On August 29, 2023, the Internal Revenue Service (IRS) published new proposed regulations on tax reporting requirements for cryptocurrency brokers. The proposed regulations build on efforts to expand IRS regulation over cryptocurrency reporting in the Infrastructure Investment and Jobs Act (PL 117-58) and modify the existing broker reporting regime to account for the rapidly growing digital asset ecosystem. A broadened definition of “broker” under these rules may increase the number of actors in the crypto space who are required to report.
The proposed regulations also expand the tax rules governing the determination of amount realized and adjusted basis to now cover digital assets. Under the proposed rules, the amount realized by a taxpayer in a digital asset disposition will be equal to the consideration received, reduced by allocable digital asset transaction costs. The basis of a digital asset will be equal to the cost paid, increased by allocable digital asset transaction costs.
These regulations do not take effect immediately. Regulations regarding the computation of gain or loss and the basis of digital assets under Sections 1001 and 1012 will not apply until these rules are adopted as final regulations. The proposed rules for broker reporting on gross proceeds will not apply until January 1, 2025. Similarly, the proposed rules for broker reporting of adjusted basis and the character of gain or loss will not apply until January 1, 2026. The US Department of the Treasury and the IRS are accepting written comments on the proposed regulations until October 30, 2023.
In this article, we outline several of the tax reporting rules for brokers discussed in the proposed regulations with respect to cryptocurrency transactions.
BACKGROUND: DIGITAL ASSETS, EXISTING REPORTING RULES AND THE INFRASTRUCTURE INVESTMENT AND JOBS ACT
Cryptocurrency is here to stay. The total implied market value of digital assets currently exceeds $1 trillion, with an all-time high of $3 trillion. Both Congress and the IRS have turned their attention to the governance of this ecosystem, acknowledging the need for comprehensive guidance as taxpayers continue to participate in digital asset transactions. The IRS’s proposed regulations aim to increase transparency in this market.
Digital Assets Generally
Digital assets are defined as any virtual representation of value that is recorded on a cryptographically secured distributed ledger or any similar technology. Rather than existing in physical form, digital assets are stored in wallets in the form of public and private keys that allow owners to access, control and dispose of them. They are used in a broad range of transactions and may be exchanged for goods, services, real estate, other property and even other digital assets. To facilitate digital asset transactions, trading platforms offer a range of services, including wallet hosting, buy/sell matching, market making, valuation and recordkeeping, often in exchange for transaction fees. The number and complexity of these transactions has steadily grown, raising concerns about the tax gap in digital asset taxation. Ambiguity regarding the proper classification of digital assets (as currency, property, commodity, security or otherwise) has contributed to uncertainty regarding the application of existing tax rules to these assets.
Existing Broker Reporting Rules
Existing rules already govern the tax reporting obligations of brokers, though they do not specifically address digital assets. Under the existing regulations, a broker is defined as a dealer, barter exchange or any other person who (for consideration) regularly acts as a middleman with respect to property or services. Generally, any person who effects sales made by others as a dealer or an agent is a broker. Under the existing reporting rules, any person doing business as a broker must file information returns and furnish payee statements. For example, for each customer for whom a broker has sold stocks, commodities or other specified assets in exchange for cash, the broker must include in their payee statements the customer’s name and address, gross proceeds details and the adjusted basis of certain categories of assets. This information allows US tax authorities to more effectively monitor and tax these transactions. Similar information reporting rules apply to persons transferring securities to a broker, securities issuers who engage in certain actions that affect the basis of their securities, barter exchanges and real estate reporting persons. While these rules implicate a wider range of potential reporting parties, this article will generally focus on the reporting requirements applicable to brokers.
The Infrastructure Investment and Jobs Act
Passed in 2021, the Infrastructure Investment and Jobs Act clarified several rules regarding how digital assets should be reported by brokers under the existing reporting rules. This was intended to provide the IRS and individual taxpayers with easier access to information on gross proceeds and adjusted basis. The Infrastructure Act clarified the definition of a “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. Other definitions such as “specified security” were similarly expanded to apply to the concept of digital assets. Because specified securities are treated as “covered securities” for purposes of basis reporting if acquired on or after January 1, 2023, the effect of this change is that brokers must report on the tax basis of digital assets transferred in sales that they effectuate. The Infrastructure Act also introduced new provisions for broker reporting on non-sale transfers of digital assets that are covered securities, provided that the transfer is not to another broker.
