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Washington Watch: The crypto industry could take tax fight all the way to the Supreme Court

The cryptocurrency community launched an all-out but ill-fated lobbying blitz to water down new proposed tax reporting rules that could be passed into law as early as next week. Now, the industry is changing tacks and readying for a constitutional fight in the courts that could help redefine Fourth Amendment protections against unreasonable government inquiries into Americans’ financial lives.

Proposed as part of a bipartisan infrastructure bill, the rules would require any person who regularly provides a service that executes transfers of digital assets to report those transactions to the Internal Revenue Service — like securities brokers must do for stock and bond trades today. If maximally interpreted by the IRS, the rules could also require the reporting of any digital-asset transactions of more than $10,000, regardless of whether it’s done through a broker.

“This law will kill the technology,” Abraham Sutherland, a former White House and State Department lawyer and adviser to the Proof of Stake Alliance, which advocates for regulatory clarity in the crypto industry, told MarketWatch.

Sutherland is particularly concerned with the $10,000 transaction reporting requirement, which could burden any American that receives a digital asset with the responsibility to report the Social Security number, address and occupation of the payer to the IRS, or face mandatory fines, a potential felony conviction and a five-year prison sentence.

“Why would anyone risk a felony transacting with digital assets when you can just go back to using banks that will report your financial dealings to the government for you?” Sutherland said.

Supporters of the proposal say the reporting requirements are necessary for the IRS to collect taxes that are already owed to the government, and a new law would simply put cryptocurrencies on a level playing field with cash.

In April, IRS Commissioner Charles Rettig told the Senate Finance Committee the absence of crypto-transaction reporting requirements contributed to the upwards of $1 trillion every year in unpaid taxes due to the federal government, and asked Congress to pass a law to fix the problem.

“I think we need congressional authority,” he said. “We get challenged frequently, and to have a clear dictate from Congress on the authority for us to collect that information is critical,” Rettig said, adding that “most crypto virtual currencies are designed to stay off the radar screen.”

A Fourth Amendment challenge

“Typically we don’t object to equal treatment of cash and cryptocurrencies, but the…reporting provision is a draconian surveillance rule that should have been ruled unconstitutional long ago,” wrote Peter Van Valkenburgh, research director at the crypto think tank Coin Center, in a recent blog post. “Extending it to cryptocurrency transactions would further erode the privacy of law-abiding Americans.”

Van Valkenburgh said in an interview with MarketWatch that Coin Center — whose board includes some of the biggest players in the industry — would likely sue the government if these new reporting requirements go into effect, as the legislation proposes in 2024.

One legal theory the organization would put forward is the law violates Americans’ Fourth Amendment rights against unreasonable search and seizure by the government.

There is a long history of Fourth Amendment challenges to laws requiring reporting of Americans’ financial information to the government. In part due to challenges to the 1970 Bank Secrecy Act, a law that requires financial institutions to assist the U.S. government in detecting and preventing money laundering, federal courts developed the so-called third-party doctrine that states that citizens do not have a legal right to privacy with respect to information they willingly give to a third party.

The BSA requires financial institutions to report all transactions in cash over $10,000 to government authorities, but in 1984 Congress extended this obligation to all businesses in an effort to increase tax compliance and raise revenue, just as Congress is aiming to do with crypto reporting.

Following the passage of the 1984 law, any business person who sold a good or service for more than $10,000 in cash had to report detailed personal information to the government about their customers.

“Obligating people to report on their commercial counterparties in this way is not a third party who’s neutral, it’s really one person, spying on or informing on another person,” Van Valkenburgh said. “It’s hard to imagine how we’re supposed to apply the third party doctrine to a transaction with only two parties.”

John Wesley Hall, a criminal defense lawyer and expert on Fourth Amendment litigation, told MarketWatch that the legal profession was the first to object to this arrangement. In the 1980s there were several lawsuits filed in federal courts objecting to a requirement that lawyers surveil their customers on behalf of the government, he said.

“I litigated this same issue back in the 1980s and 1990s and we lost miserably back then, every single time,” he said. “There’s no reasonable expectation of privacy because person A can always rat out person B.”

Carpenter to the rescue?

Van Valkenburgh argued that the Supreme Court has a much different attitude toward the third party doctrine today than it did when those cases were being fought more than 30 years ago as evidenced by the landmark 2018 case Carpenter v. United States.

In Carpenter, the Supreme Court determined that the common police practice of subpoenaing cellphone records to determine the location of potential suspects was a violation of the Fourth Amendment, even though someone voluntarily and implicitly agrees to phone companies accessing that information when they sign up for cellphone service.

“The Supreme Court said this information isn’t really voluntarily provided by customers, because cellphones are a necessity of daily life,” Van Valkenburgh said. “You can’t really be a functional part of the economy without having one, so it’s not really voluntarily.”

Furthermore, the court said that the information being sought by the government from a service provider has to be there for a “legitimate business purpose,” and that a cellphone company doesn’t really have a legitimate reason for keeping a full and complete record of a customers location.

“With Carpenter in mind, what’s the legitimate purpose of any random business person collecting the Social Security number of any customer who wants to transact in cash or cryptocurrency?” Van Valkenburgh wondered.

Blockchain and privacy

Even if the cryptocurrency industry and privacy advocates succeed in convincing federal courts that the reporting requirements in the bipartisan infrastructure bill and other similar laws are unconstitutional, that will be the beginning and not the end of a needed discussion around privacy and blockchain technology, says Paul Belonick, a professor of law and director of the center of innovation at UC Hastings.

Cryptocurrencies, after all, operate through public transaction ledgers. Anyone with sufficient technical knowledge can glean much information by studying these ledgers, and the government has displayed facility in using this information to track down criminals and recover ill-gotten gains.

This may result in an ironic outcome in which cryptocurrencies succeed in transforming the global financial system and weakening incumbent financial institutions that have become major partners in government enforcement, but do so in a way that makes surveillance potentially easier.

“We know that the government has been working, sometimes with private companies, to de-anonymize people on the blockchain,” Belonick told MarketWatch. “The government, without any policy intervention, could probably eventually de-anonymize most people.” 

Belonick said that if crypto and privacy advocates want to avoid that outcome, they should consider proactively pushing Congress to create laws that prevent that sort of activity without first getting a search warrant from the courts.

Hall, the criminal defense attorney, is doubtful that Congress will do anything to tie the hands of federal law enforcement. He pointed to the recent objections by Republican lawmakers to the possibility that the January 6th Commission might subpoena their phone records. “If they don’t like the third-party doctrine, Congress can just pass a law saying these records can’t be collected without a warrant.”

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