The Internal Revenue Service (IRS) recently released proposed regulations regarding broker reporting for digital assets, including expansions of and additions to certain definitions, rules, and requirements. The IRS seeks comments on the proposed regulations by October 30, 2023.
The IRS released the proposed regulations (Proposed Regulations) on broker reporting for digital assets on August 25, 2023. In 2021, with the passage of the Infrastructure Investment and Jobs Act (IIJA), Congress amended the definition of “broker” in Section [1] 6045(c)(1)(D) 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, among other items, expand upon the definition of “broker” for information reporting of digital asset dispositions, include new income realization and basis rules for digital assets, and add backup withholding requirements for certain sales and exchanges of digital assets. The Proposed Regulations also expand upon Section 6045(g)(3)(D)’s “digital asset” definition. The Proposed Regulations may pose practical difficulties for market participants, including decentralized exchanges (DEXs).
The IRS requested comments on the Proposed Regulations posing 51 specific questions. Comments must be submitted by October 30, 2023. If finalized, most of the Proposed Regulations would first require reporting in 2026 for reportable transactions that take place on or after January 1, 2025. Discussed below is a high-level overview of the Proposed Regulations, including certain insights into how the Proposed Regulations may affect certain industry players.
EXPANDED DEFINITION OF ‘BROKER’
Treasury Regulation § 1.6045-1(a)(1) generally defines a broker as “any person . . ., U.S. or foreign, that, in the ordinary course of a trade or business during the calendar year, stands ready to effect sales to be made by others” (emphasis added). The Preamble to the Proposed Regulations provides that this definition “retains the existing definition of broker” as clarified by the IIJA amendment.
The Proposed Regulations expand on the term “effect” in the statutory definition of a “broker” to include any person who provides facilitative services that effectuate sales of digital assets by customers and who are in a position to know the identity of the customer and nature of the transaction regardless of whether the transaction generates gross proceeds.
If finalized as proposed, the expanded definition would require operators of some DEXs to collect customer information and report sales information. A broker under this expanded definition also includes persons that regularly offer to redeem digital assets that were created or issued, e.g., an initial coin offering or redemptions by an issuer.
The proposed scope of reporting also includes digital asset wallet providers and digital asset payment processors. “Brokers” would be required to report such information related to sales or exchanges of digital assets that take place on or after January 1, 2025 on new IRS Form 1099-DA.
WHAT ARE ‘DIGITAL ASSETS’?
Code Section 6045(g)(3)(D) generally defines a “digital asset” as “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by [Treasury].”
The Proposed Regulation Section 1.6045-1(a)(19)(i) similarly, but not identically, defines a “digital asset” as “a digital representation of value that is recorded on a cryptographically secured distributed ledger (or similar technology) without regard to whether each individual transaction involving that digital asset is actually recorded on that ledger, and that is not cash.”
The Proposed Regulations require digital assets that are also securities under the federal securities laws to be reported as a digital asset and not as a security for information reporting purposes. In addition, derivatives on a digital asset are reported under the existing rules (e.g., Section 1256 contracts) in certain cases, and in other cases under the proposed rules for digital assets.
The Preamble to the Proposed Regulations clarifies that the definition deliberately includes assets regardless of whether transactions with respect to them are actually recorded on a distributed ledger because “the use of public and private keys to transfer assets[] distinguishes digital assets as defined by the [IIJA] from other virtual assets and is therefore an essential part of the definition.”
The Preamble further clarifies that some non-fungible tokens (NFTs) are digital assets (or more specifically are not excepted), stating “the definition of digital assets in the [IIJA] is expansive [and,] because the disposition of digital assets (including certain NFTs) may give rise to gain or loss, reporting of gross proceeds and basis information is useful to taxpayers as well as the IRS.”
Conversely, digital assets that can only be exchanged within a closed system (e.g., video game tokens that are purchased with fiat currency but cannot be sold for fiat currency or used outside of the game) are not intended to be included in the definition of “digital assets” within the meaning of the Proposed Regulations.
‘SALE’ FOR DIGITAL ASSET PURPOSES
The Preamble states that, to avoid gaps in information reporting with respect to this broad range of taxable exchanges, gross proceeds are determined by the amount of cash received or the fair market value of the property or services received in an exchange transaction, less the digital asset transaction costs allocable to the digital asset sale.
With respect to this broad range of taxable exchanges, proposed Section 1.6045-1(a)(9)(ii) expands the definition of a sale subject to reporting to include not only dispositions of a digital asset for cash, but also for stored-value cards (including gift cards), services, or other property differing materially in kind.
The Proposed Regulations also provide specific rules for calculating the fair market value of the property or services received in exchange for digital assets. The expanded definition of a sale is intended to capture the movement of a digital asset from a taxpayer’s account held with a broker to a private wallet. The requirement to report gross proceeds applies to sales of digital assets effected on or after January 1, 2025.
BASIS IN DIGITAL ASSETS
The Proposed Regulations also provide rules for determining the cost basis of digital assets under Section 1012. Specifically, a broker that provides custodial services for digital assets is required to provide adjusted basis information for sales of digital assets effected on or after January 1, 2026 if the digital asset was acquired and continuously held by such broker in the customer’s account since January 1, 2023.
Any broker that effects sales of financial contracts (e.g., forward contracts or options) on digital assets that are not themselves digital assets is required to provide adjusted basis information for sales of these assets if they were granted, entered into, or acquired on or after January 1, 2023. The US Treasury Department (Treasury) and IRS have requested comments on whether such basis reporting should be done on a wallet-by-wallet basis, digital asset basis, or some other basis.
