Cumbersome tax reporting requirements could pose a challenge for DeFi
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What happened
The bipartisan infrastructure bill passed in November 2021 required digital asset “brokers” to report users’ profit and loss information to the IRS, just as stock brokers already do. Since then, the definition of “broker” has been a controversial topic as the industry fears that it could include companies that have little ability to comply with the law, such as miners and decentralized finance platforms. It would be up to the IRS and Treasury Department to convert this law into formal guidance. On August 25, 2023, the IRS released proposed regulations (Regs) that define the controversial term “broker” and detail the requirements that brokers must follow to comply with tax reporting requirements related to cryptocurrency transactions.
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Key concepts
Who are brokers?
According to the proposed regulations, a broker is “any person who, in the ordinary course of conducting a trade or business, agrees to make sales for others.” The document describes four possible categories of brokers.
- Digital Asset Platforms: This category includes centralized exchanges, cryptocurrency ATMs and certain DeFi platforms where the operator is “capable of knowing the identity of the party making the sale” and retains “sufficient control or influence” over the service provided .
- Digital Asset Hosted Wallet Providers: This category includes Web3 wallet providers that allow users to exchange digital assets directly. Note: If the wallet does not offer swap functionality, it is not a broker.
- Digital Asset Payment Processors: This category includes products and services that accept cryptocurrencies, convert them into USD and send them to merchants.
- Other brokers: This category includes stablecoin issuers.
- Real estate agent: This category includes intermediaries involved in real estate transactions using cryptocurrency payments.
The proposal attempts to justify the inclusion of certain DeFi exchanges and wallets as brokers. First and foremost, it states: “The digital asset information reporting requirement does not depend on the manner in which an entity operates a trading platform.” In other words, the IRS does not believe that the manner in which you operate a operating trading platform (centralized operation vs. decentralized operation) has any impact on tax compliance requirements; All brokers must comply with information reporting requirements.
The document also notes that if certain DeFi platforms are not required to do 1099 tax reporting, CeFi trading platforms may change their operations (to look like DeFi) to avoid reporting at all. Additionally, the IRS believes that improved tax reporting for DeFi users will make the tax filing process easier for taxpayers, resulting in less under-reporting of taxes owed on crypto.
Merchants who sell goods or services in exchange for digital assets, Proof of Work (PoW) and Proof of Staking (PoS) validation services, as well as individuals who sell hardware and software wallets (without crypto swap features). not classified as a broker.
Which transactions are subject to tax?
The proposed regulations subject crypto sold for cash and crypto-to-crypto transactions, including payment of transaction fees in crypto, to information reporting. Transactions with non-fungible tokens (NFT) are also subject to reporting requirements. Brokers are expected to report profits and losses from these activities to users and the IRS on a new tax form called Form 1099-DA.
Note that gains and losses associated with credit transactions, transfers of assets in liquidity pools, and wrapping and unpacking of transactions are not addressed in the proposed regulations and are unlikely to be reported on 1099-DAs. However, it is possible that these transactions will be included in future iterations of 1099-DAs or other forms. Note that these transactions are still reportable on your tax return and may be taxable even if they are not immediately reported on 1099-DAs.
Timed coordination
The industry has a 60-day comment period, ending October 24, 2023, to respond to the proposed regulations published by the IRS and Treasury. After the comment period closes, the IRS will consider all comments, make any changes it deems appropriate based on those comments, and issue final regulations expectedly in 2024.
“If implemented correctly, these rules could help provide everyday crypto users with the information necessary to accurately comply with tax laws,” said Kristin Smith, CEO of the Blockchain Association, in a statement.
Impact on taxpayers
Under the proposed regulations, brokers are only required to report gross receipts for the 2025 tax year on Form 1099-DA. Beginning with the 2026 tax year, 1099-DAs must include gross revenue, cost basis (if known), and profit and loss amounts.
The introduction of 1099-DA reporting will definitely make life easier for crypto users by making tax compliance easier. When implemented effectively (much like in the stock world), taxpayers can rely on the gains and losses reported on these forms to complete taxes without relying on manual calculations or third-party tools.
On the other hand, taxpayers are required to share Personally Identifiable Information (PII) via Know-Your-Customer (KYC) to DeFi platforms that are classified as brokers. Privacy-conscious and pseudo-anonymous DeFi users may not welcome this new requirement, which contradicts the basic crypto ethos.
Impact on brokers
Implementing information gathering and tax calculation tools will be an extremely time-consuming and expensive process for all brokers. The increased compliance costs could stifle some innovation in the US, as DeFi exchanges, automated market makers (AMMs), self-custody wallets with swap capabilities, and payment processors will likely need to consider these additional costs in the future.
Furthermore, the collection of personal data can even be harmful to some of the fundamental business models of DeFi platforms, which are based on privacy and pseudo-anonymity. Some DeFi platforms may even choose not to serve US customers so that they do not have to comply with these burdensome tax regulations.
Impact on the IRS
The IRS plans to reduce the tax gap by requiring brokers to report users’ profits and losses directly to the IRS. This also allows the IRS to clearly identify non-compliant users, allowing it to focus its audit efforts on these bad actors.
Next Steps
- Watch how the industry responds to the proposed regulations in the next few weeks
- Evaluate how you currently report your crypto trading activities and consider how these new regulations could impact them.
further reading
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