The IRS published final regulations on information reporting obligations for certain DeFi participants and, on the same day, the Blockchain Association, Texas Blockchain Council, and DeFi Education Fund filed a lawsuit in the Northen District of Texas claiming violations of the Administrative Procedures Act and the U.S. Constitution.
My previous article provided a summary of the DeFi trading front-end service providers targeted by the IRS and noted that the IRS specifically addressed “Constitutional Concerns” raised by commenters. These constitutional concerns are outlined in the Complaint (the “Complaint”) filed by the advocacy groups along with challenges to the scope of definitions used by the IRS and Treasury to reach the conclusion that certain trading front-end service participants in the DeFi community are “brokers” with reporting requirements.
The 42-page Complaint provides extensive introduction and background sections outlining the DeFi ecosystem, legal and policy arguments raised, and the potential harm to the industry. The arguments raised in the Complaint are similar to those in comments the advocacy groups and others provided to the IRS prior to the final regulations for both custodial and non-custodial (i.e. DeFi) “brokers” now obligated to provide informational reporting. The Complaint argues that DeFi’s software allows for direct user-to-user transactions that would otherwise be inaccessible, expensive, or otherwise unattractive because of privacy concerns for many Americans without the alternative to traditional financial institutions with third-party intermediaries. According to the advocacy groups, compliance is impossible without destroying the reason for DeFi’s existence (i.e. the removal of risks inherent with third-party intermediaries), significantly altering the software involved, or requiring a cost that would functionally destroy the DeFi industry or force DeFi companies who must comply to relocate overseas.
The advocacy groups also allege that the rule itself is unlawful under the Administrative Procedures 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 the regulated parties. The APA arguments claim an overly expansive definition of “broker,” “effect,” “digital asset middleman,” “trading front-end service,” and “position to know” alleged as contrary to the statutory purpose, illogical, and that any deference to IRS interpretation is not warranted.
The United States, by rule, has a usual response time of 60 days after service on the U.S. Attorney for the relevant district. Therefore, it could be some time before we know the United States’ exact response to the Complaint. However, we do have the responses contained in the final regulations for DeFi participants on similar issues as a guide of what the United States may eventually argue.
A Broker By Any Other Name?
In the Shakespear 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 declares “What's in a name? that which we call a rose by any other name would smell as sweet.” As the characters in the play learn, a name means a lot and can result in 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 obligates to reporting requirements, the IRS essentially claims that the trading front-end services “are similar to those provided to a customer by a traditional securities broker that does not hold or custody customer’s assets.” A securities “broker,” by IRS logic, is simply the same as certain DeFi participants offering trading front-end services. Therefore, reporting obligations apply - what’s in a name?
According to the advocacy groups, the IRS “confuses a tool that digital asset holders can use for free to engage with smart contracts...with brokers who regularly and actually carry out transactions for consideration.” Further, the advocacy groups claim that “[t]here is simply no broker-like entity involved in a decentralized transaction.”
Another disagreement on the definition of “broker” is that the commenters and the advocacy groups point out that the IRS interpretation goes far beyond the usual agency related version of traditional securities brokers. Although a comparison to traditional securities brokers was fine to compare “trading front-end services” the IRS claims that “the term broker is not limited to conventional securities brokers” and can include “several other types of market participants.” The Court will ultimately need to decide if the comparison to a securities broker is fair for the DeFi ecosystem and if the obligations are, in fact, possible and reasonable under the circumstances.
Enforcement Versus Industry Burden
Both the IRS, in its final regulations, and the advocacy groups, in their lawsuit, use policy arguments to justify the obligation or elimination to provide informational reporting. The IRS regulations, and presumably the lawsuit, will outline the 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 summons process which requires an ex-parte judicial proceeding and proof of a particular person or group, reasonable basis for believing failure to comply with tax laws, that the information is not otherwise readily available, and a new requirement under the Taxpayer First Act that the request be narrowly tailored. The Department of Justice regularly uses this process and obtained two John Doe Summonses 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 regulations or in the Complaint.
The Complaint also spends pages outlining the burden reporting obligations will place on the industry, if it can even comply at all. 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 damage the United States’ 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 for both parties along with the complicated legal and constitutional issues raised in reaching its decision. The battle has only begun, but the implications on the DeFi industry are dramatic enough that all interested parties will be watching 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 at the Texas Blockchain Council and one of the author’s partners serves on the board of directors. However, neither Gray Reed nor the author are attorney of record for the Texas Blockchain Council or any of the other plaintiffs in the referenced lawsuit.
