To Fight Crypto Tax Evasion, Old-School Methods Still Work Best

The cryptocurrency market continues its upward revenue trajectory despite some volatility. But while the future of decentralized finance is promising, it also poses a challenge to tax compliance and policymaking in a way that compensates society.

As digital assets grow more popular, the tax reporting gap has also led to to at least $50 billion from revenue lost to crypto transactions. Enhancing enforcement of untaxed crypto transactions with existing policies may do more to close the gap than any revolutionary new method of crypto taxation—such as a crypto mining excise tax or the IRS wash sale rule—ever could.

Whistleblower Reform

The IRS whistleblower program has been a major asset for catching traditional tax cheats and corporate non-compliers. Since its inception in 2006, awards have totaled more than $1 billion. The tax gap has been closed by more than $6 billion owing to enforcement actions stemming from whistleblowers.

The whistleblower program isn’t perfect, however, and high-level reforms—including imposing interest on delayed awards and eliminating budget sequestration effects—would go a long way toward enhancing its efficacy.

When trying to target crypto tax evaders, government programs providing substantial contracts to outfits that break the anonymity of specific cryptocurrencies have seen success. Chainalysis, a blockchain analysis company out of New York City that helped bring down the Silk Road dark web exchange, was granted a contract by the Treasury in 2022 to de-anonymize the Monero cryptocurrency.

The expansion of artificial intelligence helps both tax cheats and those who catch them to use AI to their advantage. Creating a government market for crypto tax cheat identity information in the AI era creates a vacuum into which AI-powered solutions will be pulled.

Just as tax evaders will likely use AI to structure tax shelters and evasive transactions, whistleblowers can do the same to mine crypto platforms and their corresponding transaction records for publicly available information.

These tools can sift through vast troves of transaction data to identify patterns that indicate non-compliance and associated identity. Even the process of filing a whistleblower report itself can be automated.

This kind of expanded version of whistleblower or “bug bounty” programs could be targeted toward connecting crypto transactions with identifiable individuals. Providing a sufficient percentage of a collected assessment on an unreported taxable transaction as an award to the whistleblower could turn even the platforms against tax cheats.

Administrative Workability

The unique challenges and societal costs of crypto, in the form of anonymity and energy expenditures, may suggest that tax policies and enforcement must be similarly complex and cutting-edge. But often, old tools are the best tools.

While reforms have been floated such as application of the wash sale rule to digital currencies and an excise tax on digital asset mining, they may prove difficult to pass and enforce.

In the case of the wash sale rule, determining which coins among more than 9,000 in existence are “substantially identical,” such that the wash sale rule applies, would be a tax policy discipline unto itself. It would also muddy whether cryptocurrencies are property or securities.

The excise tax on electricity used for digital asset mining seems reasonable at first, until one considers how it would be applied to miners that may be mining at home or in a small cluster. Aside from usage amount, electricity for mining doesn’t appear any different at the meter from that used to charge an electric vehicle or make a pot of coffee.

The functional effect of such a tax would likely amount to a tax on digital mining in data centers—where massive clusters of miners consume huge swaths of electricity.

In that case, a tax instead that targets electricity use in data centers directly, foregoing any appearances of directing it toward mining, would capture externalities to other activities at such centers, such as the proliferation of large language models and AI applications.

No Revolutions Needed

Reining in tax cheats that use crypto and accounting for the costs of mining don’t require revolutionary new approaches to enforcement; it just means recalibrating existing policies to new targets.

The best advantage tax administrations have in capturing lost tax revenue in taxable transactions is that such transactions almost always involve more than one entity that knows the involved parties.

The individuals on either end of the transaction may not know each other’s identities by default, but they could be motivated to find out where possible. And the cryptocurrency exchange almost certainly knows the identity of at least one of the parties to the transaction, thanks to know your customer and other anti-money laundering rules.

The matter becomes simply one of incentivizing parties to a transaction, and the exchange itself, to ensure all transactions are tax-compliant. Attempts so far have been chiefly of the stick variety. It is becoming increasingly clear that introducing an appealing incentive—especially whistleblower reforms—could be a much-needed carrot.

Andrew Leahey is a tax and technology attorney, principal at Hunter Creek Consulting, and adjunct professor at Drexel Kline School of Law. Follow him on Mastodon at @andrew@esq.social

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