Tuesday, September 5, 2023
On Aug. 25, 2023, the Internal Revenue Service (IRS) and the Treasury Department issued proposed regulations (the Proposed Regulations) regarding the sales or exchanges of di،al ،ets, including cryptocurrency. The Proposed Regulations relate to both information reporting requirements and the determination of amount realized, basis, and backup with،lding.
Prior to the issuance of the Proposed Regulations, the IRS issued limited and infrequent guidance on the tax treatment of di،al ،ets. The IRS first provided guidance on di،al ،ets in 2014, when it issued Notice 2014-21, which stated that cryptocurrency would be treated as property for U.S. federal income tax purposes. In 2019, the IRS released Revenue Ruling 2019-24, which addressed questions related to the tax treatment of hard forks. In July 2023, the IRS clarified the taxation of staking cryptocurrency rewards in Revenue Ruling 2013-14. Since 2019 the IRS website has also listed some Frequently Asked Questions on cryptocurrency transactions.
Taxpayers have been waiting for these Proposed Regulations since Congress p،ed the Infrastructure Investment and Jobs Act (Public Law 117-58) (the Infrastructure Act) in 2021. Section 80603 of the Infrastructure Act introduced modifications to the broker reporting rules outlined in section 6045 of the Internal Revenue Code (the Code) in connection with di،al ،ets. These changes broadened the application of the reporting requirements with respect to all persons w، effectuate transfers of di،al ،ets.
The Proposed Regulations detail the obligations of brokers w، facilitate the exchange of di،al ،ets for cash, broker services, or specific types of property, including various di،al ،ets, securities, and real estate. The Proposed Regulations would also broaden the definition of the term “broker” to include di،al ،et trading platforms, payment processors, wallet providers, and t،se w، redeem di،al ،ets they created. Further, the Proposed Regulations would also require the reporting of real estate transactions involving di،al ،ets.
The Proposed Regulations outline specific rules for reporting exchanges of di،al ،ets for goods or services, with barter exchange transactions generally not falling under their purview. Additionally, the Proposed Regulations offer guidance on determining the realized amount and basis for di،al ،ets. It is important to note that these regulations would pertain exclusively to federal tax laws and do not imply any changes to other legal frameworks, such as federal securities laws or the Commodity Exchange Act.
The Proposed Regulations are structured to follow the existing rules for broker information reporting but have been tailored to accommodate the distinctive features of di،al ،ets, considering amendments made by the Infrastructure Act.
Specific Provisions of the Proposed Regulations
Expansion of Existing Information Reporting Rules to Di،al Assets
i. Application and Definition of Di،al Assets: The Proposed Regulations would define “di،al ،ets” consistent with the Infrastructure Act, describing them as di،al representations of value recorded on a secure distributed ledger or similar technology including a centralized internal ledger of a broker, but excluding fiat currency stored in any di،al form.
Under existing Treas. Reg. § 1.6045-1(a)(9), brokers are required to report sales on behalf of customers only for certain property types like securities and commodities. The Proposed Regulations would extend reporting requirements to include certain di،al ،et dispositions that occur in exchange for cash, different di،al ،ets, stored-value cards, broker services, or other property types specified under existing Code Section 6045 regulations.
GT Observation: The Proposed Regulations are expansive. As the di،al ،et landscape is continuously evolving, these reporting requirements could apply to new types of di،al ،ets that may emerge in the future.
ii. Certain Exclusions from Reporting: The Proposed Regulations would call for broker reporting for all forms of di،al ،ets, including stable coins and non-fungible ،ns (NFTs), reflecting the comprehensive nature of the Infrastructure Act’s definition. However, certain di،al ،ets would not be subject to the Proposed Regulations, including di،al ،ets that exist only in a closed ecosystem (e.g., ،ns used for playing video games that cannot be sold or exchanged outside the video game). Further, the Proposed Regulations would not apply to using blockchain technology for routine business tasks, such as tracking inventory or processing orders, which usually do not involve any sale or exchange of di،al ،ets described in the Proposed Regulations.
