Demystifying ‘DeFi’

The Basics of DeFi

A discussion of some of the intricacies of DeFi requires some basic understanding of DeFi concepts. DeFi actually encompasses a vast ecosystem of financial tools and protocols that facilitate blockchain transactions. The concept of DeFi is centered around a strong belief in noncustodial financial systems that are governed by coded “smart contracts,” rather than traditional financial institutions. A smart contract is a set of code that exists on the blockchain and automatically generates a particular output when presented with a particular input, thereby eliminating the need for third parties to clear transactions (Van Loo v. Dep’t of Treasury, 122 F.4th 549, 5th Cir. 2024). This facilitates peer-to-peer transactions without the need for intermediaries or exchanges. Many DeFi protocols originated, and still operate, on the Ethereum blockchain.

Regulators and tax authorities are still catching up with the burgeoning DeFi industry. For instance, last year, the Secretary of the Treasury issued final regulations that would have imposed broker tax information reporting requirements on DeFi protocols, requiring the protocols to provide their customers with annual Forms 1099-DA, Digital Asset Proceeds from Broker Transactions, reporting certain tax information from DeFi transactions (T.D. 10021, 89 F.R. 106928). But, in a bipartisan move, Congress recently repealed the regulations under the Congressional Review Act, leaving the users of DeFi protocols in an unsettled tax regulatory landscape (H.J. Res.25, 2025).

Liquidity Pool Transactions

The concept of a liquidity pool is central to DeFi. As the name suggests, a liquidity pool is a mechanism by which a DeFi protocol funds its operations, such as loans made to users. A liquidity pool can be viewed as analogous to a traditional financial institution receiving a bank deposit from a customer, which funds are, in turn, available to other customers. Users deposit (stake) their own cryptocurrency into the liquidity pool and generally receive an interest-like yield on their deposit, which is in turn funded by fees charged to users by the protocol. A DeFi protocol typically uses staked tokens in a liquidity pool in order to fund loans to other users or to fund swaps between particular cryptocurrencies. For the depositor, a liquidity pool provides opportunities for “yield farming,” that is, maximizing the return on cryptocurrency investments by investing or depositing in various DeFi protocols.

For some protocols’ liquidity pools, a user receives a representative liquidity provider (LP) token in exchange for making the deposit. LP tokens are generally freely transferrable upon receipt. Other protocols’ liquidity pools do not return an LP token. Prominent DeFi protocols that utilize liquidity pools include UniSwap, Compound, SushiSwap, Curve Finance, and Kyber Network.

The tax implications of staking to liquidity pools are unsettled and may depend on the characteristics of the protocol receiving the token. A commonly held position is that staking an owned token in a liquidity pool generally does not result in a realization of gain, so long as no property is returned in exchange for the staked token from the DeFi protocol. Under this theory, the staking taxpayer retains beneficial ownership over the staked token, analogous to depositing cash into a traditional bank or other financial account. The staking taxpayer may still recognize ordinary income upon receipt of interest-like rewards from the DeFi protocol (Rev. Rul. 2023-14), although some taxpayers have contended otherwise (Jarrett v. United States, No. 24-cv-01209, M.D. Tenn., complaint filed Oct. 10, 2024).

If the staking taxpayer receives an LP token in exchange for the staked token, this may change the tax considerations. Should the LP token be freely transferable, it could be argued that the staking taxpayer should realize gain upon the initial staking “exchange” and then again upon the withdrawal from the liquidity pool, which is generally accompanied by “burning” (or returning) the LP token. Under this theory, the staking taxpayer has exchanged legally distinct property and thus must realize gain [Cottage Savings Ass’n v. Comm’r, 499 U.S. 554, 1991; Treas. Reg.§ 1.1001-1(a)]. The facts and circumstances of a particular liquidity pool may present an argument as to why that treatment is inappropriate, but the IRS is likely to operate from the baseline understanding that all transactions that result in an exchange of tokens give rise to realization of gain (IRS Notice 2014-21). Users who frequently engage in liquidity pool transactions may have unexpected exposure to additional income tax liability and thus should carefully consider their options to correctly report their income.

