Shehan Chandrasekara is a crypto certified public accountant (CPA), who acts as the head of Tax Strategy at CoinTracker.io, a software that helps you comply with crypto and non-fungible token (NFT) taxes.
The current Web 2-based U.S. financial system is centered around "accounts" tied to centralized third parties. You start everything by signing up for an account using an email and a password. Accounts are maintained by centralized third parties on your behalf. These third parties are required by law to capture your identity when creating financial accounts such as bank accounts, cryptocurrency accounts and brokerage accounts. Your identity is gathered through a process known as Know-Your-Customer (KYC), which ensures your real-world identity is tied to each of your digital financial accounts.
This article is part of CoinDesk’s Tax Week
But what happens when we move to a financial system based around wallets, as envisioned by the cryptocurrency industry? Who collects this user information? How would regulators collect taxes from anonymous wallet holders?
This account-centric system ensures mass tax compliance by employing what's known as a third-party information reporting system. How this works is simple. Third parties such as centralized cryptocurrency exchanges, stock brokerages and banks report your financial activity to the Internal Revenue Service. This is a legal requirement for third parties under IRS code §6041 and §6045.
The reporting is usually done using a series of tax forms such as Form 1099-B and Form 1099-INT that report your annual capital gains/losses, interest, dividends, miscellaneous income to the IRS. You also get a copy of these forms at the end of the year to file with your taxes. So, by the time you file your tax return the IRS already has your info reported by third parties.
If you don't report the activity on your tax return and pay taxes, the IRS Document Matching System automatically detects the discrepancy and sends you a tax notice demanding you fix the error and/or pay additional taxes. This checks-and-balance system ensures mass tax compliance in the account-centric financial system we have today.
The above third-party information reporting system has been very effective when it comes to improving tax compliance. The system is designed to trigger the taxpayer to file a tax return by sending a tax form during the tax filing season. For example, 99% of taxpayers file their taxes when they receive a Form W-2 from employers. More than 80% of stock account holders file their taxes when they receive a Form 1099-B from brokerages summarizing the annual capital gain/loss activity. On the other hand, if a third party doesn't generate a tax form, more than 50% of taxpayers do not pay the taxes.
Read More: US Crypto Tax Guide 2022
Web 3: Wallet-Centric Financial System
In Web 3, you start everything by creating a wallet as opposed to signing up for an account. Your identity is tied to wallets such as MetaMask or Phantom, not to an account hosted by a centralized third party. Notably, you are pseudo-anonymous. The owner of the wallet is a public record on a blockchain identified by a series of numbers and letters (0x71C…….d8976F). The wallet is not tied to your real-world identity as in an account-centric financial system.
Web 3 is in the process of replacing the account-centric financial system with a wallet-centric financial system. For example, the most popular Web 3 wallet, MetaMask, now has over 21 million monthly active users. The biggest decentralized exchange (Uniswap) and NFT marketplace (OpenSea) are powered by wallets, not accounts. Web 3 allows you to connect with protocols and complete peer-to-peer financial transactions without ever having to go through a third-party intermediary, as seen in an account-centric financial system.
Taxation in a Pure Wallet-Centric Economy
A pure wallet-centric economy risks tax compliance and enforcement because there’s no practical way to implement a third-party information reporting system. The tried and true, traditional third-party information reporting system is fundamentally incompatible in Web 3 because Web 3 transactions don’t have a third party. Third parties are replaced by protocols that facilitate peer-to-peer transactions with no identity-related knowledge of the parties involved in the transaction.
This will make 1099 form generation impossible because in most cases there’s no third party to generate them. Even if a protocol could generate 1099s, the reports will be incomplete, without the taxpayers’ personal identification information such as name, address and Social Security number. Further, the amounts reported will be inaccurate because the protocol has visibility only into what’s happening inside the protocol.
Absent of a robust third-party information reporting system, pseudo-anonymous wallet holders have no incentive to self-report taxes. Say you get paid directly to your MetaMask account from the decentralized autonomous organization (DAO) where you work. You can pay rent in crypto. You can buy groceries in the decentralized version of Amazon that allows you to sign in using your wallet and pay in crypto. You don't have to convert anything into fiat because you can maintain your life online.
Read More: Your Staking Rewards Are Still Taxable
Accounts vs. Wallets
Owned by a Third Party
Owned by You
Guaranteed Through Third-Party Information Reporting
Potential Web 3 Tax Solutions
The right Web 3 tax policy should be enforceable, practical and preserve the anonymity of wallet holders. It will be interesting to see how regulators think about ensuring tax compliance in Web 3 in the next decade. Potential tax policy-driven approaches could include the following:
Transaction tax: Works similar to sales taxes in the U.S. and avoids complex basis tracking required under the current income tax regime
Entrance tax: Imposes a tax on fiat onboarded to the crypto world through centralized exchanges
Exit tax: Imposes a tax on crypto offloaded to the fiat world through centralized exchanges
We could also see protocols innovating solutions (e.g., by leveraging zero-knowledge proofs) that enable wallet holders to cryptographically prove their tax compliance without ever revealing their identity.
Further Reading on CoinDesk's Tax Week
To offset the impact of rising inflation, the IRS has revised a number of tax provisions to let people keep more of their money in their wallets for the 2022 tax year.
U.K. citizens who invested or dealt with crypto over the last year may be required to pay taxes on their trades. Here's what you need to know.
Like many jurisdictions, crypto assets are treated as "property" in Canada, meaning investors will owe taxes to the Canadian Revenue Agency (CRA) in certain situations.