that they should just be passed through as a matter of course. And when it’s okay to simply give the lender the right to ask for the hard fork or airdrop, if they want it. In any event, the devil is in the details. And the point is to make the economics of the loan as much as if you still held the underlying Bitcoin or whatever other asset that you’re lending out, as if you hadn’t lent it at all. That’s the guiding principle. And if you meet all those conditions, then we have gotten to a reasonable level of comfort that ought not be a taxable transaction. And I think that’s an eminently reasonable position.

And in fact, the Biden Administration has in every recent proposal for proposed tax legislation and the so-called green books that they put out each year, proposed to extend legislatively the 1058 rules to digital assets. But that hasn’t happened yet. And unless that happens, we’re operating in an environment of uncertainty. And issues that can come up here really are term crypto loans, because even if you’re reasoning by analogy to 1058, 1058 by its terms doesn’t say that a term loan of a security that you can’t recall in a short period of time necessarily triggers gain recognition.

But there was a court case Samuelity that appears to read a requirement like that into the rules. And that creates uncertainty for term securities loans. And that uncertainty is magnified for term crypto loans, if you can’t get the crypto back within a short period of time. I think there are still reasonable arguments that Samuelity was wrongly decided, and that shouldn’t be a realization event, but you’re operating in a higher risk environment if you’re doing term loans.

And then the other higher risk environment is DeFi lending. Because when you look at these protocols, there’s no contract at all. You’re relying on the software for your right to get the crypto back. And in the case of pooled crypto lending, you’re getting back a token that allows you to participate in a pool that lots of people contribute crypto to, but you’re participating on a pro-rata basis. So your rights are no longer necessarily tied to the specific cryptocurrency that you lent. And in those environments, it starts getting really tricky and you might really start getting worried that you’re triggering the built-in gain in the crypto, because getting back something that’s very different from the underlying Bitcoin or whatever other cryptocurrency that you lent. So those are areas where I would say there are more red flags and people should be cautious before they enter into transactions of that kind, if they have a lot of built in gain in their crypto.

Ian:

Yeah, that’s fascinating. Because I think I would’ve said, well, if I was depositing into a liquidity pool, unless there’s some sort of unusual lockup period, I meet that opportunity to withdraw within one to five days. And I think for most of these constructs, you’re still eligible to receive airdrops or the forked, but it’s specifically the lack of the direct contract and the fact that it’s pooled with other assets that you think would potentially trigger it becoming a taxable gain event.

Lorenz:

Right. And by the way, I think that is the right answer. If I were writing the rules, I would absolutely say that under the circumstances you just described, that should not be a realization event. The problem is the tax rules were not written with smart contracts in mind. They were written in a world where the only contracts that existed were plain old legal form legal contracts.

The non-tax legal treatment of smart contracts I think is unclear, right? The whole point is they settle automatically on the blockchain. I don’t know, do you have a right to go to a court and show them the software and say, “Hey, this is actually a contract, but it’s just written in computer code. Please enforce this for me.” I don’t know the answer to that. I’m not sure that anyone knows the answer to that.

Ian:

We need a test case. Somebody should bring this forward. If you’re listening, let’s try this out.

Let’s talk about a related topic, staking. What’s the situation there? I mean, this has become incredibly popular, particularly in the Ethereum ecosystem since the upgrade to proof of stake architecture. Where does this fall in realm of taxable activity? What should we be concerned about here?

Lorenz:

Yeah, we actually addressed this in one of the bar reports, so if you want to read more about this after the podcast, highly recommend you read that it’s NYSBA Report 1461.

So economically, staking rewards, there are amounts that are paid by proof of stake cryptocurrency to holders of the cryptocurrency that stake their crypto with the protocol in exchange for the right to validate transactions on the protocol’s blockchains with the rewards earned if validation is completed correctly and successfully. So when you think about it like that, it’s a carrot and stick approach to ensure that transactions are validated correctly, with the carrot being the staking rewards. And the stick, at least generally, is that the protocol can reduce or “slash” the cryptocurrency that you’ve staked if you try to validate transactions incorrectly, like a double spending transaction. So it is basically an incentive system that is ultimately very similar to mining rewards that people may be more familiar with from the Bitcoin ecosystem where the mining reward context, the carrot is the rewards and the stick is the massive energy and hardware costs that the sunk costs that a miner bears if they solve the mining puzzle and proceed to validate transactions but do so incorrectly. Because they gain the right to validate transactions and they’ve incurred all these sunk hardware costs, but then they earn no mining reward.