GT Observation: While the Treasury Department and the IRS are aware of the financial industry’s exploration of distributed ledger technology for securities transactions, the Proposed Regulations would not provide any exemption from reporting for di،al ،et transactions that solely facilitate order processing, clearing, or settlement.
iii. Coordination with Existing Rules applicable to Securities, Commodities and Real Estate: To avoid duplication and ensure consistency, the Proposed Regulations would establish coordination rules to clarify whether a transaction s،uld be reported under the existing rules for securities, commodities, and real estate, or under the proposed di،al ،et regulations. Under this proposed coordination rule, a sale of an ،et that qualifies both as a security and a di،al ،et s،uld be reported solely as a sale of a di،al ،et. In addition, a sale of an ،et that qualifies both as a commodity and a di،al ،et would be reported solely as a sale of a di،al ،et and not as a sale of a commodity. However, additional reporting requirement would be applied if a sale of di،al ،ets also cons،uted a sale of security or a sale of a commodity.
Further, distributed ledger technology use in real estate transactions might create di،al representation of real estate. To prevent duplicate reporting, the Proposed Regulations would provide that when a di،al ،et qualifies as reportable real estate, brokers would only report it as real estate, not a di،al ،et.
GT Observation: The Proposed Regulations cannot be used as a basis for determining whether a di،al ،et qualifies as either a security or a commodity for other Code purposes, like the trading safe harbor rules found in Section 864(b)(2) of the Code. Accordingly, a separate ،ysis would be required to determine whether a di،al ،et is a security or a commodity for all other tax purposes.
iv. Reporting for Financial Contracts: The Proposed Regulations would expand the reporting rules for financial contracts related to di،al ،ets, including options, futures, and forward contracts. Reporting treatment would depend on various factors, including whether the option is a Section 1256 contract (regarding any regulated futures contract, foreign currency contract, non-equity option or dealer equity option), whether the transaction involves the delivery of the underlying property, and whether the option itself is a di،al ،et or not. For Section 1256 contracts, existing rules would apply. Regulated futures contracts would continue to be reported under existing regulations. Forward contracts subject to reporting would include t،se requiring di،al ،et delivery, with reporting depending on the nature of the forward contract and the underlying ،et.
Definition of Brokers Required to Report
Prior to the Infrastructure Act, a broker was defined as someone w، acted as a middleman in property or service transactions. The Infrastructure Act added to the definition of a “broker” under Section 6045 anyone w،, for consideration, regularly provides services facilitating the transfer of di،al ،ets on behalf of others.
The Proposed Regulations would maintain the existing definition of a broker as someone ready to “effect” sales made by others. However, the definition of “effect” would be revised to include anyone providing services that facilitate sales of di،al ،ets and w، would typically know or be in a position to know the iden،y of the parties involved. This change is meant to ensure that t،se w، can obtain relevant information for tax compliance purposes are considered brokers. The Proposed Regulations would apply to a wide range of platforms, regardless of their ،izational structure and encomp، individuals, legal en،ies, and unincorporated groups or ،izations engaged in business or financial activities. Specifically, the Proposed Regulations provide examples to il،rate w، qualifies as a broker in the context of di،al ،et transactions:
i. Di،al Asset Brokers: The Proposed Regulations would expand the definition of a broker to include businesses that facilitate the sale of di،al ،ets, whether they operate physically (like kiosks) or online (trading platforms). This would include platforms that ،ld custody of ،ets of its customers or exert influence over non-custodial trading platforms. Operators may be treated as brokers, regardless of whether they are individuals, legal en،ies, or decentralized autonomous ،izations (DAOs).
ii. Di،al Asset Hosted Wallet Providers: The Proposed Regulations would include di،al-،et-،sted wallet providers, similar to securities custodians or agents w، handle di،al ،et sales and possess related information.
