Clearer Lines in Crypto Reporting Sand Would Cast a Wide Net

On August 25, 2023, Treasury and the IRS released an initial set of proposed broker reporting regulations that would apply broadly to cryptocurrency transactions. The proposed rules seek to implement provisions of the 2021 Infrastructure Investment and Jobs Act aimed at curbing tax avoidance and simplifying taxpayer compliance.

Under the proposed regulations, “digital asset brokers” would generally be subject to the same reporting rules as brokers of stocks, securities, and other financial instruments. Fortunately, the delayed implementation should allow time to address challenges in complying with the proposed rules. The initial reporting of gross proceeds would begin in 2026 for sales and exchanges that occur in 2025. Also, beginning in 2027, certain brokers would be required to report adjusted basis on digital assets sold in 2026 that were acquired on or after January 1, 2023.

This alert highlights selected components of the rules, including the scope (e.g., market participants and sales transactions), information to be reported, and foreign sales exemptions, along with selected implementation challenges.

DIGITAL ASSET BROKERS

Under the proposed regulations, any person that (1) in the ordinary course of a trade or business stands ready to facilitate the sale of digital assets by others and (2) is in a position to know (a) the identity of the seller and (b) the nature of the transaction potentially giving rise to gross proceeds would be a “digital asset broker” subject to reporting requirements under I.R.C. section 6045.

Digital asset brokers would thus include:

• Centralized and decentralized exchanges (DEXs) and other non-custodial digital asset platforms that do not request customer information, but could modify smart contracts, protocols, and operations to comply with the proposed regulations;
• Licensors of software that provide direct access to a trading platform from a wallet platform;
• Digital asset payment processors;
• Persons required to report real estate transactions, who are treated as brokers for dispositions of digital assets (though such persons still fall under the existing reporting rules); and
• Issuers of stablecoins (digital assets linked to the value of another asset or multiple assets).

Market participants not subject to the rules would include:

• Validators of distributed ledger transactions through consensus mechanisms (e.g., proof-of-work, proof-of-stake) that do not provide other functions or services;
• Sellers of hardware or licensors of software that is limited to controlling private keys that allow access to digital assets on a distributed ledger; and
• Merchants who regularly sell goods or other property (other than digital assets) or services in exchange for digital assets.

SALES TRANSACTIONS

The proposed regulations, consistent with the statute, would define “digital asset” as any digital representative of value that is recorded on a cryptographically secure distributed ledger or similar technology. Sales transactions subject to the broker reporting rules would include digital assets exchanged for:

• Cash, one or more stored-value cards, or a different digital asset;
• Property subject to broker reporting under I.R.C. section 6045 (e.g., stock or real estate); and
• Broker services, regardless of whether the broker is a digital asset broker.

Exceptions would not be provided for transactions involving:

• Stablecoins; and
• Non-fungible tokens (NFTs) – ownership interests in unique assets, such as digital artwork, video, or music, or sports or other entertainment memorabilia.

Not all transactions involving digital assets that might give rise to income are addressed in the proposed rules, such as loans of digital assets, transactions involving digital asset transfers to and from a liquidity pool, and the receipt of digital assets in hard forks.

GAIN OR LOSS INFORMATION

Taxpayers must determine the amount and character of the gain or loss on sales of digital assets (i.e., amount realized, adjusted basis, and holding period). The amount realized would be equal to the sum of cash received, the fair market value of any materially different property received (or in the case of debt exchanged for digital assets, generally the issue price), and the fair market value of services received, reduced by allocable digital asset transaction costs (e.g., gas fees).

Digital asset brokers would determine gross proceeds using a reasonable valuation method based on contemporaneous evidence of the value of the services, stored-value cards, or other property. If the fair market value of the property or services received cannot be determined with reasonable accuracy, it would be determined based on the value of the transferred digital asset. If the fair market value of property, services, and digital assets cannot be reasonably determined (e.g., likely most NFTs), brokers would report the value of the services or property received as undeterminable. If transaction costs are paid in cryptocurrency, the fair market value would be based on the value of the digital assets.

The initial basis of a digital asset acquired would generally be the cost of the digital asset received — the sum of cash and the fair market value of property and services transferred — plus any allocable digital asset transaction costs. The proposed regulations would initially limit the mandatory adjusted basis reporting requirements to digital assets acquired by hosted wallet providers, until further guidance is provided on the transfer statement and issuer reporting necessary for non-custodial brokers to report adjusted basis.

FOREIGN EXEMPTIONS

Existing broker reporting rules presume customers transact with brokers in physical locations for purposes of determining whether reporting exemptions apply (i.e., for sales effected at an office outside the U.S. or involve an exempt foreign person). Therefore, the proposed regulations provide special rules for the sales of digital assets, including:

• New documentation requirements for a U.S. digital asset broker, a controlled foreign corporation (CFC) digital asset broker, and a non-U.S. digital asset broker;
• Presumptions that sales by U.S. brokers would generally be treated as effected at an office inside the U.S. and subject to digital asset reporting, unless the customer can be treated as an exempt recipient or exempt foreign person; and
• Generally treating sales by CFC brokers and non-U.S. brokers as effected at an office outside the U.S. with payments not being subject to backup withholding tax unless, for example, the broker conducts substantial business within the U.S. or has actual knowledge that the customer is a U.S. person.

A&M TAX SAYS

Although previously subject to debate, it is clear now that the broker reporting rules, if adopted as proposed, would apply to DEXs and other decentralized protocols. Specifically, DEXs would have to prepare and issue a new Form 1099-DA to every U.S. person using their exchange to trade cryptocurrencies. The penalties for non-compliance are severe: $250 per form per year up to a maximum of $3 million per year.

Compliance with some Know Your Customer (KYC) standards would be required, which may be challenging for DEXs that only know their customers’ wallet address. Specifically, DEXs will need to collect, among other things, each customer’s name, address, and taxpayer ID number to complete the Forms 1099-DA. DEXs would need to collect this information to be able to determine which of their customers are U.S. (subject to the rules) versus non-U.S. persons (exempt from the rules, which would require additional documentation). For customers that refuse to provide such information, backup withholding at a 24% rate is required, which would also be challenging for any DEX to implement. Fortunately, there are ways to collect this data that should not compromise the decentralized nature of DeFi, for which A&M Tax can assist.

The good news is DEXs would only need to report gross proceeds, though determining the appropriate fair market value for each digital asset must be done with proper care. Cost basis reporting would generally not be required for DEXs, though that could change once the transfer statement guidance is released.

A&M Tax is a full-service tax firm that could assist you with (1) determining whether your company is subject to these rules, (2) implementing KYC protocols, (3) gathering data from the blockchain, and (4) populating and delivering the Forms 1099-DA. Please feel free to reach out to Chris Kotarba for assistance.