It goes without saying that the concept of decentralized money and the U.S. Internal Revenue Service (IRS) are at odds. Hence, the U.S. tax agency has recently increased its efforts to crack down on tax crime enabled by Bitcoin and related technologies.
In an August New York Times article, it was mentioned that tools developed or adopted by the IRS and other American agencies were helpful in seizing bitcoin used by terrorist groups. The IRS is also purportedly initiating a deal with Coinbase for a new tool to track cryptocurrency transactions.
More recently, the IRS has sent warning letters to a number of cryptocurrency users believed to be misappropriating their transactions.
Now, according to new U.S. government contracts, the IRS is targeting Bitcoin's Lightning Network, which offers improved privacy compared to transactions made on the Bitcoin mainchain.
The IRS branch leading this contract is the Criminal Investigation Department (IRS-CI). This branch was previously involved in the takedown of the Silk Road, the first major dark web marketplace that used bitcoin for transactions.
According to a proposed government contract published on September 4th, the IRS will pay up to $625,000 for developers who manage to trace private cryptocurrency transactions.
"IRS-CI is seeking a solution with one or more Contractors to provide innovative solutions for tracing and attribution of privacy coins and Layer 2 off-chain transactions, such as expert tools, data, source code, algorithms, and software development services to assist their Cyber Crimes agents in carrying out their mission as it relates to cryptocurrency privacy technologies."
The IRS specifically mentioned Monero, the largest privacy-focused cryptocurrency, Bitcoin's second-layer scaling solution the Lightning Network, and "cryptocurrency obfuscation technologies." Second-layer solutions for other cryptocurrencies were also mentioned.
Along with offering low-cost and rapid transactions, the Lightning Network has been touted as a way to increase the privacy of Bitcoin transactions.
A March 2020 paper from researchers at Cornell University titled "An Empirical Analysis of Privacy in the Lightning Network" suggests the Lightning Network offers three privacy properties thus far: third-party balance secrecy, off-path payment privacy, and on-path relationship anonymity.
The IRS mentioned the growth of the Lightning Network, referencing the over 10,000 active Lightning nodes, as a reason why they "have the need to [be] able to investigate illicit activity on these networks."
In targeting "cryptocurrency obfuscation technologies," the IRS may also be referring to Bitcoin's on-chain mixer technologies. As development has been relatively slow on the front of layer-one privacy, there has been an uptick in the adoption of technologies like CoinJoin, which combines multiple transaction inputs to obfuscate the origin of an end transaction.
Not all developers who apply will receive this grant. The contract suggests that to apply, potential contractors must submit a prototype of how they intend on tracing "Monero or another anonymity-enhanced cryptocurrency" by September 16th.
Contractors that have their proposal accepted will receive $500,000 for the development of a prototype, then an additional $125,000 once the end product is approved by the government. Those that take the IRS's offer will need to submit a "proof of concept and an initial working system" within eight months.