And so once you understand really that the rewards serve a similar purpose and feel economically similar, it’s hard to distinguish from a tax perspective why they should be taxed differently. The IRS had said all along pretty early on that mining rewards are taxable when received. And for a period of time, there was uncertainty whether that same logic would extend to staking rewards. But in 2023, the IRS issued guidance clarifying that staking rewards are also income that’s taxable in receipt, which I don’t think surprised most tax practitioners. I think some taxpayers tried to argue that staking rewards aren’t income either because they’re self-created property, like when a farmer grows corn, the farmer isn’t taxed on the corn when the corn grows on the stock, you’re taxed when you dispose of the corn. And then there was another argument that these are really like rata stock dividends, because if everyone in the protocol is getting staking rewards equally, then no one’s really getting an accretion to wealth.

And I think both of those arguments, look, you can make them with a straight face, but when you examine them in more detail and get into the weeds, they run into a variety of conceptual difficulties. Including that stakers, when you validate a transaction, you’re in no real sense creating the cryptocurrency, it’s being created by a software protocol that’s being run by an aggregation of network participants. And just because the tax rules haven’t yet found ways to categorize what that software protocol is, doesn’t mean that it’s necessarily analogous to a case where a farmer is planting crops. And the same thing with this idea of, okay, it’s all pro rata and therefore no one has any value. When you look at participation and staking in these various proof of stake protocols, it varies somewhere between 40, 60, 80%. And so there really can be a non-pro rata accretion to wealth element here. And so I think most people were expecting the IRS to make this clarification. And in fact, advising taxpayers even prior to this guidance that they should be including these amounts and income when received.

And that’s not to minimize the issues for taxpayers that are created by having to report all these transactions. With cash transactions, you generally know what you get, you know the dollar value and it’s pretty easy to report. If you’re generating staking rewards, you have to look, they’re generally denominated in the same cryptocurrency protocol that you’re validating transactions for. And then you have to figure out what the fair market value of those tokens is when you receive them. And as we all know, valuations in the crypto space are still not entirely transparent and two exchanges may say different things. So what value do we report? You have to figure out some reasonable method to do the tax reporting. I don’t want to downplay the significant brain power and time that’s required to do all this.

Ian:

Is there any difference or nuance in the scenario where I’m running a node directly and staking on that node or I’m using a pooled service, there’s a number that are fairly popular in the Ethereum ecosystem like Rocket Pool and Lido. Does that change my situation at all from a tax perspective?

Lorenz:

It can. I mean, I think broadly speaking, three ways to do this. You can do it directly, you can do it by delegating it, usually under some legal form delegation agreement. If you’re on a platform with a centralized custodian, they’ll often allow you to enter into a legal agreement where they do the staking for you and then they pay through 90% or 95% of the staking rewards that they earn and you receive those. Or you can do it in a DeFi pool, by contributing your proof of stake cryptocurrency to a software protocol where you then take a token back and it stakes the crypto on your behalf. Those three scenarios can be subject to very different tax treatment.

In the first case, the cubby holes here that potentially come into mind are either it feels like passive income, like interest on a bond, or it feels like you’re performing some validation service where services income to you. For a domestic taxpayer, those different characterizations may not necessarily matter that much. For an offshore taxpayer, they might matter quite a bit in terms of whether it’s subject to withholding tax. If you’re doing a delegated staking arrangement where you’re entering into a legal agreement with a third party, then you start getting into a world where maybe that’s a royalty. Maybe what you’re doing is you’re licensing the intangible right to validate transactions embedded in your crypto under this delegation agreement and receiving royalties in exchange. And that can have certain tax ramifications.

And then the third bucket might be the most interesting bucket. Where, if you are contributing your proof of stake crypto to some smart contract that also receive proof of stake crypto from lots of other token holders and then stakes the crypto on a pooled basis, that’s one of those DeFi fact patterns where this really starts feeling like potentially some business entity. Our tax rules don’t require a juridical entity to have a deemed tax entity.

