Understanding the Latest IRS Proposed Regulations for Digital Assets

On August 29, 2023, the Internal Revenue Service (IRS) released proposed regulations regarding broker reporting for digital assets.¹ These proposed regulations aim to clarify the definition of a “broker” and provide proposed guidance on information reporting, backup withholding, and determinations of basis and amount realized for transactions involving digital assets.

Acknowledging the growth and advantages of digital assets as both a payment method and investment or trading asset akin to fiat currency, the IRS while lauding innovation also recognizes the need for tax transparency and closing the tax gap. Aligning with the laws outlined in the Infrastructure Investment and Jobs Act,² the proposed regulations take an initial and multiphase approach to finalizing broker reporting regulations for digital assets. It will expand the IRS’s regulations over cryptocurrency reporting, and broadly modify existing broker reporting rules.

Effective January 1, 2025, the proposed regulations require broker reporting on gross proceeds. Reporting of adjusted basis and the character of gain or loss will be effective January 1, 2026. The Department of Treasury and IRS extended acceptance of written comments from October 30, 2023, to November 13, 2023. As of the time of this writing, the IRS has posted multiple thousands of comments on its regulations.gov website.

Here is a brief summary of the key aspects of the proposed regulations.   

Defining Digital Assets

Digital assets are defined as any virtual representation of value that is recorded on a cryptographically secured distributed ledger, such as blockchain. Unlike fiat currencies, they do not exist in physical form and are typically stored in wallets that provide the owner with anonymity, control, and the ability to dispose without a third party or intermediary. Digital assets encompass various types, including stablecoins and non-fungible tokens. They serve multiple functionalities, such as facilitating transactions that may be exchanged for goods, services, real estate, and other property.

The proposed regulations aim to ensure broad recognition of digital assets classified as a security or commodity. However, certain digital assets, such as Central Bank Digital Currencies and other government-based digital currencies, closed-looped virtual assets (e.g., video game tokens), and blockchain technology applied for “ordinary commercial purposes that do not create new transferrable assets” (e.g., inventory or order-tracking) are explicitly excluded.

Who Needs to Report: Defining Digital Asset Brokers

Under the existing rules for broker reporting, digital assets are excluded. According to current rules, a broker is defined as a dealer, barter exchange, or any other person who (upon consideration) regularly acts as a middleman in property or service transactions. Furthermore, under current reporting requirements, brokers must file an information return and provide a payee statement reporting the gains, profits and income resulting from the payments, as well as the name and address of the recipient of the payment.

The new proposed regulations expand the definition of a broker, in line with the recently passed Infrastructure Investment and Jobs Act (2021), to include individuals involved in transactions dealing with digital assets. The broader definition encompasses “any person that stands ready to effect sales to be made by others in the ordinary course of a trade or business.” It is consistent with the current statutory rule that “any person who, for consideration, is responsible for regularly providing a service effectuating transfers of digital assets on behalf of another person.”

The broad implication of these proposed regulations is that anyone who may be facilitating services that effectuate sales of digital assets by customers would potentially be considered a broker and thus subject to these proposed regulations. The regulations clarify that the determination of where a sale is effected depends on the broker’s status and not the physical location of the digital asset sale. Three categories of brokers status are listed: U.S. digital asset broker, controlled foreign corporation (CFC) digital asset broker; and non-U.S. digital asset broker.

The examples provided in the proposed regulations cover a wide range of actors that would fall into this category and thus subject to the newly defined reporting policy. They include online brokers, trading platforms, operators of noncustodial trading platforms, digital asset payment processors, owners and operators of digital asset kiosks, wallet hosting service providers, real estate brokers facilitating the use of cryptocurrencies as consideration for real estate transactions, and anyone that directly or indirectly may effectuate the sale of digital assets. However, miners, merchants collecting digital assets as payment for goods and services, persons solely engaged in validating distributed ledger transactions through proof-of-work or proof-of-stake concepts, and persons strictly engaged in selling storage software technology are not considered brokers.

In the context of broker reporting rules, "effecting" refers to the act of executing or facilitating a sale. Specifically, it means that a broker carries out sales made by others as part of its regular business activities. This includes activities such as an obligor retiring its own debt obligations, a corporation redeeming its own shares, or an issuer of digital assets offering to redeem those assets. It’s important to note that a person who acts as a principal with respect to a sale is only treated as effecting a sale if they are acting in the sale as a broker. For example, a retailer accepting digital assets from a customer as payment for goods is not considered to be effecting the sale unless that retailer is also a dealer of digital assets. Certain categories of exempt brokers are carved out of these rules (e.g., certain corporations, financial institutions, tax-exempt organizations, or governments).

What Information Must Be Reported?

Brokers under the proposed regulations have certain reporting requirements. First, they are required to report the adjusted basis of a security, as well as whether any gain or loss associated with the security is long-term or short-term (this is known as adjusted basis reporting). Secondly, brokers must furnish a written statement containing specific information when transferring securities to another broker.

Broadly speaking, the proposed rules now allow brokers to report the adjusted basis of each digital asset sale. This includes reporting the adjusted basis of the digital asset sold, the purchase date and time the digital asset, and whether any gain or loss with respect to the digital asset sold is long-term or short-term. This information can be reported on either Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, or on another form prescribed by the Secretary, provided it is available in time for reporting.

The current tax rules for determining the adjusted basis of a security apply to digital asset transactions. This includes the inclusion of digital asset transaction costs when calculating the initial basis of a specified security. It is also important to note that brokers are not permitted to adjust the basis of securities acquired to reflect income recognized upon the exercise of a compensatory option, or the vesting or exercise of other equity-based compensation arrangements. Additionally, real estate agents must report the fair market value of digital assets used as consideration in a real estate transaction to the IRS.

How Will the IRS Enforce These Rules Overseas? FATCA Déjà Vu!

The Treasury and the IRS are considering ways to implement the proposed regulations through the Organisation for Economic Development and Co-operation's (OECD) Crypto-Asset Reporting Framework (CARF). This approach allows the IRS to receive information on sales made for U.S. taxpayers by non-U.S. brokers through an automatic exchange of information with other countries, similar to IGAs under FATCA.

For the United States to adopt CARF, the proposed regulations will need to be modified to ensure U.S. brokers collect the necessary information to be shared under the CARF framework and to exempt certain non-U.S. brokers if they provide relevant reporting documentation. These modifications may require U.S. brokers to report certain transaction information for customers identified as exempt foreign persons and relieving certain non-U.S. brokers from reporting under tax laws on sales made for U.S. customers. The IRS intends to implement these rules in phases, with future modifications subject to a notice and comment period before implementation.

Buchanan’s Blockchain and Digital Asset Practice Group stands ready to assist you and your organization in navigating digital asset transactions or other broker activities.