IRS Proposes Crypto Reporting Regulations

Jason Schwartz Commentary by Jason Schwartz

The Internal Revenue Service proposed crypto broker reporting regulations.

Background

Section 6045 of the tax code requires brokers to provide customers and the IRS with 1099s showing the customer's name and address, proceeds from the sale, and basis of assets sold, and to "backup withhold" on customers who don't provide certain identifying information. The Infrastructure Investment and Jobs Act revised the definition of "broker" to include "any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person." The proposed regulations implement that change.

Digital Asset

The proposed reporting requirements apply to transfers of digital assets, which the tax code defines as "any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary." Most crypto tokens aren’t technically "representations of value," either because they aren't semiotic (e.g., BTC or ETH) or they represent financial positions (LP tokens), credentials (ENS domain names), or...cartoons (most non-fungible tokens).

The proposed regulations retain that definition, and the preamble indicates that the definition applies to anything transferrable onchain, including stablecoins, NFTs, semi-fungible tokens, and tokenized stock and bonds (with a coordination rule to avoid duplicative 1099s). Assets whose sales would not be reportable if effected offchain (e.g., memorabilia or customer reward points) can give rise to a reporting requirement when sold in tokenized form. (Note: under the Financial Action Task Force guidance on virtual assets, tokens "that are in practice used as collectibles rather than as payment or investment instruments" are not digital representations of value.)

Broker

Current regulations define a broker as "any person that, in the ordinary course of a trade or business, stands ready to affect sales to be made by others." The proposed regulations retain that definition, but redefine "effect" to turn virtually every crypto app into a broker. "Effecting" now would include acting as a "digital asset middleman," (someone providing facilitative services - other than "solely" validating - who is in a position to know the seller's identity). "Facilitative services" would include providing access to smart contracts. Under the proposal, someone is in a "position to know" a seller's identity if they could know it (e.g., by token-gating a website), or if they have the ability to change the fees charged for the facilitative services. Brokers can include: publishers of DEX sites or wallets with built-in token swap routing; decentralized autonomous organizations; multisigs; and individual participants in the foregoing.

Reporting

Under the proposed regulations, brokers have to report the name, address, proceeds, transaction ID and wallet address for each sale they facilitate beginning in 2025, and the asset's basis beginning in 2026. Foreign brokers are exempt, unless a sale has U.S. indicia such as an IP address "indicating" a U.S. location. (It is unclear whether someone's use of a virtual private network ("VPN") "indicates" a U.S. location.) Under the proposed regulations, reporting obligations apply to brokers, even if they sit within a chain of other digital asset brokers. For example, the publisher of a wallet with a token swap button is a broker, even if the button just routes into a DEX app whose publisher also is a broker.

Basis

Under the proposed regulations, transaction costs (including gas and broker fees) on a token swap are allocated 1/2 to each side of the transaction. The new token's basis is its fair market value plus 1/2 of the transaction costs. The preamble reminds taxpayers that paying gas is itself a tax event.

Specific Identification

Under the proposed regulations, U.S. taxpayers who don't "specifically identify" which tokens they are selling must use the first in, first out ("FIFO") method. Specific identification is available only on a wallet-by-wallet basis and must be made in a taxpayer's books and records, or by instruction to a custodian broker, no later than the date of sale.

There is a 60-day comment period beginning upon publication in the Federal Register.

Commentary

The proposed  definition of digital asset middleman would turn website developers into brokers if the websites "facilitate" digital asset sales. That's bad law and bad policy.  

BAD LAW. Websites for DEXes, NFT platforms and many block explorers present information about the state of a blockchain relating to a specific set of smart contracts, and give users an intuitive interface to indicate what actions they want to perform through those smart contracts. The website translates user input into a data object that can be fed into a separate wallet application and, if the user wants, submitted by the wallet for inclusion onchain. Importantly, the website translates the user's intentions into hypothetical function calls, but does not interact with the chain.[1] That is true even when a token swap button is built into a wallet: The swap button creates a data object that the user may or may not deploy.

The proposed regs thus interpret "effectuating transfers on behalf of another person" to include providing information that another person might use to effectuate transfers on their own. That interpretation is inconsistent with the statutory text and with historical notions of what constitutes a broker-customer relationship. It also presents a woefully unclear standard. Presumably a static website isn't a broker. What about a site that generates code but requires the user to copy-paste it into their wallet? How bad does a web application's user experience ("UX") have to be to avoid broker status? And why should broker status turn on the quality of a UX?

BAD POLICY. The effect of the regs would likely be a complete quarantine of U.S. people from reputable blockchain technology. U.S. people could speculate on tokens by buying them on a centralized exchange, but couldn't access web apps that enable token swaps.  Websites that "turn a blind eye" to U.S. users and do not comply with reporting requirements are likely to be hosted offshore and far from the reach of U.S. regulators, making blockchain transactions generally more dangerous for even savvy U.S. users.

Compare Facebook Marketplace, a virtual meeting hall for peer-to-peer transactions. Facebook earns ad revenues for its marketplace, but isn't a broker if it doesn't intermediate sales. It's in our national interest to keep the marketplace within the reach of U.S. consumer protection laws. Using an offshore-hosted marketplace would be more dangerous for Americans.

DEXes and NFT platforms are analogous. They earn compensation for publishing information that makes it easier for people to sell their tokens. They do not intermediate sales and thus should not be regulated as brokers.

The putative benefit of deputizing web publishers as brokers - specifically, "traditional finance"-style transaction reporting for the IRS and users - doesn't outweigh the cost of denying Americans safe access to blockchain infrastructure. The IRS could instead require CEXes to provide the public keys of any self-hosted wallets into which U.S. taxpayers withdraw their funds. That would let the IRS determine taxpayers' gain and loss just as taxpayers do - by plugging their wallet addresses into tax prep software. Moreover, the taxation of many crypto transactions, like liquidity provision and staking inside of an application, is still unclear. Requiring protocols to report those transactions raises many questions for infrastructure providers that decide not to geofence out U.S. addresses.

It wouldn't be an understatement to describe the definition of "digital asset middleman" as an acute threat to the availability of blockchain technology to U.S. taxpayers. Anyone who cares about Americans' access to blockchain tech should submit comments to the IRS at regulations.gov.

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[1] See Gabriel Shapiro, A Functionalist Framework for DeFi Regulation (July 27, 2022), https://lexnode.substack.com/p/a-functionalist-framework-for-defi.

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