RELEVANT ACTORS: WHO IS A BROKER FOR REPORTING PURPOSES?
The proposed regulations further expand and clarify the definition of a broker for reporting purposes as “any person that stands ready to effect sales to be made by others in the ordinary course of a trade or business.” This generally appears to align with the existing statutory definition of a broker as “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” Ostensibly a simple definition, the meaning of various terms including “effect,” “person” and “sale,” as well as other rules and exceptions, create a complex architecture for taxpayers to navigate in determining whether they are a broker for reporting purposes. For example, by defining “effect” more broadly and therefore expanding the definition of a broker, the IRS exposes additional actors involved in digital asset transactions to these reporting rules.
The IRS lists several examples of online brokers, including trading platforms that hold custody of their customers’ digital assets and operators with sufficient control or influence over certain noncustodial trading platforms. Some may be surprised to find operators of noncustodial trading platforms are classified as brokers under the new rules. These operators do not necessarily know the identity of their customers or the gross proceeds of their sales, and it therefore may be difficult under their existing infrastructure to report this information. Based on the meaning of “effect,” however, the IRS generally considers persons providing facilitative services that directly or indirectly effectuate the sale of digital assets to be brokers and subject to the new reporting requirements. The IRS considers the ability to require that customers provide this information sufficient to qualify such noncustodial trading platforms as brokers.
Based on an expansive definition of “person,” brokers may also be individuals, legal entities, and unincorporated groups or organizations through which any business, financial operation or venture is carried on. This definition also encompasses decentralized groups or organizations that share fees from a trading platform. The IRS specifically contemplates the classification of a decentralized autonomous organization as a person that could be treated as a broker. As a result, owners of governance tokens or taxpayers who otherwise participate in the control of platforms engaging in broker activities may find themselves classified as brokers and subject to the new reporting requirements.
Common Categories of Brokers
Common parties to digital asset transactions that may be considered brokers subject to the reporting rules include digital asset trading platforms that also provide custodial services, operators of noncustodial trading platforms, digital asset payment processors, operators and owners of digital asset kiosks, wallet hosting service providers (to the extent that they function in certain roles or provide certain additional transaction services) and real estate reporting persons with respect to digital assets used as consideration for real estate transactions. In contrast, merchants who merely accept digital assets directly from customers as payment for the provision of goods or services, cryptocurrency miners and other persons solely engaged in validating distributed ledger transactions through proof-of-work or proof-of-stake, and persons solely engaged in selling wallet hardware or licensing wallet software without providing other services are generally not considered brokers.
The proposed rules governing sales effected at an office outside the United States or on behalf of exempt foreign persons are quite complex. Under the proposed regulations, the determination of whether a sale is effected inside or outside the United States will not depend on the physical location of the acts undertaken but on the classification of the broker. A broker may be classified as a US digital asset broker, a controlled foreign corporation digital asset broker or a non-US digital asset broker. Rules for determining the location of a digital asset may depend on the type of broker. Under these rules, it may be possible for a non-US actor to be considered a broker for purposes of these reporting rules.
PROPOSED REGULATIONS: ADAPTING THE BROKER REPORTING RULES FOR DIGITAL ASSETS
Sales Subject to Broker Reporting
The proposed regulations under Section 6045 generally incorporate the concept of digital assets into the existing reporting rules, expanding the definition of a “sale” subject to reporting. Under the proposed regulations, sales include certain dispositions of digital assets for cash and services, property, securities, real estate and other digital assets. The delivery of digital assets pursuant to derivatives or other financial contracts are also sales. Notably, both stablecoins and non-fungible tokens are treated as digital assets for purposes of reporting. However, the IRS explicitly excludes hard fork transactions, airdrops and the receipt of digital assets by broker customers in return for services, such as taking surveys, from the definition of a sale.
Reporting on Gross Proceeds
For each reportable sale, brokers generally must report gross proceeds by following specific rules for computing the amount realized. For example, a broker for a digital asset sale must calculate gross proceeds by taking into account the US dollars or other currency credited to the customer’s account, the fair market value of any property received or the issue price of debt instruments received by the customer, the fair market value of services received by the customer and the allocable digital asset transaction cost (which reduces gross proceeds). Similarly, a digital asset payment processor effecting a sale on behalf of a party must report gross proceeds by considering the amount paid in cash, the fair market value of digital assets received, the digital asset transaction costs withheld and the allocable digital asset transaction cost (which reduces gross proceeds). These calculations depend on the details of each transaction because the fair market value determination may be made by reference to the valuation of the consideration received in exchange for the digital asset.