BACKUP WITHHOLDING OF DIGITAL ASSET INCOME
The Proposed Regulations extend the backup withholding provisions under Section 3406 for sales of digital assets on or after January 1, 2025. That is, brokers under the Proposed Regulations’ expanded definition must collect taxpayer identification numbers from customers to be in a position to comply with the new backup withholding requirements. Collecting such identification information is directly at odds with the user anonymity that appeals to some digital asset investors.
EARLY REPORTING
Per Proposed Regulation Section 1.6045-1(d)(2)(iii)(B), if brokers choose to report sales of digital assets before the applicability date of these regulations (i.e., gross proceeds from the sale of digital assets effected prior to January 1, 2025 or adjusted basis information with respect to sales effected prior to January 1, 2026), such brokers will not be subject to penalties under Section 6721 or 6722 for failure to report or furnish that information correctly.
INDUSTRY IMPLICATIONS
Merchants, Miners, and Private Key Software Providers
Merchants, miners, and private key software providers are exempted from these reporting requirements in some cases where the merchant, miner, or provider at issue does not also provide unrelated functions or services to the exempted function or service.
Per the Preamble, Proposed Regulation Section 1.6045-1(b)(2)(viii) through (x) illustrates that the term “broker” does not extend to (1) merchants that sell goods or services in return for digital assets; (2) persons who are solely engaged in the business of validating distributed ledger transactions (e.g., miners) through proof-of-work, proof-of-stake, or any other consensus mechanism, without providing other functions or services; or (3) persons who are solely engaged in the business of selling hardware or licensing software, the sole function of which is to permit a person to control private keys which are used for accessing digital assets on a distributed ledger, without providing other functions or services.
Decentralized Exchanges
DEXs are not exempted in many cases. The Preamble states that Treasury and the IRS expect that the clarified proposed definition of “broker,” including the clarification of “effect,” will ultimately require operators of some platforms generally referred to as decentralized exchanges to collect customer information and report sales information about their customers if those operators otherwise qualify as brokers.
Non-Fungible Tokens
NFTs do not appear to be exempted from these reporting requirements as a category of digital assets. The Preamble states that Treasury and the IRS considered whether transactions featuring NFTs should be subject to the Proposed Regulations. NFTs differ from some other digital assets, including cryptocurrency, due to their non-fungible nature—that is, they are unique and thus not directly interchangeable with other NFTs.
For purposes of the Proposed Regulations, NFTs also are digital assets that may represent artwork; antiques; written compositions, articles, or commentaries; music; videos; films; fashion designs; or sports or other entertainment memorabilia, the sale of which is not currently subject to reporting under Section 6045. However, Treasury and the IRS further state that they see no indication in the IIJA or its legislative history that Congress intended to exclude certain digital assets from Section 6045 reporting.
NFTs are digital assets that are bought, sold, and traded on digital asset trading platforms similar to other digital assets. The disposition of NFTs may give rise to gain or loss, and the reporting of gross proceeds and basis information is equally useful to taxpayers and the IRS as reporting on other digital assets. Thus, Treasury and the IRS ultimately decided that transactions involving some NFTs should be included under the Proposed Regulations.
Real Estate Brokers
The Proposed Regulations require real estate reporting persons who are treated as brokers with respect to reportable real estate transactions to report the fair market value of digital asset consideration received by real estate sellers in reportable real estate transactions. Additionally, these real estate reporting persons are required to file information returns and furnish payee statements with respect to real estate purchasers that use digital assets to acquire real estate in these transactions.
Payment Processors
The Proposed Regulations also require digital asset payment processors to provide information on reportable dispositions of digital assets. In general, a “payment processor” for these purposes would be “a person who in the ordinary course of a trade or business stands ready to effect sales of digital assets.”
The Preamble to the Proposed Regulations suggests that payment processors that effect a transaction involving the exchange of merchandise for digital assets will need to report on the disposition of the merchandise under both Section 6050W on Form 1099-K and on the digital asset disposition under Section 6045 on new Form 1099-DA assuming no exceptions apply.
Timing
If the Proposed Regulations are finalized, many of the regulations are set to take effect at some point in 2025, which means reporting would generally be required to begin in 2026. While this is perhaps longer than was originally expected when the IIJA was first enacted, as a practical matter, the parties subject to the reporting requirements generally should, if they haven’t already, begin putting procedures in place to satisfy the forthcoming reporting requirements.
Any software or other internal infrastructure required to comply will need to be operational by 2025, leaving only a little over a year to prepare. Further, the Proposed Regulations are subject to additional changes, leaving even less time to adapt to such changes.
Other Digital Asset Guidance
The Proposed Regulations “do not address every transaction involving digital assets that may give rise to income, such as the receipt of digital assets in hard forks.” Treasury felt “it is more appropriate to address those transactions under other provisions of the Code.”
The Proposed Regulations acknowledge other “legal regime[s]” that might relate to digital assets, including the federal securities laws and the Commodity Exchange Act, but disclaim that “[n]o inference is intended” with respect to the operation of those laws or the treatment or classification of digital assets and digital asset transactions with respect to them.
Monitoring a potential patchwork of legal regimes—federal tax law, federal securities laws, and the Commodity Exchange Act, the definitions and application of which may not overlap precisely with respect to similar assets and transactions—will be important for market participants.
[1] Unless otherwise indicated, all “Section” references are to the Internal Revenue Code of 1986, as amended, codified at 26 U.S.C. (the Code), and the Treasury Regulations promulgated thereunder, codified at 26 C.F.R. (Treas. Reg.).
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