Flash Loans

Flash loans involve a DeFi protocol (such as dYdX or Aave) disbursing cryptocurrency to a borrower, who must return an equivalent amount of the same cryptocurrency (plus transaction fees) in the same instantaneous (atomic) blockchain transaction. The coding of a flash loan transaction conditions each step of the transaction on an essentially simultaneous repayment. Should the coding of the borrower’s transaction not result in repayment, the transaction simply fails, with no assets changing hands. Critically, flash loans require no collateral because of the codified assurance that the borrowed funds will be returned. Viewed from outside the DeFi space, a flash loan seems odd. One might appropriately ask why someone would take out a loan that is instantly repayable. The economic benefit from such a circular transaction is not immediately apparent.

But the use case for a flash loan is rooted in the instantaneous nature of the blockchain and the unique ways that DeFi users can use that fluidity to generate value. For example, some investors use flash loans to engage in cross-protocol arbitrage. If a user notices a slight differential or lag between the exchange rates on two protocols (which could be caused by the use of different pricing data, or “pricing oracles,” or a volatile market), a flash loan could be used to leverage up that opportunity. To illustrate, if a particular token is listed at $5 on DeFi exchange X but $5.01 on Exchange Y, a user could take out a flash loan to fund a large purchase of the token on Exchange X, followed by an instantaneous sale on Exchange Y in an equal amount. The user would instantaneously repay the flash loan and pocket the proceeds from the $0.01 price differential.

DeFi users also employ flash loans to leverage up yield farming positions. One version of the strategy involves taking out a flash loan of tokens, staking those tokens in a liquidity pool where the user already has a staking position, and then using the tokens as collateral to take out an overcollateralized loan from the protocol, which is used to repay the original flash loan—all of which happens instantaneously if correctly coded. The end result is that the user now has equally offsetting loan and liquidity pool positions, with a possibility for arbitrage occurring if the liquidity pool rewards are paid out at a higher rate than the interest rate on the loan.

As with staking transactions, the tax implications of flash loans and other loans of digital assets are complex. Loans of fungible property have a complicated treatment in tax law. Under IRC section 1058(a), loans of securities do not give rise to gain or loss if made under an agreement that meets certain specified requirements. But the definition of “securities” cross-referenced by section 1058(a) does not allow for the possibility of digital assets being subject to section 1058’s non-recognition provision [IRC § 1236(c)]. That leaves loans of cryptocurrency subject to general tax principles under common law, which predated section 1058(a)’s enactment and arguably remain applicable. The key inquiry under the caselaw and IRS guidance is whether the borrower of a fungible digital asset obtains the benefits and burdens of the asset upon the loan disbursement, thus resulting in obtaining beneficial ownership for income tax purposes (Rev. Rul. 57-451, 1957-2 CBI). In particular, the right to control the asset after the loan disbursement, including the rights to sell, dispose of, or pledge the asset as collateral, is particularly dispositive (Alex Raskolnikov, “Contextual Analysis of Tax Ownership,” Boston University Law Review, vol. 85, no. 431, pp. 481–82, 2005).

Does a taxpayer obtain beneficial ownership over borrowed tokens pursuant to a flash loan? Arguably, the taxpayer’s right to freely dispose of the borrowed tokens is often limited by the obligation to instantaneously return an equivalent amount in the same atomic transaction. What about tokens borrowed via longer-term non-flash loans with pledged collateral? Answers to these questions are highly dependent on the specific facts of the transaction, including the extent of the taxpayer’s right to control the tokens upon disbursement.