Reporting on Adjusted Basis
Broker reporting on adjusted basis will also be mandatory for certain digital assets. Specifically, under the proposed regulations, brokers who are otherwise required to make a return with respect to a covered security must report the adjusted basis with respect to those securities. Generally, a covered security is any specified security, including digital assets acquired on or after January 1, 2023, but only if the broker has received a Section 6045A transfer statement with respect to that security. Because Section 6045A rulemaking is still ongoing, for purposes of basis reporting, a “covered security” is currently limited to digital assets acquired in a customer’s account by a broker providing hosted wallet services. Brokers must also report the date and time that the digital asset was purchased and whether any gain or loss with respect to the digital asset is long-term or short-term.
Calculating Amount Realized and Basis for Digital Asset Transactions
The proposed regulations also modify the general rules in Sections 1001 and 1012 for determining the adjusted basis and initial basis for securities to accommodate digital assets. These rules generally apply to property subject to the broker reporting rules even if they are not a security. The initial basis for digital assets will generally be determined based on the cost of the digital asset, increased by any allocable digital asset transaction costs. The amount realized from a disposition involving digital assets generally will be the value of any cash, property, or services received, reduced by any allocable digital asset transaction costs. Special rules for determining the fair market value of such property or services and for allocating digital asset transaction costs to digital assets also apply, depending on the transaction type.
While the proposed regulations under Sections 1001 and 1012 generally refer to a “taxpayer,” the proposed regulations under Section 6045 refer to a “customer” instead. Under the proposed regulations for Section 6045, brokers will be required to report on transactions engaged in by their customers. A customer (within the definition of Section 6045) may not mean the same thing as taxpayer under historic tax ownership principles.
Under the existing rules governing withholding for reportable payments, payors must deduct and withhold tax on reportable payments at the statutory backup withholding rate (currently 24%) if the payee fails to provide a taxpayer identification number (TIN) or provides an incorrect TIN. Any reportable payment by a broker is subject to the backup withholding, based on gross proceed amounts. While these rules are already broad enough to cover digital asset transactions, the IRS modified these regulations to specifically include digital asset transactions.
The regulations regarding the computation of gain or loss and the basis of digital assets are proposed to apply to taxable years for all sales and acquisitions of digital assets after the adoption of these rules as final regulations. However, taxpayers may rely on these proposed rules for dispositions in taxable years ending on or after August 29, 2023, so long as they consistently follow the proposed regulations in their entirety and in a consistent manner for all taxable years through the applicability date of the final regulations.
The proposed rules on broker reporting for gross proceeds from the sale of digital assets are applicable if the sale is effected on or after January 1, 2025. Similarly, the proposed rules on broker reporting of adjusted basis and the character of gain or loss with respect to a sale of digital assets are applicable if the sale or exchange is effected on or after January 1, 2026.
The proposed regulations on broker reporting do not immediately take effect and are generally not effective until January 1, 2025 (or later). This will allow taxpayers time to interpret and respond to the IRS’s request for comments on these rules. The impact of these rules will likely soon be felt in the digital asset ecosystem. They may require significant changes to the existing infrastructure of digital asset services providers falling within the expanded broker definition. These changes may conflict with anonymity and decentralization, two major characteristics of digital assets that draw taxpayers to transact with them in the first place. On the other hand, clearer reporting standards may provide welcome transparency and additional clarity for taxpayers seeking more secure compliance with US tax laws.
These proposed regulations represent only a portion of the ongoing guidance the IRS plans to release on crypto reporting. The IRS is still considering the regulation of transfer statement reporting, which the current proposed regulations take into account (providing certain exceptions until additional guidance is released). The IRS has requested comments on these proposed regulations, as there are many open questions it is still considering in connection with these rules. Until these regulations are finalized, they are still subject to change and may be modified to more effectively address the tax administration challenges presented by digital assets and related technologies.
While the discussion above provides a broad overview of the broker reporting rules modified by the proposed regulations, many issues are not discussed in this article. Voluntary reporting, coordination rules, ordering rules, foreign sales reporting, barter exchange reporting, real estate transaction reporting and numerous other tax issues are addressed in greater detail in the regulations. The potential consequences these rules merit additional attention. We plan to address several of these issues in a follow-up article.
If you have questions about the tax implications of digital asset transactions or other broker activities, please do not hesitate to contact the authors of this article or your regular McDermott lawyer(s).