2019’s DeFi Boom Creates New Questions for Tax Filing Season

The decentralized finance (DeFi) boom of 2019, leading to over $785 million in locked crypto assets, is already making accountants dizzy.

If you lock up bitcoin or ether in exchange for a synthetic asset or a stablecoin, as nearly a dozen projects and platforms today allow, is that a trade or merely a temporary reorganizing of the original asset?

Cryptio CEO Antoine Scalia, of the accounting startup that received a small investment from ethereum co-founder Joe Lubin’s ConsenSys, said there’s no clear answer yet.

“The challenges will be how to account for all the use cases in 2020,” Scalia said. “The more complex transactions and assets are, the more complex the accounting is.”

That’s why firms such as Dragonfly Capital and Winklevoss Capital, the latter of which is owned by Tyler and Cameron Winklevoss of the Gemini exchange, invested $5 million in startups like TaxBit. TaxBit CEO Austin Woodward said so far “thousands” of users have signed up for the 2020 tax season, including a few exchanges.

Dragonfly Capital co-founder Alex Pack said connecting automated software to an exchange account could create additional privacy risks, in the case of a cloud breach, which is why the firm invested in TaxBit’s experienced team.

“There are a lot of attacks on blockchain around anonymity or pseudonymity that rely on knowing a lot of the addresses between various exchanges,” Pack said. “That’s why we would only trust something like TaxBit … which comes from the business-to-business, security-focused mindset.”

He added the Internal Revenue Service (IRS) is being “heavy-handed” when it comes to staking and DeFi products. Because there’s no clear categories for the experimental assets, prudent DeFi users record everything from wallet addresses to open source code links in case the IRS comes knocking. That’s why these new compliance tools record and aggregate data across various networks.

“Our software offers real-time monitoring, because we have the API connections. We’re pulling in data as you trade, at least daily,” TaxBit’s Woodward said. “We’re releasing a lot of functionality around tax optimization. Recommending trades that could give users the most beneficial tax answer.”

So far, Woodward said DeFi users that used MakerDAO loans and other financial products beyond exchanges need to enter transaction details manually, relying on support from TaxBit’s chat hotline with tax attorneys and CPAs (Certified Public Accountants).

Both of the above-mentioned startups are working with clients to improve their systems’ ability to automatically flag potentially taxable events in the DeFi ecosystem.

As for Cryptio, which is strictly focused on serving businesses and doesn’t offer a TurboTax-style option for retail users like TaxBit, Scalia said his team is helping clients that used DeFi products to record information related to every smart contract the asset touched along the way.

“The exchange of the ETH that I’m depositing on the Compound smart contract for the c-ETH in my wallet, could be seen as a trade. This [compliance standard] is unknown,” Scalia said, referring to the lending platform Compound, which uses synthetic crypto assets. “You have to be able to say, ‘Here is all the smart contract activity and transactions that led to the creation of this synthetic asset.’”

CoinDesk reached out to the team at MakerDAO, DeFi’s most popular loan platform, about the accounting challenges presented by leaderless services and will update the article if we hear back.

In part because the accounting requirements are so unclear, a Credit Karma survey found just 0.04 percent of Americans reported their crypto transactions in their 2018 taxes, compared to an estimated 4 percent of the population saying they used crypto. This is expected to change since the IRS issued a crypto-oriented guidance update in 2019.

Pack, Scalia and Woodward all agreed tax reporting is a major barrier to crypto adoption. People don’t know how to use the technology without the headache of so much paperwork. As such, these startups see their role as enabling the next wave of mainstream, compliant usage.

“My thesis is that within the next few tax seasons, the number of [people reporting crypto on their taxes] will be 100x larger,” Dragonfly’s Pack said. “That hasn’t even been factored in yet. … I think figuring out how to [definitively] do accounting for DeFi is still several years out.”