Key Takeaways

• The Proposed Regulations (as defined below) track the statutory definition of a digital asset under the Internal Revenue Code but provide that non-fungible tokens (NFTs) and stablecoins also constitute digital assets.
• The definition of a broker is extremely broad and includes persons who act as digital asset “middlemen.” Not surprising, the definition of middleman will not be well received by the digital asset community as it will impose significant costs and reporting obligations on the persons with control or influence over a digital asset platform.
• The broad definition of a broker also includes persons who act as payment processors with respect to digital assets. This definition is also expected to capture parties who may not have anticipated having to comply with the broker reporting rules.

The Internal Revenue Service (IRS) and the Department of the Treasury issued a 282 page notice of proposed rulemaking regarding digital assets and broker reporting on Aug. 26 (the Proposed Regulations), nearly two years after the enactment of the Infrastructure Investment and Jobs Act that expanded the broker reporting rules to include brokers of digital assets.[1] The digital asset broker reporting rules were originally scheduled to take effect on Jan. 1, 2024, but the IRS announced on Dec. 23, 2022, that digital asset brokers would not need to report digital asset transactions until regulations implementing the provisions were finalized.[2] The Proposed Regulations require brokers to (i) report gross proceeds from sales of digital assets occurring on or after Jan. 1, 2025, and (ii) report the adjusted basis and character of any gain or loss from the sale of digital assets occurring on or after Jan. 1, 2026. Below is a brief discussion of some of the key aspects of the Proposed Regulations.

Digital Asset Definition – Clarifications

The Proposed Regulations define a “digital asset” to mean “any digital representation of value that is recorded on a cryptographically secured distributed ledger (or any similar technology), without regard to whether each individual transaction involving that digital asset is actually recorded on that ledger, and that is not cash.”[3] The Proposed Regulations thus track the statutory definition of a digital asset, but the Preamble clarifies that NFTs and stablecoins are considered digital assets for purposes of the broker reporting rules.[4] The Proposed Regulations additionally make clear that a digital asset’s classification as a security or a commodity for Securities and Exchange Commission or Commodity Futures Trading Commission purposes does not mandate that the digital asset is also a security or commodity for federal tax purposes. In addition, the Proposed Regulations state that nothing in the Proposed Regulations can be cited as authority with respect to whether a digital asset is or is not a security or commodity for any other purpose of the Internal Revenue Code (the Code).[5] The Preamble also curiously states that the IRS is not aware of any digital asset option that qualifies as a 1256 contract.[6]

Definition of Digital Asset Broker

While the IRS retains the definition of a “broker” under existing Treas. Reg. § 1.6045-1(a)(1) as someone ready to “effect” sales made by others, the Proposed Regulations modify the definition of “effect” to include any person who provides services that facilitate sales of digital assets and who ordinarily would know, or be in a position to know, the identity of the party making the sale and the nature of the transaction potentially giving rise to gross proceeds from the sale. The Proposed Regulations refer to this person as a “digital asset middleman.”[7]

A digital asset middleman is in a position to know the identity of the party engaging in the sale if the person maintains sufficient control or influence over the facilitative services, including having the ability to set or change the terms of its service, including the fees it charges users of its platform, and to request that the selling party provide that party’s name, address and taxpayer ID.[8] A “facilitative service” includes any service that directly or indirectly effectuates a sale of digital assets, such as by providing (i) a party in the sale with access to an automatically executing contract or protocol, (ii) access to digital asset trading platforms, (iii) automated market maker systems, (iv) order matching services, (v) market making functions, (vi) services to discover the most competitive buy and sell prices, or (vii) escrow or escrow-like services to ensure both parties to an exchange act in accordance with their obligations.[9]

Facilitative services, therefore, now encompass not only centralized (custodial) service providers that act as customers’ legal agents in executing trading activity but also decentralized finance (noncustodial) trading platforms that rely on self-executing smart contracts without the intervention of operators.