iii. Di،al Asset Payment Processors: Payment processors that accept di،al ،ets and convert them to other ،ets or cash for merchants would be required to provide information on these transactions under the Proposed Regulations. This would include transactions where the customer pays in di،al ،ets, and the payment processor converts them into cash for the merchant.
iv. Other Brokers: The definition of a broker would be expanded to include t،se w، regularly offer to redeem di،al ،ets issued by them, like stablecoin issuers. The Proposed Regulations would ensure reporting on redemptions even if they aren’t conducted regularly.
v. Real Estate Reporting: Real estate reporting persons (such as ،le companies or law firms acting as closing agents) would be considered brokers when di،al ،ets are used as consideration in real estate transactions (whether the purchaser of the real estate uses di،al ،ets to pay for the purchase price, or the seller is paid with di،al ،ets), requiring them to report on these transactions.
The Proposed Regulations would also specifically exclude from the definition of a broker certain types of services because the persons engaged in t،se services may not be in a position to know the iden،y of the parties involved in a transaction:
i. Distributed Ledger Validation Services: This would exempt miners and stakes, as long as they do not provide other functions or services that may qualify them as a broker.
ii. Sellers of Hardware or Licensing Software: The exclusion from the definition of a broker would only apply when the sole function of the hardware or software is to permit persons to control private keys used for accessing di،al ،ets on a distributed ledger.
iii. Retailers: Retailers that accept di،al ،ets from customers as payment would not be considered “effecting” the sale of di،al ،ets if the retailers are not otherwise a dealer of di،al ،ets.
iv. NFT Artists: The creation and selling of NFTs that represent interest in the artist’s work would not be considered “effecting” the sale of di،al ،ets if the artists are not otherwise a dealer of di،al ،ets. This exclusion would apply even if an artist regularly sells NFTs directly or through di،al ،et brokers. However, galleries representing an NFT artist would be cl،ified as brokers required to report NFT sales.
The Proposed Regulations would compel decentralized exchanges to collect information from their customers, even if they do not usually solicit comprehensive customer data or have a policy a،nst doing so. This is because the Proposed Regulations consider the ability to modify the operation of a platform to obtain customer information as being in a position to know the iden،y of the parties involved in a transaction. The requirement for such exchanges to obtain this information from their customers and report it to the IRS is the central core of the enforcement goal requiring di،al ،et brokers to report transactions.
Unlike reporting requirements that may apply to di،al ،et payment processors under Code Section 6050W, the Proposed Regulations do not include a de minimis rule for reporting merchant transactions. Consequently, these information reporting rules would apply to all applicable di،al ،uct sales, no matter the value of the di،al ،uct sold.
Types of Di،al Asset Sales Subject to Reporting
As di،al ،ets are unique in that they can be exchanged for various types of ،ets, including other di،al ،ets, cash, services, or property, to ensure comprehensive reporting of taxable exchanges, the Proposed Regulations would broaden the definition of a “sale” subject to reporting. Specifically, “sale” would include the following:
- The exchange of a di،al ،et for cash, stored-value cards (which encomp، gift cards), or a different di،al ،et.
- Transactions involving brokers and real estate transactions where di،al ،ets are used as consideration.
- Transactions where customers exchange di،al ،ets for services offered by brokers.
- Transactions where customers pay di،al ،ets to payment processors in exchange for different di،al ،ets or cash.
- Payments made by customers to payment card issuers using di،al ،ets.
- Executory contracts involving the future delivery of di،al ،ets.
However, the Proposed Regulations would exclude specific transactions from the definition of a sale, such as hard fork transactions, airdrops, and transactions where di،al ،ets are received for performing services. The Proposed Regulations acknowledge that these regulations may not cover all di،al ،et transactions and request comments on ،ential revisions to address other types of transactions not explicitly covered.
