Form Would Impose De Facto KYC Obligations Relating to Unhosted Wallets
On April 18, the Internal Revenue Service (“IRS”) issued a draft version of Form 1099-DA, a proposed information reporting form regarding certain digital asset sales and exchanges that “digital asset brokers” will need to file with the IRS and provide to the individuals involved in the sales and exchanges (“Draft Form”). The detailed and complicated Draft Form would be the first of its kind.
If ultimately promulgated, the Draft Form and its supporting regulations would impose customer identification obligations upon a potentially broad swath of digital industry participants, including those who currently take the position that they do not need to collect customer identification information because they provide only decentralized finance (“DeFi”) services and/or provide only “unhosted” digital wallet services. Such customer identification obligations would be imposed under the Internal Revenue Code (the “Code”), rather than – as has been discussed for years – anti-money laundering (“AML”) and Know Your Customer (“KYC”) requirements under the Bank Secrecy Act (“BSA”). From the perspective of the digital asset industry, the precise source of the obligations would not matter much, because the practical consequences would be similar: they will need to collect tax identification information from sellers and buyers of digital assets.
The Draft Form was developed to enforce proposed regulations published on August 29, 2023 by the IRS and the U.S. Department of the Treasury (“Treasury”) under Code section 6045 (“Proposed Regulations”) as amended by the Infrastructure Investment and Jobs Act (the “IIJA”). The IIJA expanded the information reporting requirements of brokers under section 6045 by expanding 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 would apply in 2026, and would require the reporting of transactions which occurred in the 2025 calendar year. Further, as the Draft Form reflects, the Proposed Regulations broadly define who might qualify as a “broker” for the purposes of digital asset transactions.
Reflecting its breadth, the Draft Form asks whether the filer is a digital asset kiosk operator, digital asset payment processor, hosted wallet provider, unhosted wallet provider, or “other.” This important question assumes that the Draft Form and the underlying regulations apply broadly to digital asset industry participants, evidenced by the inclusion of unhosted wallet providers. Further, the Draft Form asks about the date of the transaction at issue, the sales price, whether the filer is reporting gross or net proceeds, and the taxpayer’s basis for the digital assets at issue. The IRS regards digital assets as “property” and the Draft Form, therefore, seeks information used to determine the amount of gain or loss (and its character).
The Draft Form also asks about identifying information regarding the person involved in the transaction, including a tax reporting number. This means, of course, that the filer must know exactly who is involved in a reported transaction. Importantly, the Draft Form also might apply, in very specified circumstances, to filers who are physically located outside the United States.
Although the Draft Form and the Proposed Regulations implicate numerous potential legal issues, the bottom line is that the Draft Form asks challenging factual questions, including as to the identities of those involved in a digital asset sales. The Draft Form assumes a high degree of knowledge, and relatively sophisticated systems, by the filer. Of course, persons using DeFi services often resist providing personal identifying information, and DeFi services frequently describe themselves as not subject to traditional KYC under the BSA. Although there are nuances, the Draft Form and Proposed Regulations generally would impose BSA-like KYC requirements regarding specific customer identification information, courtesy of the Code.
De-Fi Operators Subject to KYC?
Condensing greatly, “true” DeFi services, and those providing “unhosted” wallet services, are generally not considered to be “financial institutions” covered by the BSA and subject to numerous AML requirements – including the collection of “customer” (and that is a loaded, conclusory legal term) information. Although legal issues abound, the primary question is whether a service has “custody” over the private key which controls access to the wallet of the holder of digital assets. If so, then the Financial Crimes Enforcement Network (“FinCEN”) takes the position that the service is a money transmitter subject to the BSA. Generally speaking, providers of unhosted wallet services have argued that they are not money transmitters under the BSA and FinCEN’s guidance because they lack such custody. Both FinCEN and the U.S. Congress have made proposals to subject unhosted wallet providers, and other DeFi services, to AML and KYC duties to close the perceived loophole. To date, nothing has been finalized.
Enter the IRS. The following is complex, but it is necessary to understand how the IRS might impose KYC obligations on many digital asset industry participants, despite the lack of success to date by FinCEN or Congress. This would occur through the “back door” of the Code with the looming threat of substantial information reporting penalties that could be imposed on reporting agents who fail to comply with the requirements.
Consistent with the IIJA, the Proposed Regulations define “broker” as “any person . . . that, in the ordinary course of a trade or business during the calendar year, stands ready to effect sales to be made by others.” Further, the Proposed Regulations define “effect” to include acting as “a digital asset middleman . . . for a party in a sale of digital assets.” The Proposed Regulations in turn define “digital asset middleman” as “any person who provides a facilitative service . . . with respect to a sale of digital assets wherein the nature of the service arrangement is such that the person ordinarily would know or be in a position to know the identity of the party that makes the sale and the nature of the transaction potentially giving rise to gross proceeds from the sale.” A “facilitative service” is defined as “the provision of a service that directly or indirectly effectuates a sale of digital assets.”
The definition of a “digital asset middleman” – which turns on the person’s potential ability to know the identities of other persons using the service – is complicated and controversial. The IRS presumably will impute responsibility for such knowledge relatively broadly, thereby seeking to create an obligation to obtain such identity knowledge for many industry participants who currently take the position that they don’t and/or cannot know the identities of persons using their service. Indeed, the Proposed Regulations provide that any person with the ability to modify a fee charged for a facilitative service is presumed to be in a position to know the identity and nature of the transaction, and that a facilitative service includes providing access to trading platforms. (There is a limited exception from the definition of “facilitative service” for persons who solely provide validating services or who sell or license software or hardware solely designed to allow persons to control private keys for accessing digital assets.)
Likewise, the Proposed Regulations state in the preamble that “an operator of a peer-to-peer or [automated market making] trading platform, that facilitates a digital asset sale on behalf of a customer should be required to file an information return, and furnish a payee statement with respect to that sale.” The Proposed Regulations define an “operator” as “[a] person who in the ordinary course of a trade or business operates a non-custodial trading platform or website that stands ready to effect sales of digital assets for others by allowing persons to exchange digital assets directly with other persons for cash stored-value cards, or different digital assets, including by providing access to automatically executing contracts, protocols, or other software programs that automatically effect such sales.”
Collectively, the Draft Form and the Proposed Regulations suggest that many digital asset service providers will be presumed to be able to identify those using their services, and therefore must identify them. Industry participants may argue that such identification is impossible as a practical matter. Of course, the Proposed Regulations still must be finalized, and will be subject to potential legal attack. But the fact that the Draft Form presupposes that providers of unhosted wallets are subject to its reporting requirements strongly suggests that the Treasury, through the IRS, seeks to significantly change the game for the digital asset industry.
[View source.]