And that raises a whole can of worms of issues of, first of all, do you have realization on the way in or on the way out on the embedded gain in the crypto that you’re contributing to this pool? Second of all, as the pool earns staking rewards, are you taxed on those the way in or on the way out, or are you taxed on a current basis on your pro rata share of staking rewards as the pool earns rewards? And that would generally be the answer if this thing is a partnership. And then, who’s doing the K-1 reporting? So lots of interesting questions there. Not a whole lot of answers, but it’s very interesting.

Ian:

The other one that I’m curious about is DeFi transactions. And we’ve talked about smart contract lending, but I’m thinking more when I’m exchanging one token for another token, an asset swap through a DEX, and I’ve seen arguments that suggest that that shouldn’t be treated as a realization event, but I understand that maybe everyone considers it to be or recommends that it’s actually treated that way when filing taxes. Where do you fall on this one?

Lorenz:

Well, it really depends on what asset, the substance of the exchange. If you’re talking about wrapping Bitcoin into some ERC 20 token that can work on the Ethereum blockchain, then I think there are probably pretty good arguments that that should not be a realization event. Again, this is a question we address in the bar report that I mentioned. But if you’re talking about just engaging in an exchange of one cryptocurrency for a different type of cryptocurrency like Bitcoin for ETH or Bitcoin for DAI or whatever, on a decentralized exchange, then I think that is definitely taxable. There’s not really a lot of questions around whether or not that’s taxable. So I don’t know if those two fact patterns you were referring to.

Ian:

Yeah, I think I was including both, and that was where the discrepancy is, is that you have to actually unpack what you’re doing there. So if I’m maintaining the underlying asset in the case of wrapping one token and moving it to a different crypto network, that doesn’t trigger realization generally, but if I’m turning the asset into something else, then it likely does is what it sounds like you were saying.

Lorenz:

Yes. And both conclusions are highly fact-dependent. So the reason why wrapping generally ought not to result in realization is, I mean if you hold securities in the custody account as opposed to in certificated form, the mere fact that you hold them in a custody account with a broker shouldn’t mean that you stop beneficially owning those securities, and taking them from certificated form or transferring them to a broker shouldn’t give rise to realization. But that relies on the fact that you can get them back and out at any time that you get all the income items and so on and so forth. So provided that the wrapping arrangement meets those conditions, and again subject to the difficulty that if there’s no legal agreement, there’s always the overarching question of are your rights to get the crypto back purely blockchain based and what does that mean for tax rules that were crafted for legal agreements?

But I think the right answer is that if those conditions are satisfied, there shouldn’t be realization. But yeah, if you’re exchanging Bitcoin for ETH through a DEX, that’s a taxable transaction. I don’t think really anyone would say it’s not a taxable transaction. A different question is whether it gets reported. Because there’s this whole issue which we get into later, which is that, in the context of a pure DeFi exchange, there may not be a centralized person there that the IRS can tag with information reporting responsibility. And so you may not end up getting a 1099 or any tax reporting telling you that an exchange occurred and that you need to report it, but that doesn’t mean that you don’t need to report it on your own tax return. That’s why it’s so important to keep track of all your transactions.

Ian:

Yeah. I am curious maybe more broadly about different tax considerations for people who are not just buying and holding forever, but those that are maybe more actively trading. Any other areas that you would suggest they’d be aware of?

Lorenz:

Yeah, so the considerations for investors versus traders in crypto can be very different. And it’s a really important question to ask, so I’m glad you asked it. First, there’s the obvious fact that if you’re buying and selling different types of crypto with high frequency, then you’re going to have to do a lot more legwork to keep track of all your gains and losses in the tax bases in your assets. But second, if you are trading in the crypto in the sense that you’re entering into offsetting positions in crypto, so longs and shorts, you can end up getting caught by the straddle rules, which are pretty nasty and have the effect or at least can potentially have the effect of deferring tax losses but not gains on your trading book, and also destroying long-term holding periods necessary for the preferential capital gains rate to apply.

