The IRS issued final regulations on information reporting requirements for certain DeFi participants, and on the same day, the Blockchain Association, the Texas Blockchain Council, and the DeFi Education Fund filed a lawsuit in the Northern District of Texas, alleging violations of the Administrative Procedure Act and the U.S. Constitution.
My previous article provided a summary of DeFi trading front-end service providers targeted by the IRS and noted that the IRS was specifically addressing “constitutional concerns” raised by commenters. These constitutional concerns are described in the complaint (the “Complaint”) filed by the advocacy groups, along with challenges to the scope of the definitions used by the IRS and Treasury in reaching the conclusion that certain Front End Services participants trading companies in the DeFi community are “brokers” with reporting requirements.
The 42-page complaint provides detailed introductory and background sections describing the DeFi ecosystem, the legal and policy arguments raised, and the potential harm caused to the industry. The arguments raised in the complaint are similar to comments that advocacy groups and others provided to the IRS ahead of the final regulations for custodial and non-custodial “brokers” (i.e. DeFi) now required to provide information reports. The complaint argues that DeFi software enables direct user-to-user transactions that would otherwise be inaccessible, expensive, or unattractive due to privacy concerns for many Americans without the alternative to traditional financial institutions with third-party intermediaries. According to advocacy groups, compliance is impossible without destroying the reason for DeFi’s existence (i.e. removing the inherent risks of third-party intermediaries), significantly changing the software involved, or requiring a cost which would functionally destroy the DeFi industry or force DeFi companies that must comply to relocate overseas.
Advocacy groups also claim that the rule itself is illegal under the Administrative Procedure Act (APA) and unconstitutional under the Fourth and Fifth Amendments to the U.S. Constitution. The constitutional challenges revolve around the privacy rights of participants and the due process rights of regulated parties. The APA’s arguments claim that an overly broad definition of “broker”, “bill”, “digital asset intermediary”, “trading front-end service” and “knowledge position” is alleged to defeat the purpose statutory, illogical and that full compliance with the IRS interpretation is not warranted.
The United States, as a general rule, has a customary response time of 60 days after service on the United States Attorney for the appropriate district. Therefore, it may be some time before we know the United States’ exact response to the complaint. However, we have the answers contained in the final regulations for DeFi participants on similar issues as a guide to what the United States could potentially argue.
A broker by any other name?
In Shakespeare’s play (Romeo and Juliet), two feuding families prevent the main characters from being together because of the family name. At one point in the play, Juliet states, “What’s in a name?” what we call a rose by any other name would smell just as good. As the characters in the play learn, a name means a lot and can lead to tragedy.
The IRS uses the same logic as Romeo and Juliet for its comparison of “brokers” in the DeFi context. Identifying an “interface layer” of the DeFi ecosystem that the IRS ultimately requires to meet reporting requirements, the IRS essentially asserts that trading front-end services “are similar to those provided to a customer by a traditional stockbroker that does not hold or guard client assets. A securities “dealer,” according to IRS logic, is simply the same as some DeFi participants offering front-end trading services. Therefore, reporting obligations apply – what’s in a name?
According to the advocacy groups, the IRS is “confusing a tool that holders of digital assets can use for free to enter into smart contracts… with brokers who regularly and actually transact for a fee.” Additionally, the advocacy groups claim that “there is simply no broker-like entity involved in a decentralized transaction.”
Another disagreement over the definition of “broker” is that commentators and advocacy groups point out that the IRS’s interpretation goes well beyond the agency’s usual version of traditional securities dealers. Although a comparison to traditional securities brokers is acceptable when comparing “front-end trading services”, the IRS states that “the term broker-dealer is not limited to conventional securities brokers” and may include ” several other types of market actors. The Court will ultimately have to decide whether the comparison with a securities broker is fair to the DeFi ecosystem and whether the obligations are indeed possible and reasonable in the circumstances.
Application and industry burden
Both the IRS, in its final rule, and the advocacy groups, in their lawsuit, use political arguments to justify requiring or eliminating the provision of information reports. The IRS regulations, and likely the lawsuit, will present examples, studies and multiple arguments in favor of third-party reporting and its impact on compliance and enforcement. Without third-party reporting, the IRS must rely on more cumbersome methods such as the John Doe subpoena process which requires an ex parte court proceeding and proof of a particular person or group, a reasonable basis to believe non-compliance with tax laws, that the information is not otherwise readily available, and a new requirement under the Taxpayer First Act that the request must be narrowly tailored. The Department of Justice regularly uses this process and obtained two John Doe subpoenas in December 2024 to obtain the identities of taxpayers participating in the “Gig Economy” using a digital platform and those using offshore service providers to allegedly hide assets. This alternative to third-party reporting was not specifically addressed in the Final Rule or the Complaint.
The complaint also contains pages describing the burden the reporting requirements will place on the industry, if it can even comply. The complaint raises a concern not specifically addressed in the final regulations that the burden could, and likely will, cause some companies to relocate overseas and thereby harm the U.S. economy and competitiveness. in the DeFi industry. Perhaps the United States will address this concern in its response to the complaint. Regardless, the Court will need to weigh the needs and burdens of both parties as well as the complex legal and constitutional issues raised in reaching its decision. The battle has only just begun, but the implications for the DeFi industry are dramatic enough for all interested parties to follow the litigation closely.
Disclosure: The author’s law firm, Gray Reed, is a member of the Texas Blockchain Council (one of the plaintiffs in this lawsuit). The author is a member of the Financial Services Committee of the Texas Blockchain Council and one of his associates serves on the board of directors. However, neither Gray Reed nor the author are attorneys of record for the Texas Blockchain Council or any of the other plaintiffs in the mentioned lawsuit.
