The Kingdom Of Glass: Cryptocurrency Account Disclosures To Be Mandated By The US Internal Revenue Service – Fin Tech

At the end of August 2023, the US Internal Revenue Service (the
“IRS”) proposed new cryptocurrency tax reporting
regulations in furtherance of the legislative mandate to expand
such reporting contained in 2021’s Infrastructure Investment
and Jobs Act (PL 117-58).
¹ The smart money isn’t betting that these new
rules will be made effective in the short term. When these rules
are finalized, however, they will create substantial tax reporting
obligations on digital asset trading platforms, payment processors
and wallet providers. This Legal Update summarizes, in Q&A
format, some of what the IRS has in mind and certain ins and outs
of the proposed regulations. The IRS will be holding a hearing on
the proposals on November 7, 2023 (and has listed no less than 49
issues on which it is seeking input). So, it’s fair to say that
cryptocurrency tax reporting is still a work-in-progress.

These proposed regulations are the most comprehensive and
significant federal tax proposal on cryptocurrencies to date and
would significantly expand both the types of persons required to
provide information to the IRS and the amount of information that
the IRS would receive. If there’s any guiding principle to the
proposed regulatory scheme, it’s the Dalai Lama’s thought
that “a lack of transparency results in distrust and a deep
sense of insecurity.” The opacity around cryptocurrency
trading has stoked a sense within the IRS that US taxpayers may not
be reporting all of their income and gains from digital asset
transactions. The proposed regulations create a 21st century
reporting regime on top of the existing rules for security
transactions.

I. What Transactions Will Be Subject to Information
Reporting?

The proposed regulations provide that most dispositions of
digital assets will be subject to information reporting, including
dispositions for cash, digital assets that differ “materially
in kind or extent,”
² stored value cards, broker services or certain
other property.
³ While the direct purchase of goods and services
with cryptocurrencies generally will not be subject to reporting,
if the property acquired is subject to other reporting requirements
(including stock and real estate), the use of cryptocurrency to
acquire that property becomes reportable. And although direct
purchases are not subject to reporting, if the transaction is
processed by an intermediary, the intermediary will have tax
reporting requirements. (In other words, it’s likely that
luxury good dealers who directly accept bitcoin will become very
popular.)

Under the proposed regulations, cryptocurrencies received in
hard forks and airdrops will not be subject to reporting. The
proposed regulations exempt loans of digital assets from
information reporting. But the IRS has stated that is likely to
change this rule in the future.

Derivatives

Speaking of financial transactions involving cryptocurrencies,
tax reporting for option and forward contract transactions will be
determined based on whether the option or contract is a digital
asset, not based on the property subject to the option or contract.
Accordingly, if the option or forward is itself traded on a
blockchain, digital asset reporting will be required.
⁴ If the option or forward is not blockchain traded,
even if the derivative references a digital asset, it remains
subject to the existing rules for option and forward contract
reporting.
⁵ The proposed regulations reserve on reporting for
Section 1256 contracts referencing digital assets (as the IRS
believes that such contracts do not yet exist). In the case of both
options and forward contracts, however, if the option or forward is
physically settled, digital asset reporting will be required for
the settlement. Other physically settled derivatives involving
cryptocurrencies also will be subject to information reporting.
⁶

If a broker executes a transaction that is internal to its
platform, such as matching buy-sell orders with inventory, instead
of by purchasing cryptocurrency in an open market transaction to
fill an order, the transaction will be subject to information
reporting. Reporting will be required even if the exchange ledger
is not widely distributed, i.e., it is private or permissioned.

If a transaction constitutes both a securities transaction and a
digital asset transaction, such as a transaction in a regulated
futures contract, the transaction will be reportable only as a
digital asset transaction.
⁷ The IRS specifically acknowledged that the
digitization of existing financial assets by brokers could raise
special issues but decided to require reporting of such
transactions only as digital asset transactions. Similarly, the
digital asset reporting rules, and not the commodity reporting
rules, will apply to digital asset transactions that also meet the
definition of a commodity transaction. (The definition of commodity
will be expanded to include assets that are self-certified to the
Commodity Futures Trading Commission.) These proposed regulations
will also allow brokers to defer basis reporting for “dual
classification assets” until the digital asset rules are
finalized. In contrast to the rules for most dual asset
transactions, the use of cryptocurrencies in real estate will be
subject only to the real estate reporting rules.

The payment of gas fees, staking fees and like amounts are
treated as dispositions of cryptocurrency under the proposed
regulations. Accordingly, the payment of these fees will trigger
tax reporting. There is no proposed de minimis
exception.

II. Who Will Be Required to Provide Information Reporting on
Digital Asset Transactions?

The new reporting requirements will apply to
“brokers.” Notwithstanding some congressional concern
about the breath of the definition of a broker, the IRS has
proposed a fairly expansive definition of broker for this purpose.
A broker will include digital asset platforms, payment processors,
hosted wallet providers and issuers of cryptocurrencies who
regularly offer to redeem their digital currencies, such as stable
coin issuers. The IRS will also require reporting with respect to
persons who use cryptocurrencies to purchase real estate or stocks
but, in general, not other assets or services. Furthermore,
“any person that provides facilitative services that
effectuate sales of digital assets by customers” is treated as
a broker, provided that such person is in a position to know the
identity of the party that makes the sale and the nature of the
transaction.
⁸ A person who controls the payment services for
cryptocurrency payments will be considered to have the ability to
control the transaction. Regularity of activity will bear on
whether a person is acting as a broker. The IRS will require
exchanges that are “willfully blind” to the identities of
their customers to modify their systems to capture this information
and become reporting agents.