And in a nutshell, those rules were designed to capture tax motivated transactions where a taxpayer goes long and short, the same shares in year one then waits till year-end to see which position goes in the money and which position goes out of the money, disposes of the loss position prior to year-end, so basically accelerating that loss into the current tax year, and then holding on to the gain position until a later tax year. But the straddle rules ultimately have a much broader reach than that very simple fact pattern, because they’re drafted incredibly broadly to capture any offsetting positions, not just perfect hedges. So that means that if you have two different cryptocurrencies, but the trading prices are closely correlated, then having a long and one cryptocurrency and in a shorten the other could at least potentially be a straddle for purposes of these rules.

And so in the securities and commodities trading context, traders often elect into the so-called mark to market rules for traders, which is one way to avoid many of these whip saws. And those rules basically allow you to mark to market all of your positions at the end of the tax year, rather than having losses potentially deferred under the straddle rules.

And then maybe just as importantly, if not more importantly, whereas for individuals that trade insecurities and commodities but don’t make these elections, capital losses are limited. Traders that make the mark to market elections get to treat all of their losses as ordinary and not subject to those limitations. So while these rules also have the effect of turning capital gains into ordinary gains, that may not matter for traders because they would’ve had short-term holding periods anyway.

And so suffice it to say that in many instances, making this mark to market election can be very advantageous if you are trading rather than investing. And oftentimes, the biggest downside to making this mark to market election is that on day one, any unrealized gain in your trading book is going to be subject to tax in that year, that can potentially accelerate a lot of tax.

But for traders in crypto, it’s not really clear that the mark to market election is even available. So for cryptocurrencies like Bitcoin and ETH that have futures trading on CFTC regulated commodities exchanges, I think there are strong arguments, they’re not free from doubt, but they’re strong, that bitcoin and ETH should be commodities for purposes of this election and therefore should already under current law be eligible for this election. When you’re dealing with other types of popular cryptocurrencies that don’t have futurist trading or don’t yet have futurist trading on CFTC regulated commodities exchanges, that analogy may be tougher to draw. I’m not saying that you couldn’t reasonably make the argument, but it’s just a little bit harder, because the CFTC doesn’t necessarily regulate them as commodities.

So I think it’s an area of uncertainty, but certainly if you are trading in crypto at a high degree of frequency, something that is worth talking to your tax advisor about, does this election make sense for me?

There may also be other benefits to being a trader rather than an investor, including the ability to deduct certain business expenses. But it’s important to remember that it’s not like an elective status. You can’t just say I’m a trader or I’m an investor. It ultimately depends on what you actually do. The basic distinction between an investor and a trader for tax purposes is that whereas an investor holds for long-term capital appreciation and dividend and interest income and generally has longer holding periods, a trader trades on shorter term price dislocations, like in the securities context, a merger or a transaction. And where you fall in those two buckets depends on the substance of what you actually do.

Ian:

So open-ended that my head is spinning a little bit here on the decisions that have to get made and then adding in the complexity of crypto to make some of these distinctions gets really hard.

We have a big international audience that listens to the podcast and we’ve been obviously talking about tax here in the US, but I suspect that actually quite a few people internationally probably have to be aware of US tax law. It seems like the reach of the US tax authorities is ever expanding.

Lorenz:

Yes, the US tax dragnet has an unfortunate tendency to extend internationally, and there are definitely tax traps in which offshore investors that are unwary could get caught up in, that can often be avoided through careful planning and putting in place reasonable guidelines.

So one way you might get caught up in the US tax dragnet is if you’re entering into transactions with US counterparties or US-based businesses. For example, lending crypto to a US borrower or delegating your proof of state cryptocurrency to a US counterparty or at least a counterparty that has their validators and servers located in the US. To in the first case, earn loan fees, in the second case, earn staking rewards.

And although there may be reasonable arguments that under certain factual configurations, those amounts aren’t subject to outbound US 30% withholding tax, I think some more conservative US counterparties in those transactions may be tempted to just withhold in cases of uncertainty because the way that our outbound withholding rules work, if you’re a withholding agent and you’re potentially responsible for withholding, the IRS can come directly after you, you’re jointly and severally liable for those taxes and potentially also interest in penalties if you don’t withhold and you were supposed to withhold.