The Proposed Regulations expand the definition of “broker” to include “digital asset payment processors” that facilitate digital asset payments in the ordinary course of their business by (i) receiving digital assets from one party and exchanging them into different digital assets or cash paid to the second party; (ii) acting as a third-party settlement organization that facilitates payments, either by making or by submitting instructions to make payments, using one or more digital assets in settlement of a reportable payment transaction; or (iii) acting as a payment card issuer that facilitates payments, either by making or by submitting the instruction to make payments, in one or more digital assets, to a merchant acquiring entity in a transaction that is associated with a payment made by the acquiring merchant in settlement of a reportable payment transaction.[10] Importantly, a merchant that accepts digital assets directly from a customer as payment for its goods or services is not treated as a broker under the Proposed Regulations.[11]

US Brokers of Digital Assets

The IRS specifically delineates the Proposed Regulations’ applicability to a “U.S. digital asset broker,” which includes a U.S. person, a foreign branch of a U.S. person, a U.S. branch of a foreign entity that is treated as a U.S. person for certain purposes of the Code, a foreign partnership with controlling U.S. partners and a U.S. trade or business, and a foreign person of which 50 percent or more of its gross income is effectively connected with a U.S. trade or business.[12] The Proposed Regulations require a U.S. digital asset broker to report information with respect to sales effected for its customers via an information return (on new Form 1099-DA, expected to be published in 2024) reporting the customer’s name, address and taxpayer ID; the name or type of digital assets sold; and the number of units sold, the sale date and time, and the gross proceeds of the sale. To aid the IRS in verifying reported gross proceeds, brokers also would be required to report the transaction ID or hash associated with the sale, the digital asset address from which the asset was transferred, and whether the consideration received was cash, a different digital asset, other property or services.

Non-US Brokers of Digital Assets

Non-U.S. digital asset brokers are subject to different rules, with limited exceptions, which allow them to not report transactions. The key to determining whether a non-U.S. digital asset broker is subject to the broker reporting requirement is whether it conducts money services business (MSB) activities.[13] Generally, a non-U.S. digital asset broker not conducting activities as an MSB is treated as effecting sales from an office outside the U.S. and therefore would not be considered a broker that is required to report pursuant to the Proposed Regulations, unless it obtains documentation indicating a customer has connections to the U.S. or is a U.S. person.[14] If, however, the non-U.S. digital asset broker is an MSB, it must determine the place of sale of digital assets and the foreign status of its customers.[15] As an MSB, a non-U.S. digital asset broker is required to report information with respect to sales effected for its customers unless the broker can treat the customer as an exempt recipient under the broker reporting rules.

Because of the comprehensive nature of the Proposed Regulations, digital asset platforms, whether centralized or decentralized, as well as payment processors need to identify whether they meet the definition of a “broker” and, if they do, consider how to implement controls and policies to gather the appropriate information from customers before they are required to report to the IRS.

Written comments on the Proposed Regulations must be provided by Oct. 30, and a public hearing has been scheduled for Nov. 7.

[1] REG-122793-19.

[2] IRS Announcement 2023-2, Dec. 23, 2022.

[3] Prop. Treas. Reg. § 1.6045-1(a)(19)(i).

[4] 88 Fed. Reg. 59,576 (Aug. 29, 2023), at 59,582.

[5] Prop. Treas. Reg. § 1.6045-1(a)(19)(ii).

[6] 88 Fed. Reg. at 59,584. LedgerX has taken the position that certain option contracts are 1256 contracts and are reported as such by LedgerX. See https://support.ledgerx.com/hc/en-us/articles/1500004683822-Documents-Tax-Information.

[7] Prop. Treas. Reg. § 1.6045-1 (a)(21).

[8] Prop. Treas. Reg. § 1.6045-1(a)(21)(ii).

[9] Prop. Treas. Reg. § 1.6045-1(a)(21)(iii)(A).

[10] Prop. Treas. Reg. § 1.6045-1(a)(22)(i).

[11] Prop. Treas. Reg. § 1.6045-1(b)(2)(viii).

[12] Prop. Treas. Reg. § 1.6045-1(g)(4)(i)(A); Treas. Reg. § 1.6049-5(c)(5).

[13] Prop. Treas. Reg. §§ 1.6045-1(g)(4)(i)(D) and 1.6045-1(g)(4)(iv).

[14] Prop. Treas. Reg. § 1.6045-1(g)(4)(iv).

[15] Prop. Treas. Reg. § 1.6045-1(g)(4)(v).

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