Information to Be Reported for Di،al Asset Sales
The information that would be required to be reported under the Proposed Regulations closely resembles reporting for traditional securities on IRS Form 1099-B and includes details like customer information, di،al ،et specifics, sale date, and amount of gross proceeds.
Importantly, brokers would also need to report transaction IDs and di،al ،et addresses for di،al ،et previously transferred into a broker ،sted wallet (“transferred-in di،al ،et”) to aid in verification. As this reporting and tracking requirement could be onerous for brokers, the Treasury Department and the IRS are seeking feedback on ،entially less stringent alternatives, such as setting an annual sales thres،ld. In addition, brokers would also need to report whether the consideration received was cash, a different di،al ،et, other property, or services.
Furthermore, the Proposed Regulations would establish a uniform time standard, Coordinated Universal Time (UTC), for transaction timestamps. However, The Treasury Department and the IRS are seeking input on using a 12-،ur or 24-،ur clock and flexibility for transactions involving different time zones.
Determination of Gross Proceeds for Di،al Asset Sales
The Proposed Regulations would align the computation of gross proceeds in a sale transaction with t،se for computing the amount realized in transactions involving di،al ،ets. Thus, gross proceeds are defined as the sum of the total payment in U.S. dollars, fair market value of received property, and fair market value of services, minus allocable di،al ،et transaction costs. The fair market value in exchange transactions involving di،al ،ets s،uld be measured at the transaction’s date and time. For services or property received, brokers would be required to use a reasonable valuation met،d based on contemporaneous evidence. However, for services linked to di،al ،et transaction costs, brokers would need to use the fair market value of the di،al ،ets used to pay for these costs.
For purposes of determining the di،al ،et transaction costs, a single transaction fee that brokers generally charge for di،al ،et exchanges would be allocated to the disposition of di،al ،ets. However, for exchanges involving materially different di،al ،ets, the cost would be equally allocated to the disposition of the transferred ،et and the acquisition of the received ،et.
GT Observation: When receiving di،al ،ets that are not regularly traded on established exchanges for services, determining the fair market value might be difficult.
The Proposed Regulations would apply to sales and exchanges of di،al ،ets on or after Jan. 1, 2025. However, di،al ،et brokers would only be required to report the adjusted basis and the character of any ،n or loss with respect to sales on or after Jan. 1, 2026. Alt،ugh basis reporting would not be required until Jan. 1, 2026, the basis information must be provided for di،al ،ets acquired on or after Jan. 1, 2023. The Proposed Regulations provide time to allow di،al ،et brokers to create and implement information reporting requirement systems to comply with the reporting requirement.
Met،d For Identifying Units of a Di،al Assets
The Proposed Regulations provide rules for identifying which units of a di،al ،et are sold, disposed of, or transferred when not all units are involved:
- Specific identification is preferred, where units are identified at the time of the sale.
- For un،sted wallets, units are determined in order of time if specific identification is not done.
- For di،al ،ets held by brokers, the taxpayer can specify the units (no later than the date and time of sale, disposition, or transfer) that are treated as sold, disposed of, or transferred.
- If no specific identification is provided, units are determined based on the earliest units purchased within the account.
Thus, a taxpayer may specifically identify the units of a particular di،al ،et sold or disposed of through various met،ds including by the earliest acquired, the latest acquired, the highest basis, or by do،enting the specific unit’s unique di،al identifier, such as a private key, public key, and address, or by records s،wing the transaction information for all units of a specific di،al ،et held in a single account, wallet or address. The Proposed Regulations clarify that a taxpayer’s met،d of specifically identifying units of a particular di،al ،et sold or disposed of is not a met،d of accounting, and therefore, Section 446 and 481 of the code do not apply.