So I mean those issues can often be addressed by just talking to your counterparty and making sure you’re aware of their tax profile and how they’re thinking about these issues. And also allocating the risk appropriately in the agreement. You can always include a gross up provision that says, hey, if you’re going to withhold tax on me, sure you can do that, but you have to make me hold for the amount of tax that you withhold so that I’m essentially indifferent economically that you’re withholding.

The good news is that these taxes are generally collected by withholding its source. So generally you don’t have to file a US tax return if the withholding gets done correctly. And also there are exemptions that may be available to taxpayers located in jurisdictions with a good tax treaty with the US. And most of the major OECD jurisdictions have tax treaties, and it’s just a question of is it a tax treaty that exempts this particular type of income?

Another fact pattern where a non-US person might get caught up in the US tax dragnet is if you’re trading in cryptocurrency through US employees or a US agent, even a US broker. Because in general, trading activity can rise to the level of a business activity for tax purposes. And ordinarily, business activities that are carried on through US SIDUS people are subject to US net income tax, at least on the income that is so-called effectively connected with the US business. In the industry, it’s commonly referred to as ECI.

And although there are broadened, I think taxpayer favorable safe harbors that exempt income from trading in securities commodities and derivatives from ECI taxation, it’s not free from doubt whether or what extent those safe harbors extend to trading and digital assets.

I think for cryptocurrencies like Bitcoin and ETH, again, because they have futures trading on CFTC regulated commodities exchanges, my view is that they ought to qualify for the commodities trading safe harbor. But I think those arguments become weaker for cryptocurrencies or digital assets where there’s no futures trading on CFTC regulated exchanges. So suffice it to say that if you’re a non-US person and you’re trading in crypto through US employees or a US agent, it is worth talking to a knowledgeable tax advisor about developing appropriate policies to mitigate ECI risk.

Ian:

Yeah, that’s a big one. If you’re trading Dogwifhat, it’s probably not a commodity.

Lorenz:

Yeah. That might be a tough argument.

Ian:

Any Pepe coin out there, it might not be a commodity. You touched on information reporting a few minutes ago, and this seems like it’s a fairly debated topic in terms of what the right approach is. I know that there’s been some attempts to actually push the reporting requirements all the way down to entities like node validators or non-custodial wallet providers. Primarily by expanding this definition of a broker to what some people I think argue is overdoing it. What’s your perspective on this? Where does the information reporting line make sense, in order to make all of our lives easier as we’re approaching tax reporting without being a overly onerous burden on the technical infrastructure that underpins crypto?

Lorenz:

Right. I think it’s a great question. And I think whether you think these rules, so first of all, I think you’re referring to regs that are still in proposed form. Absolutely, they haven’t been finalized, but they have a very broad definition of broker, and I think we can assume that the [inaudible 00:40:37] Treasury will retain some variation of that definition in the final regulations. But I think whether you view those rules as reasonably really depends on what angle you’re looking at them from.

In the context of transactions and securities, reporting there is straightforward because virtually all transactions and publicly traded securities are conducted through centralized brokers, and it’s easy for the government to tag them with information reporting responsibility. Whereas in the DeFi ecosystem, as we’ve already talked about, you can exchange digital assets for other digital assets including stablecoin through decentralized software protocols, at least some of which aren’t really controlled by any identifiable individual or juridical entity that the government can readily identify as a reporting agent.

From the government’s perspective, the experience from the security space and the empirical evidence that lack of tax reporting tends to lead to a very significant tax gap in voluntary tax reporting and tax payments, I think has borne out that you need robust information reporting rules. I think in the securities context, the government measured that capital gain self-reporting was something like 60% before the securities broker reporting rules were rolled out. And it’s closer to 90 to 95% thereafter. So in view of that reality, I think they feel like they have no choice but to develop a fundamentally new and very broad definition of broker to account for the reality of DeFi. And I think the expectation is that, and I’m not saying this is right or wrong, but I sense that the expectation is that these rules will either drive the crypto space to greater centralization, or that if not, DeFi contracts can be updated to do normal tax onboarding and information reporting functions.

I’ve spoken to people in the government that say, look, you tell us that DeFi can do all these magical things. If it can do algorithmic market making, then certainly it can collect tax reforms and report that information to the IRS. And I think there’s some level of-

Ian:

It’s a pretty good point.