Interactions with DAOs

Decentralized autonomous organizations (DAO) are another unique DeFi concept that can present significant tax compliance challenges for taxpayers. DAOs can arise in two forms: (1) “wrapped” within a traditional legal entity formed under state or foreign law; or (2) standing on its own, outside of any formal legal entity. Within the DeFi space, the use of a wrapping entity is not typical (Dennis Post and Jeff Wong, “The Right Legal Wrapper Can Protect a DAO and Its Members,” Bloomberg Law, July 31, 2023). In its purest formulation, a DAO is intended to be regulated entirely by the code governing its applicable smart contracts, not by any formal partnership agreements or articles of organization. But the use of a wrapped entity has obvious benefits from a regulatory and tax perspective.

Without a wrapping entity, a DAO does not control its own tax destiny. A DAO often shares key characteristics with a traditional common law partnership, such as the joint sharing of profits between members. One feature that distinguishes DAOs from partnerships, or virtually any other common business entity, is the lack of any centralized management, such as a managing partner (or board of directors in the case of a corporation). Two federal district courts (applying California law) have suggested, in dicta in the context of a motion to dismiss, that DAOs may be properly treated as partnerships under state law [Samuels v. Lido DAO, No. 23-cv-06492, 2024 WL 4815022, at *6–8, N.D. Cal. Nov. 18, 2024; Sarcuni v. bZx Dao, 664 F. Supp. 3d 1100, S.D. Cal. 2023)]. This trend seems likely to continue for DAOs without a wrapping entity. By failing to affirmatively choose a state law entity and to elect federal income tax treatment, an unwrapped DAO will be subject to the default rules under the check-the-box regulations. For most DAOs, that will likely result in partnership treatment [Treas. Reg. § 301.7701-3(b)(1)(i), (2)(i)].

Furthermore, absent proper structuring with state and foreign law entities, U.S. sourcing of income, and thus U.S. taxation of DAO members, is a possibility. For example, if active members (i.e., partners) are acting on behalf of the DAO within the United States, the DAO might be considered to be engaged in a U.S. trade or business, with income derived from the trade or business being deemed effectively connected income (ECI) that is taxable to foreign-based DAO members [see IRC § 875(1); YA Glob. Invs., LP v. Comm’r, 161 T.C. 173, 2023]. Under such circumstances, foreign DAO members may unwittingly find their investment in the DAO subject to U.S. taxation.

The novel nature of DAOs, their lack of a governing board or managers and officers, and the uncertainty as to what they are and how they are treated makes them prone to tax non-compliance. Like-wise, individual members of DAOs that could be deemed to be partners may not have considered the tax ramifications of their membership and may not even be aware of a U.S. tax filing requirement. If deemed to be partners in a partnership generating ECI, individual members would have the obligation to report their proportional share of the partnership’s items of income, gain, loss, deduction, or credit. Given that an unwrapped DAO is unlikely to be tracking this information or issuing a Schedule K-1 to its partners, compliance with this requirement would be difficult. Furthermore, absent an effort by DAOs, which have no centralized control structure, to voluntarily comply, the prospects for the individual members to obtain this information are unlikely.

This is not to suggest that individual DAO members are defenseless in the event of an IRS audit. For individual members subject to an audit or investigation, one potential argument is to concede that a partnership may have existed but contend that the individual member was not one of its partners. This argument was raised by the plaintiff in Lido DAO: the argument being that ordinary token-holding members were not necessarily partners, with partner status only being attributable to those members that “meaningfully participated” in DAO administration and decision-making. DeFi users who may be exposed to potential tax liability through their token holding in a DAO should move quickly to explore compliance options and possible defenses.

Vigilance in the Face of Uncertainty

DeFi is a novel, burgeoning, and, for many, exciting development in the rapidly evolving world of global finance. As with everything novel in the financial world, it is subject to great regulatory uncertainty. This is especially true with respect to the taxation of DeFi transactions. Tax professionals and their clients who participate in DeFi need to be vigilant if they are going to ensure compliance with an area of the tax law that is developing in real time.