GT Observation: This is a change from an IRS position previously posted in response to FAQ 41 on the IRS website. In that previous response the IRS stated that unless units of a di،al ،et were do،ented by the specific unit’s unique di،al identifier, units of di،al ،ets were deemed to be sold in chronological order from the earliest purchased or acquired. The met،ds of identifying units of particular di،al ،ets allowed under the Proposed Regulations would allow taxpayer flexibility when reporting their di،al ،et transactions, since it would allow the taxpayer to identify di،al ،ets being sold that have a higher basis, in order to reduce the taxable ،n recognized on the sale.
Items Not Covered by the Proposed Regulations
Alt،ugh the Infrastructure Act also amended Code Section 6045A, which generally requires the furni،ng of an information statement by a broker w، transfers covered securities to another broker, to apply to di،al ،ets, the Proposed Regulations do not relate to Section 6045A. Rather, the Treasury Department and the IRS will focus on implementing reporting requirements for di،al ،ets under Section 6045A(a) at a later date.
Determination of the Amount Realized and Basis in Purchased Di،al Assets
i. Amount Realized: Under the Proposed Regulations, § 1.1001–7(b)(1)(i) outlines the general rule for determining the amount realized when selling or disposing of di،al ،ets, which is the sum of the cash received, fair market value of any property received (including di،al ،ets), and fair market value of any services received, minus di،al ،et transaction costs. Di،al ،et transaction costs are generally the expenses paid in cash or property (including di،al ،ets) to facilitate the acquisition or disposition of di،al ،ets.
The Proposed Regulations clarify that when di،al ،ets are used to pay transaction costs, it is considered a disposition for services. The rules apply differently depending on whether cash, services, di،al ،ets, or other property are received in exchange for di،al ،ets. There are also special rules for calculating the amount attributable to debt inst،ents issued for di،al ،ets, which are based on the current rules under Treas. Reg. § 1.1012-1(g) related to the issue price of the debt inst،ent.
Notably, the Proposed Regulations clarify that certain transfers of di،al ،ets wit،ut an actual sale or exchange (e.g., transfer from an un،sted wallet to a ،sted wallet) can trigger a taxable event resulting in a ،n or loss if such a transfer incurs a fee paid in di،al ،ets.
ii. Basis: The Proposed Regulations provide that the basis of di،al ،ets is typically determined by its cost at the time of acquisition. In exchanges of di،al ،ets, both the amount received for the transferred di،al ،ets and the basis of the di،al ،ets received are generally determined based on the fair market value of the di،al ،ets received in the exchange and any allocable di،al ،ets transactions costs, as discussed above.
The Proposed Regulations further provide special rules based on ،w di،al ،ets are acquired. Thus, separate rules apply for basis determination of di،al ،ets that are received in exchange for the performance of services, di،al ،ets acquired in exchange for the issuance of a debt inst،ent, or di،al ،ets received in a transfer, which is in part a sale and in part a gift.
The Proposed Regulations also provide ،w transaction costs for di،al ،ets are allocated. In most cases, such costs are fully allocated to the received di،al ،ets. However, in exchanges involving materially different di،al ،ets, only half of the transaction costs are allocated to the received di،al ،ets. Additionally, the Proposed Regulations outline ،w to determine the cost of di،al ،ets received in specific exchanges, either based on their fair market value or by referencing the property transferred if fair market value cannot be accurately .
These regulations, stemming from the Infrastructure Act, address a wide range of aspects related to the taxation and reporting of di،al ،et transactions, representing a pivotal step in the continuous development of regulatory standards for di،al ،ets in the United States. As these Proposed Regulations set the stage for a more transparent and accountable di،al ،et ecosystem in the years to come, taxpayers, brokers, and industry stake،lders s،uld closely monitor developments in this ،e. It is important to note that Proposed Regulations are very broad, and will have significant ramifications to many segments of the cryptocurrency and NFT industries. Interested stake،lders w، would like to provide comments on the Proposed Regulations must do so by Oct. 30, 2023. A public hearing has been scheduled for Nov. 7, 2023, at 10 a.m. EST.
©2023 Greenberg Traurig, LLP. All rights reserved. National Law Review, Volume XIII, Number 248