Lorenz:

Yeah. On the other hand, from the crypto industry’s perspective, the entire idea of information reporting for digital assets is anathema to the decentralized ethos of the industry, because it inherently requires centralization. And a move toward transparency in terms of beneficial ownership and reporting information about beneficial ownership to the government. And it’s not really clear to me that there’s any good way to square those opposing mentalities.

And rather than trying to do that, I fall back on the position that, look, the reality is that the crypto reporting rules will ultimately go into effect. And players in the crypto space need to be ready for them.

Ian:

I think that’s a great point. I’ve never heard it put so succinctly as look, the smart contract can do anything. Let’s figure out how to make it handle sending 1090s to all the participants like that.

Lorenz:

Exactly.

Ian:

That seems like a solution path forward. I’m sure there’s some smart people out there listening to this who are working on zero knowledge proof systems and various digital identity architectures that could come up with a solution here that still maintains the conceptual appeal of decentralization, but also solves for this reporting requirement.

I’m curious, when you think about all the people that you interact with across clients, perspective clients, when you go through some of the content we’ve talked about so far, what does that do for them? I mean, I could see people going, wow, this is just way too complex and uncertain. There’s too many open-ended interpretations here. I’m going to stay on the sidelines of this game until we get things quite a bit more figured out, or are people willing to jump in and deal with the ambiguity?

Lorenz:

So my clients are mostly sophisticated, centralized crypto custodians and intermediaries or sophisticated institutional investors or very high net worth individual investors. And we pride ourself in our ability to provide them with quick, accurate and actionable advice so that tax never becomes a bottleneck in terms of their business or investment objectives. And I think it’s generally possible to do that. I mean, sometimes they may not like the answers, but at least we can give them clear guidance. But this assumes deep pockets, right? Because it is not cheap to get legal advice at that level. And so I think in the case of retail crypto investors or startups that can’t really pay for sophisticated tax advice, I do think that at least to the extent people are aware of tax issues, tax is unfortunately a barrier to playing in this particular sandbox. At least for taxpayers that, like I said, are aware of the rules and want to comply with them.

In some sense, and I think you alluded to this earlier, my hope is that developing good information reporting rules will equalize the playing field here, because retail investors will hopefully get the high quality tax reporting that they need in order to prepare their tax returns correctly and not be concerned that they’re missing something. I also think it is incumbent on the government to draft rules in a way that doesn’t create tax traps for unwary retail investors and people without the deep pockets that are acting in this space.

And I think one of the most single important things the government could do here is provide taxpayer favorable guidance on crypto lending. Crypto lending generally should not be taxable. If I lend my Bitcoin and ETH out to generate yield and I have a really low basis, because I just bought it in the crash, I shouldn’t have massive amounts of phantom taxable income just because I did that. I think the government really needs to provide guidance in that arena. And if Congress doesn’t act, I think it’s incumbent on Treasury or the IRS to provide interim guidance. It’s just not fair to retail investors to be stuck with that risk.

Ian:

Yeah, yeah. I love that. I am curious about stablecoins, because we’ve seen this incredible rise over the last few years of stablecoins. The latest state I’ve seen says nearly two thirds of all transactions on blockchains involve stablecoins now. And I think for a lot of people, something like USDC or Tether, is the same thing as a dollar. They see it has zero volatility relative to a dollar. It’s just digital in nature. It’s easy to move around. It’s almost like a holding ground for your dollar based assets as you’re moving into or out of the crypto ecosystem in a lot of cases. At least my naive understanding is that there are potentially some of those tax traps that you just described that people may unwittingly fall into that you wouldn’t expect based on the experience of using actual dollars. Can you talk a little bit about the stablecoin situation?

Lorenz:

Sure. I mean, and it’s not really surprising that stablecoin has become so popular. It’s the lubricant that keeps the digital asset ecosystem moving, because it turns out that Bitcoin and Ether actually pretty terrible stores of value or mediums of exchange, because they fluctuate wildly in value. Stablecoin is also very different from a cryptocurrency like Bitcoin. Both economically, and as you suggested, in terms of how it’s treated for tax purposes. If you think of the most vanilla form of non-algorithmic stable form USDC or Tether or Gemini Dollar, it’s generally supported by an off blockchain juridical sponsor entity that maintains or purports to maintain cash reserves and has an off blockchain legal user agreement that may contractually entitled a holder of the stablecoin with the right to exchange it for a dollar. So that’s a completely different animal from a Bitcoin, which exists solely on the blockchain, and it’s not pegged to the value of any off blockchain asset or a fiat currency.

