IRS Targets DeFi: How New KYC Rules Could Impact Decentralized Finance Platforms

• IRS regulations classify DeFi protocols as brokers, requiring compliance with KYC rules and transaction reporting for tax purposes.
• Blockchain Association leads lawsuit against IRS, alleging the new DeFi rules violate constitutional rights and stifle innovation.

The Internal Revenue Service (IRS) recently unveiled rules reclassifying specific decentralized finance (DeFi) protocols as brokers, requiring these platforms to implement Know Your Customer (KYC) measures and report user transactions.

These changes could affect as many as 875 DeFi platforms, sparking widespread objections from the crypto industry, which argues that the rules are both intrusive and counterproductive.

This regulation mandates the disclosure of taxpayer information, including personal details, to improve compliance with tax laws. Critics argue that the rule goes beyond the Treasury’s authority and could violate the Administrative Procedure Act (APA).

Organizations such as the Blockchain Association and the DeFi Education Fund are preparing a lawsuit to challenge the regulation. Their argument focuses on the claim that the rule imposes unnecessary burdens on the cryptocurrency industry and fails to account for the decentralized structure of blockchain systems.

Congressional Oversight Expected

Congress may review the IRS rule, potentially blocking its implementation. Earlier this year, Congress voted to disapprove Staff Accounting Bulletin 121 (SAB 121), which also targeted cryptocurrency-related reporting. Observers suggest that a similar outcome could occur if lawmakers determine that the IRS regulation places excessive constraints on the digital asset sector.

The IRS asserts that these measures aim to enhance tax compliance within the digital asset sector. However, crypto stakeholders have raised concerns that such requirements conflict with DeFi’s decentralized principles, where platforms operate without centralized control. 

Legal and Industry Pushback

In response to the regulations, the Blockchain Association, along with the DeFi Education Fund and the Texas Blockchain Council, has filed a lawsuit challenging the IRS’s authority to enforce these rules. The legal challenge asserts that the regulations overreach constitutional boundaries and impose undue burdens on the growing DeFi sector .

Kristin Smith, CEO of the Blockchain Association, emphasized the need to protect DeFi’s operational model from heavy-handed policies. She expressed optimism that a pro-crypto administration under Donald Trump could review and revise these rules to support innovation while maintaining compliance.

Legal experts within the crypto industry have also voiced strong objections. Jake Chervinsky, Chief Legal Officer at Variant, criticized the IRS for exceeding its regulatory scope. Miles Jennings, General Counsel at a16z Crypto, warned that the rules risk redefining DeFi in a way that could stifle its growth entirely.

Broader Implications

The crypto community continues to reject these regulations , arguing they are incompatible with DeFi’s decentralized structure. The concern is that KYC requirements could inadvertently centralize operations, undermining the efficiencies of decentralized systems.