A hosted wallet provider who solely holds and transfers digital
assets but does not and cannot process gross proceeds will not be
treated as a broker. Payment processors, including credit card
companies, that facilitate the payment for cash, goods, other
cryptocurrencies and services for cryptocurrencies, however, will
be treated as brokers.

The preamble to the proposed regulations makes clear that
decentralized autonomous organizations (“DAOs”) will be
treated as persons and, hence, brokers. This rule will apply
regardless of whether the DAO is formed as an organization. In
other words, DAOs that are just collections of participants holding
governance tokens will be treated as brokers. DAOs and similarly
situated persons are referred to as “digital asset
middlemen” under the proposed regulations.
⁹ The IRS has invited comments on when the holding
of governance tokens causes someone to become a digital asset
middleman.
¹⁰ A person whose sole role is staking, however,
will not be treated as a digital asset middleman. Likewise, persons
engaged in hardware sales and software licensing will not be
treated as digital asset middlemen.

Stablecoin issuers that redeem their stablecoins for cash are
treated as brokers. As stated above, merchants who accept digital
assets for goods and services, however, will not be treated as
brokers.

In general, non-US brokers (other than foreign partnerships
controlled by US persons) will be exempt from the cryptocurrency
tax reporting rules unless part of the transaction is effectuated
from inside the United States. The location of sales is determined
based on the residence of the digital asset broker rather than the
office location used to effectuate the transaction (as is the case
with securities sales). A transaction will be considered an exempt
foreign transaction only if the broker “completes the acts
necessary to effect the sale outside the United States pursuant to
instructions directly transmitted to that office from outside of
the United States by the broker’s customer.”
¹¹ Virtually any indication that the client is a
U.S. person will bring the transaction within the new reporting
rules. Foreign brokers reporting certain sales of cryptocurrencies
under the FATCA regime will be exempt from the new reporting
rules.

Complex rules are proposed to distinguish sales effected by US
brokers, non-US brokers and controlled foreign corporations
(“CFCs”).

III. Which Assets Will Be Subject to Reporting?

The proposed regulations make clear that stablecoins and
nonfungible tokens (“NFTs”), as well as cryptocurrencies,
are subject to new reporting requirements.

IV. Who Is Exempt from Information Reporting?

The existing list of tax reporting “exempt recipients”
will carry over to the cryptocurrency reporting regime.
Accordingly, most foreign persons, corporations, financial
institutions and tax-exempt organizations will not be subject to
cryptocurrency tax reporting. Transactions between digital asset
brokers, however, will not be exempt from reporting.

V. What Must Be Reported Under the Proposed Reporting
Regulations?

The proposed regulations require that the following information
be reported by the broker to the IRS and the taxpayer:

1. Name, address and taxpayer identification number of the
   payer;




2. The date and time of disposition using Coordinated Universal
   Time;




3. Gross proceeds (dollars or fair market value of goods and
   services, reduced by one-half of transaction costs);




4. Transaction ID (if any);




5. Digital asset address;




6. Consideration received for the cryptocurrency; and




7. If the transaction involves a hosted wallet, the information
   necessary to identify the wallet and the amount originally
   transferred into the wallet.

Section 80603(b)(1) of the Infrastructure Investment and Jobs
Act mandates basis reporting requirements for cryptocurrency
acquisitions that occur on or after January 1, 2023. The proposed
regulations follow this statutory mandate but only for sales that
occur on or after January 1, 2026. In other words, brokers must
keep basis information for client cryptocurrency acquisitions on or
after January 1, 2023, but will be required to report such
information only for dispositions in 2026 and after. If a broker
chooses to adopt earlier reporting, the IRS will not impose
penalties for mistakes in such reporting. Taxpayers may elect
specific identification of the coins sold or, if a specific
identification method is not elected, use a “FIFO” method
in determining the cryptocurrencies that have been sold.

VI. Will These Rules Really Be Made Applicable to 2023?

It’s hard to tell, but it appears unlikely. The reporting
burden appears to be phenomenal. And based on our experience,
it’s hard to see how any broker could comply with these rules
for 2023 and have statements ready by early 2024. But it’s
possible that reporting could be mandated in short order, maybe
beginning in 2025 for 2024.

Footnotes

1. REG-122793-1 (August 29, 2023).

2. The proposed regulations do not offer any guidance on
when the IRS believes that one cryptocurrency materially differs
from another cryptocurrency.

3. Prop. Treas. Reg. § 1.6045-1(a)(9).

4. Prop. Treas. Reg. §
1.6045-1(e)(9)(ii).

5. Prop. Treas. Reg. §
1/6045-1(e)(9)(i).

6. Prop. Treas. Reg. §
1.6045-1(a)(9)(ii)(A)(3).

7. Prop. Treas. Reg. §
1.6045-1(c)(8)(i).

8. Prop. Treas. Reg. § 1.6045-1(a)(10). The
“position to know” standard is taken from the Financial
Action Task Force (“FATF”) recommendations.

9. Prop. Treas. Reg. §
1.6045-1(a)(21)(i).

10. Prop. Treas. Reg. §
1.6045-1(a)(21)(iii)(A).

11. Prop. Treas. Reg. §
1.6045-1(g)(3)(iii)(B).

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