From a tax perspective, assuming that the user agreement is sufficiently robust that it gives the holder of the stable stablecoin actual legally enforceable claim to get that dollar from the sponsor, and assuming that the sponsor holds sufficient reserves, that the holder of the stablecoin has a reasonable expectation that it’ll actually honor that claim. I think the most natural classification for tax purposes, it’s just debt. It’s like a bank deposit. It’s, we already have a bucket for this. And the blockchain based digital record is just really a record keeping tool for who holds this zero interest debt instrument.

That’s it. In some cases, the user agreement, when you actually look at it, it’s pretty vague. And I’m not sure it conveys any legally enforceable rights. At which point, you’re back to something that feels a lot like Bitcoin because the value really is people believe it has value. Although it’s surprising how closely some of these stablecoins maintain their pegs. Even when you look at the user agreement, it doesn’t appear to give the user actionable rights. I guess, instead of believing that it has some amount of arbitrary value, people believe that it’s worth a dollar. And that somehow is reasonably effective in allowing the crypto to maintain its peg.

I’m not sure that there’s a great deal of tax crap for the unwary with stablecoin, other than the obvious fact that if you’re going to exchange your Bitcoin for stablecoin, that is clearly a taxable transaction. Please report it as such. I think the one issue that’s going to create headaches here is, the crypto reporting regs we just talked about, at least the proposed ones, draw really no distinction between stable coins and other digital assets in terms of what’s reportable and what’s not reportable. So if that doesn’t change, there are going to be a whole lot of 1099s out there for the Starbucks coffee I bought with Stablecoin, and it’s just a nightmare. So I think commentators have made this comment to the government, you need to create reasonable exceptions for stablecoin transactions so that taxpayers aren’t flooded, and the IRS frankly, aren’t flooded with useless 1099s reporting stablecoin transactions that really involve no material gain or loss.

Ian:

Yeah. Yeah. That’s an important one. We don’t want to flood our friends at the IRS with data that they don’t actually need. That seems like putting a burden on that agency when they certainly don’t need any additional burdens.

Lorenz:

Well, unfortunately, it’s never stopped them before. When they rolled out other information reporting regimes like FATCA. I mean, they are sitting on reams of information reporting and anyone’s guess whether they actually look at any of it.

Ian:

Yeah. Yeah. Well, this has been a fantastic conversation. I want to wrap on my customary closing question, which is, when you think out to the future here, what are you interested in paying attention to or most excited about in the area that we’ve been talking about today?

Lorenz:

From both a tax and a non-tax perspective, I am fascinated by the continued evolution of DeFi. And in particular, can DeFi protocols really start replacing juridical entities and juridical contracts. Are people going to trust software protocols enough that at least in some circumstances can replace courts and legal agreements with software protocols? And then, the tax question that layers on top of that is when do you treat these things as entities? And if you treat them as entities, what entities are they? I think that’s one of the most interesting unsolved riddles in this space. And it’s both a question of how the ecosystem involves and how the tax rules are crafted to address it.

The other question that I think is going to be really interesting in the upcoming year is, what any re-proposed or final crypto broker regulations look like. Does the government take the comments we made to add reasonable exceptions like the stablecoin exception we just discussed?

And then I think another really important question is, when is the government going to finally provide clear rules for the substantive treatment of crypto, including crypto lending, the application of the trading safe harbor? I mentioned the digital assets, the application of the mark to market rules for traders and dealers to digital assets, because many of those would appear to require congressional legislation, and the Biden administration keeps proposing updates to the rules for these purposes. But Congress hasn’t done anything. I think it’ll be very interesting to see if and when Congress actually acts there.

Ian:

That is a fantastic answer to that question, and I am looking forward to all three of those becoming more clear for us in the coming year.

Lorenz, thank you so much for joining us on the podcast and sharing your expertise. This was a terrific conversation.

Lorenz:

Thank you so much for having me, Ian.

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