Code as Law: Using Ethereum Smart Contracts to Ensure Compliance with Federal Tax Law

In OpenLaw’s most recent demo, we explore how smart contracts can serve to enhance and enforce laws. In other words, we represented law as code.

Overview

With Ethereum-based smart contracts, governments have the opportunity to experiment with new means of code-based regulation to achieve specific policy goals. Objectively verifiable legal rules and regulations can be translated into simple and deterministic code-based rules that are automatically executed by the underlying blockchain network. Governments have the ability to model laws and regulations — especially those with objectively verifiable restrictions or parameters — and incorporate them into code.

In this demo, we demonstrate one example of this future: using Ethereum-based smart contracts to ensure tax compliance. We’ve extended our Real-Time Employee Offer Letter, modeling U.S. federal employment tax requirements in a smart contract, which is triggered and enforced once the agreement is signed by relevant parties.

We have created an automated enforcement mechanism that has the potential to streamline compliance with these tax law provisions. With Ethereum and OpenLaw’s blockchain-based protocol, we’re creating a more efficient future, where an employer can pay an employee in ether every minute, eliminating the costs of payroll processors or the need for other centralized intermediaries in the process, while at the same time decreasing the tax gap and the needless waste of resources associated with tax compliance.

OpenLaw’s Real-Time Employee Offer Letter not only governs the terms of employment between an employer and an employee but also allows employers to simultaneously withhold federal wage withholdings from the salaries that they pay their employees. Every minute employees are paid, a portion of their salary is withheld, timely withholding payments are tracked on the blockchain, and the withholding amounts and matching employer tax obligations are immediately remitted to the IRS in real time — making the collection of revenue instantaneous.

We modeled the withholding and tax obligations of employers set forth in the demo on current federal tax law. The demo includes the 2018 Percentage Method withholding amounts for federal income tax withholdings and the tax requirements under the Federal Insurance Contributions Act and the Federal Unemployment Tax Act. These acts enumerate the withholding requirements for Medicare, Social Security, and federal unemployment tax for employers.

With OpenLaw’s demo, we can begin to see a more efficient future where payment and tax compliance costs go down. The cost that the United States government incurs as a result of noncompliance and by conducting audits and pursuing enforcement actions against those who do not comply with the tax law provisions set forth in the Internal Revenue Code (the “Code”) is vast. In fiscal years 2016 and 2017, the IRS incurred more than $4 billion dollars conducting enforcement activities. Between 2008 and 2010, an estimated $458 billion dollars of tax liability was not paid voluntarily or on time.

Furthermore, the complexities that are present in the Code and the disparate withholding requirements that each state imposes also make compliance costly and time consuming for employers. In 2017, an estimated 8.1 billion hours were spent complying with the Code — more than 400 million of which were spent by employers completing requirements for quarterly and federal unemployment tax returns. With this demo, we aim to show that the extensive time and costs that currently burden both government agencies and those who must comply with tax withholding obligations can be significantly diminished through the combination of law and code.

Practical Considerations

This is our first iteration of the employment tax use case, and therefore addressed only part of governments’ complex tax requirements. We decided only to include the structure for federal employment tax requirements while acknowledging that employers have both federal and state tax obligations to consider. We chose first to demo the federal wage withholding requirements to show how compliance with current tax obligations could be conducted through an employment agreement using OpenLaw’s blockchain-based protocol. Although the IRS has not explicitly approved the acceptance of ether tax payments, state legislatures have already adopted and begun to move towards the adoption of laws permitting tax payments to be accepted in the form of cryptocurrencies (See Arizona Senate Bill, Illinois House Bill, Georgia Senate Bill). As laws in the United States evolve, the practical application of implementing an employment agreement that includes the subtraction of wage withholdings and the remittance thereof to the IRS will become more attainable.

Additionally, because current laws do not include withholding amounts for cryptocurrencies, and the conversion rate of ether into USD is subject to volatility, we have converted the salary that an employee receives in ether into USD based off the conversation rate as of May 21, 2018 in order to make the appropriate tax calculations. We then converted the tax and adjusted salary amounts back to ether using the same conversion rate. Depending upon how laws shape themselves around cryptocurrencies in the future, the conversion of ether to USD may require the use of an oracle or, possibly, stable coins.

Going Forward

This demo has some far-reaching implications for both taxpayers and government tax agencies like the IRS. We will continue to work through and embolden features of tax law through code as solutions emerge on the OpenLaw protocol.

Along with our Real Estate demo, we plan on exploring other proof of concepts over the next few months, leading up to our public release. Plan on visiting our Medium page for write-ups on some of the following demos we’re thinking about working through next:

• A tokenized Stock Purchase Agreement;
• An automated Advertising Agreement; and
• A basic Will and Testament with asset transfer on a life event.

Please reach out to hello@openlaw.io if you have any inquiries or suggestions (demo ideas too!) moving forward.

We’re trying to change the future of commercial law, come join us!

Disclaimer: The views expressed by the author above do not necessarily represent the views of Consensys AG. ConsenSys is a decentralized community with ConsenSys Media being a platform for members to freely express their diverse ideas and perspectives. To learn more about ConsenSys and Ethereum, please visit our website.