Arguably, one of the largest developments affecting the digital asset industry this year comes from a sleepy corner of the tax law. In August, the Department of the Treasury and the Internal Revenue Service issued proposed regulations implementing a law that extended Form 1099 information reporting by securities brokers to digital asset brokers.
The proposed regulations would apply broadly to many businesses in the digital asset ecosystem, which will require them to set up systems to collect and report the information to the IRS and their customers and require collection of most of the information beginning in 2025, and since we do not anticipate final regulations until sometime next year, companies will have little time to set up their systems.
This post is part of CoinDesk's Tax Week 2023, presented by TaxBit.
Here we discuss the broad scope of the proposed digital asset reporting regulations and what it might mean for potential brokers and their customers.
Before the Infrastructure Investment and Jobs Act of 2021, section 6045 generally required brokers to file information returns on Form 1099-B for each customer for whom the broker sold stocks, commodities, regulated futures contracts, and other specified financial instruments. The Form 1099-B is filed with the IRS, and a copy is sent to the customer so that the customer has the information needed to complete and file their tax return. The IRS then matches the Form 1099-B to the tax return and identifies any under-reported amounts.
Because of this matching process, Americans’ voluntary tax compliance increases substantially when there is third-party information reporting. For example, the U.S. Government Accountability Office published an analysis in December 2020 showing that the net amount misreported was 55% where there was little or no information reporting (e.g., sole proprietor earnings or sale of business property), but that amount fell to 5% where third-party information reporting was required. As a result, when the IRS expressed concern that there was substantial nonreporting of cryptocurrency transactions, Congress responded by expanding information reporting to digital asset brokers.
Read more: Kirk Phillips - The IRS Is Making Crypto Compliance Impossible
The amendments made by the Infrastructure Act were effective for information returns filed after December 31, 2023, which means that brokers would have had to begin collecting information on January 1, 2023 for Forms 1099 required to be filed in early 2024. However, the proposed broker regulations were not issued until August 29, 2023, so the rules propose to delay information collection until January 1, 2025 for Forms 1099 to be filed in early 2026. The IRS has announced that it plans to issue a new form for this purpose, a Form 1099-DA (for digital assets).
Scope of digital asset broker
The proposed regulations introduce a new term, “digital asset middleman,” to refer to brokers that make sales of digital assets. The definition of this term is very broad and would include multiple brokers with respect to the same transaction. Specifically, the definition includes any person who provides a facilitative service with respect to a sale of digital assets, and 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 customer and the nature of the transaction.
The proposed regulations further broaden this definition by providing that facilitative services include services that indirectly effectuate a sale of digital assets and persons are in a position to know the customer identity and nature of the transaction if they have the ability to change the fees charged for these services. For example, the proposed regulations would treat as reporting brokers:
- digital asset trading platforms that provide custodial wallet services;
- non-custodial digital asset trading platforms (including decentralized platforms that operate through smart contracts);
- wallet providers that include software that allows users to directly access trading platforms;
- digital asset payment processors;
- operators and owners of digital asset kiosks; and
- issuers who regularly offer to redeem digital assets (including stablecoin issuers).
Although the proposed regulations contain exceptions for validators (e.g., miners and stakers) and hardware and software wallet providers, these exceptions only apply if no other functions or services are provided. In addition, retailers who accept digital assets from a customer as payment for goods or services, and artists who create and sell NFTs representing interests in the artists’ work are also excluded.
Impact on customers
This broad definition would include multiple brokers for the same transaction. For example, if a user connects their self-hosted wallet to a DeFi platform and engages in a swap of tokens, then at a minimum the wallet provider and the DeFi platform could be digital asset middlemen. In addition, it is not clear whether ancillary participants, such as liquidity providers and holders of governance tokens controlling the DeFi platform, would also be digital asset middlemen.
The securities broker reporting rules contain a multiple broker rule, which exempts brokers who conduct sales on behalf of other brokers so that only the broker with the closest relationship to the customer is required to report. But the proposed regulations do not provide a similar rule for digital asset middlemen. As a result, each digital asset middleman involved in the sale of digital assets must send its own Form 1099-DA to the IRS and the taxpayer. This could create a lot of confusion for the taxpayer. Some taxpayers may just report the gain from each Form 1099-DA, which would result in over-taxation. Other taxpayers may try to reconcile all the Forms 1099-DA and report the transaction only once, which could trigger an IRS notification due to a mismatch between what was reported by the brokers and by the taxpayer. Either way, it would impose a burden on the taxpayers.
Impact on potential brokers
Before the proposed regulations were issued, some companies reasonably believed that they would not fall within the definition of digital asset broker, so these rules were not on their radar. Although many remain hopeful that Treasury and the IRS will scale back the definition of digital asset middleman in the final regulations, any scale-back will likely just be around the edges. As a result, businesses throughout the digital asset ecosystem will have to develop, test, and implement information collection and reporting systems.
If the proposed effective dates are retained in the final regulations, businesses will not have much time to do this. Most of the information required to be reported (e.g., customer data, name and number of units of digital assets sold, gross proceeds, transaction ID and wallet address) would need to be collected beginning in 2025, but presumably, no one will want to program their systems until the regulations are finalized. As of writing, more than 120,000comments had been filed in response to the proposed regulations. These will take some time for the government to review and consider, so it seems unlikely that Treasury and the IRS could issue final regulations before Spring or even Summer 2024. This seems like an enormous lift for companies that do not currently collect any customer data, as they do not have any of the required systems in place.
We believe that final regulations should address the two critical points to ensure that the Forms 1099-DA are useful: (1) a multiple broker rule to prevent multiple Forms 1099-DA for the same transaction; and (2) an extension of the effective date to give companies sufficient time to develop information reporting systems that are reliable and compliant. Otherwise, a tool to promote tax compliance could turn into a tool that results in tax confusion.