Regulatory clarity for crypto tax information reporting has arrived. See our comprehensive analysis of the proposed regulations and the implications to the crypto industry.
US Treasury Releases Blueprint for Digital Asset Tax Regime
Regulatory clarity for crypto tax information reporting has arrived.
The U.S. Treasury Department issued proposed regulations clarifying the definitions, requirements, and implementation timelines for digital asset brokers’ tax information reporting requirements as outlined in the Infrastructure Investment and Jobs Act (IIJA) passed by Congress in 2021. As noted in the IRS Newsroom, “These proposed regulations are designed to help end confusion involving digital assets and provide clear information and reporting certainty for taxpayers, tax professionals, and others,” said IRS Commissioner Danny Werfel.
Key takeaways:
- The U.S. Treasury Department issued proposed regulations clarifying the definitions, rules, and implementation timelines for the tax information reporting requirements of digital asset brokers as outlined in the Infrastructure Investment and Jobs Act (IIJA) passed by Congress in 2021.
- Important Effective Dates:
- Previous Tax Years & Today – Voluntary broker reporting for tax years prior to tax years 2025 & 2026 is being encouraged by the IRS by offering penalty waivers.
- Tax Year 2023 forward – Digital asset brokers will have to know cost basis information going back as far as January 1, 2023, in cases in which they continuously hosted digital assets for customers for periods that might go back that far.
- Tax Year 2025 – Gross proceeds reporting is mandatory.
- Tax Year 2026 – Gross proceeds and adjusted cost basis reporting is mandatory.
- Digital Asset Broker Classification Clarity:
- Digital asset brokers include any person who provides services facilitating the sale or exchange of digital assets, including centralized exchanges, digital asset payment processors, and certain decentralized protocols where there is sufficient control or influence over the protocol to make changes to it.
- Digital Asset Definitional Clarity:
- Digital assets include any digital representation of value that is recorded on a cryptographically secure distributed ledger, even if not every transaction is individually recorded.
- Clarification that Stablecoins and NFTs are considered in scope.
The proposed rules have extensive implications for crypto enterprises. As noted by the IRS in the proposed regulations, these information reporting requirements are directly related to helping to close the tax gap and for the benefit of the taxpayer. As a digital asset broker, it is important to ensure that you are ready for compliance, and have systems and processes in place for the following:
- Collect certified customer information, including a US Taxpayer Identification Number (TIN)
- Store and track customer lot-level transactional data
- Track and apply the correct cost basis to disposals using a permissible accounting method
- Generate, distribute, and file Forms 1099 to the IRS and applicable states
Digital Asset Broker Defined
Under the IIJA, a digital asset broker is defined as “Any person who is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” The IIJA broker definition is very broad, and would subject a wide range of digital asset companies to broker-related compliance and reporting obligations. While not as broad as the IIJA, the proposed regulations are more expansive than originally anticipated. Tom Shea, EY Financial Services Crypto Tax Leader, commented, “These eagerly anticipated proposed regulations go beyond the bare-bones outlines in the Infrastructure Act and anticipate a world where cryptocurrencies and other digital assets are a routine part of the economy, widely accepted by merchants and investors. This is, hopefully, a major step towards a comprehensive framework for taxing digital assets fairly, while continuing to bridge the current reporting gap.”
Under the proposed regulations, the definition has been refined to focus on three types of enterprises under the umbrella of a “digital asset middleman”:
- Centralized exchange operators that facilitate digital asset transfers on behalf of users
- Digital Asset Payment Processors
- Decentralized protocols accessible to US individuals that meet certain requirements (discussed below)
Notably, miners, stakers, and wallet software providers are excluded unless any of those services are bundled with a service that facilitates the sale or exchange of digital assets. For example, wallet software that merely permits an individual to exert control over a digital asset is not a broker, but software that also permits an individual to buy and sell digital assets within the same software is a broker.
Centralized Exchanges
It is no surprise that centralized exchange operators fall within the definition of a digital asset broker. The services they provide are very analogous to the traditional role of a broker because they facilitate the exchange of property between unrelated parties.
Digital Asset Payment Processors
The proposed regulations address the role of digital asset payment processors in facilitating transactions involving digital assets. These regulations define digital asset payment processors as entities that regularly facilitate digital sales by receiving digital assets from one party and exchanging them into different digital assets or cash to be paid to another party, such as a merchant. The regulations outline reporting requirements for digital asset payment processors to provide information on customer dispositions of digital assets, ensuring transparency and compliance in transactions involving these payment processors. Additionally, the regulations include provisions that consider transaction structures involving temporarily fixed exchange rates and expand the definition of digital asset payment processors to include certain payment settlement entities and payment card issuers involved in digital asset transactions.
Decentralized Protocol Clarification
Deciphering which decentralized protocols will fall within the definition of a digital asset middleman will be a nuanced analysis.
The proposed regulations state that a digital asset middleman is a person that:
- Provides a facilitative service; and
- Based on the nature of the service, would know or be in a position to know both (1) The identity of the party making the sale, and (2) The nature of the transaction potentially giving rise to the proceeds from the sale.
Facilitative Service
The regulations define facilitative services as facilitating the sale (or exchange) of digital assets regardless of whether that is done through an autonomous protocol, access to a trading platform, automated market maker systems, or any order matching service. This approach illustrates Treasury’s understanding of how digital asset trading services differ from traditional financial broker services.
Digital asset middleman is much more nuanced than traditional broker definitions. Not because they are not effectuating transfers but because autonomous protocols may not be seen as a “person” under the tax code. The rules may apply to decentralized exchanges, financial protocols such as lending or liquidity pools, and NFT marketplaces—really any situation where a protocol is effectuating the transfer of a digital asset between parties.
Being in a Position to Know
The regulations explain that a person would know or be in a position to know if they have the ability to set or change the terms under which the services are provided. In substance, this seems to focus on whether a person has sufficient control over an autonomous protocol to make changes, updates, or otherwise influence its operation.
If the DeFi protocol can be managed, controlled, or overwritten by a centralized group in any way, that protocol will likely be viewed as sufficiently centralized to be treated as a digital asset broker. Conversely, if the protocol truly operates autonomously, without any oversight, intervention, or influence from a particular group, it will not be considered a digital asset broker and not be subject to the reporting requirements.
Cost Basis Tracking
Similar to securities, digital asset brokers will be required to track and report cost basis information for digital assets that have been disposed of. While most digital asset brokers historically have recorded and maintained transaction-level data, they will need to ensure they have systems in place to track and apply the correct cost basis to disposals using a permissible accounting method selected by individual users who are customers of brokers.
The proposed rules mirror cost basis tracking used for other financial products. Individuals will be required to specifically identify which units are being sold if less than all of the units held in a single account or address are being sold, and will need to make that identification at or before the time of the sale. If such an identification is not made, a default rule will apply, treating units sold in the order of acquisition from oldest to newest.
These proposals revise current IRS FAQs with respect to digital assets. Individuals will now need to identify which unit is being sold at or before the time of the sale. And if no identification is made, a first-in-first-out method will be applied on a per-account basis, rather than the current universal basis.
Although this rule applies to individual taxpayers, digital asset brokers will need to revise customer agreements and implement systems that permit customers to select the default accounting method and/or decide before the moment of sale which cost basis lot is used.
Fees and Commission Treatment
In addition to cost-basis-lot selection, the regulations also clarify how fees and commissions (classified as digital asset transaction costs under the regs) are dealt with. For most sales of digital assets, digital asset transaction costs will be applied to reduce the sale proceeds received in the transaction.
However, where the sale of a digital asset is for another digital asset – an exchange of digital assets – the costs will be split equally between both sides of that transaction. Half of the costs will reduce the sale proceeds, while the other half will be applied to the acquisition cost basis of the digital asset received in the transaction. This rule will apply regardless of whether the costs are paid with cash, property, either of the digital assets involved in the transaction, or with a third digital asset that is not part of the transaction.
Form 1099 Reporting
The core component of the IIJA provisions is to require digital asset brokers to file annual information returns detailing information about the taxable dispositions of property belonging to customers. These information returns are filed with the IRS and furnished to the individual customers to help ensure accurate tax reporting.
Denise Hintzke, Managing Director and Global Information Reporting Market Leader at Deloitte Tax LLP commented: “The release of the newly proposed regulations provides the industry with a roadmap that can be used to meet the deadline for digital asset reporting on or after January 1, 2025.”
Historically, Form 1099-B has been used in traditional finance to report the required information. Although not specifically referenced in the proposed regulations, the IRS has commented publicly about creating a new form (1099-DA) to be used for digital assets.
Similar to reporting on traditional financial assets, digital asset reporting will require a broker to include the following pieces of information for each transaction:
- Name, address, taxpayer identification number
- Digital asset details (name, type, number of units)
- Date and time (UTC)
- Gross proceeds of the sale and Adjusted Cost Basis
- Transaction ID or hash
- Digital asset addresses involved
- Form of consideration received
For assets that were transferred into a Broker and subsequently disposed of, the following information will also be required:
- Date and time of such transfer-in transaction
- Transaction ID or hash of such transfer-in transaction
- Digital asset address (or digital asset addresses if multiple) from which the transferred-in digital asset was transferred
- Number of units transferred in by the customer as part of that transfer-in transaction
Once rules are published under Sec. 6045A related to transfer statements, this additional transfer information may not be required on Form 1099-DA.
Customer Personal Data
To effectively comply with 1099 reporting, Digital Asset Brokers will need to know who their customers are for tax reporting purposes. This means they will need to be able to identify and collect the following information for reportable accounts:
- Identification of accounts as US or non-US
- Collection of names, addresses, and certified US Tax Identification Numbers (TIN).
Brokers within the traditional finance industry currently have an obligation to collect certified tax identification numbers (TINs). Accordingly, digital asset brokers will assume that same obligation. This requirement will impact digital asset customer onboarding in a significant way. Digital asset brokers will be required to collect certified taxpayer identification numbers (TINs), achieved by collecting a Form W-9 or Substitute W-9. The information collected on a Form W-9 is used to populate and file Form 1099-B, and the new Form 1099-DA, specific to digital asset broker reporting.
What we still don’t know
The regulations state that Treasury is taking a piecemeal approach to implementing IIJA. These regulations tackle the first component under section 6045, but defer on other elements.
Transfer Statements
The proposed regulations do not address how brokers will facilitate the reporting or sharing of cost basis information when a digital asset is transferred from the broker to another broker or to a non-broker. Treasury is likely interested in hearing feedback on these proposed rules first because these rules establish important definitions and other elements necessary for those transfer rules.
Form 8300 Reporting
The proposed regulations also do not address the disclosure reporting required when a person receives more than $10,000 of digital assets as part of their trade or business. Traditionally required for cash on Form 8300, this type of reporting has been the subject of some debate since the passage of the IIJA. There are also some administrative uncertainties because historical Form 8300 reporting has been made to the Financial Crimes Enforcement Network (FinCEN) rather than the IRS. Still, the new provision seems to require reporting to the IRS. It is likely that the Treasury is still working through some of the details on how to implement this new reporting and what information will be required.
What happens next?
Now that the proposed regulations have been published by the U.S. Treasury, it is important to understand the next steps. Following the formal publication of these proposed regulations on August 29, 2023, in the Federal Register, there is a 60-day comment period for the public to provide feedback on the proposal.
There are several important things to note during the comment period:
- It is important that the digital asset community utilize this comment period to educate regulators about the challenges or gaps present in the proposed regulations.
- Comments can be submitted via the Federal eRulemaking Portal at www.regulations.gov.
- All submissions are public.
- Treasury will hold a public hearing on November 7, 2023 (and maybe the next day, too, if needed) at which stakeholders can provide feedback directly to the drafters of these proposed regulations. Attendance can be in person or by phone. Those who might wish to attend, dial-in, or testify should send emails according to the detailed instructions listed on pages 170-71 of the proposed regulations.
- Treasury will review and consider “all relevant matters.” This is a long-awaited opportunity for the industry to work with regulators to develop a tax-reporting system that helps taxpayers, and industry.
Although not entirely fixed as of writing, the proposed regulations provide detailed guidance for how digital asset brokers should prepare. As it stands, digital asset brokers have a clear roadmap and deadline for compliance.
The key areas of focus for the near term should include:
- Systems and procedures to capture customer information as outlined above
- Voluntary compliance feasibility- as previously mentioned, tax information reporting for tax year 2023 and 2024 is optional for digital asset brokers. The IRS will not penalize you for any errors in the reporting process, and voluntary reporting is encouraged to show good faith to regulators while improving customer experience (and helping them avoid costly audits). In addition, the voluntary reporting window presents the opportunity to test compliance operations.
How Taxbit can help
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