DeFi under threat with IRS’s New Crypto Tax Rules

What Happened

According to the infrastructure law that was enacted by both parties in November 2021, “brokers” of digital assets were compelled to disclose customers’ gains and losses to the IRS in the same way that stock brokers already do. Since then, the definition of “broker” has been a contentious issue due to industry worries that it could include companies that would find it difficult to comply with the law, including miners and decentralized finance platforms, in its scope. To make this statute into official guidance, it would be up to the IRS and the Treasury. On August 25, 2023, the IRS released proposed regulations (Regs) defining the contentious term “broker” and outlining the procedures brokers must follow to abide by tax reporting standards pertaining to cryptocurrency transactions.

Key Concepts

Who are brokers?

Any individual who, in the normal course of a trade or company, is prepared to effect sales that will be made by others is deemed to be a broker, per the proposed regulations. Four prospective broker categories are listed in the document.

Digital asset platforms: This category includes centralized exchanges, cryptocurrency ATMs, and certain DeFi platforms when the operator knows the identity of the party making the sale and has sufficient control or influence over the service offered.

Web3 wallet providers that allow users to trade digital assets directly: This category comprises web3 wallet providers that allow customers to swap digital assets directly. It should be noted that if the wallet does not include a swap option, it is not a broker.

Payment processors for digital assets: This category comprises products and services that accept the digital currency, convert it to USD, and then transmit it to merchants.

Other brokers include: Stablecoin issuers fall into this group.

Real estate intermediaries: This category comprises middlemen involved in real estate deals using cryptocurrency payments.

The proposal makes an effort to defend the designation of specific DeFi exchanges and wallets as brokers. First and foremost, it declares that how a company runs its trading platform is not important in light of the need for information reporting on digital assets. In other words, all brokers are required to comply with information reporting standards; the IRS does not feel that the method a trading platform is operated (centralized operations vs. decentralized operations) has any influence on the tax compliance obligation.

The document also warns that CeFi trading platforms may change their operations (so they behave like DeFi) in order to avoid reporting at all if certain DeFi platforms are exempt from the requirement to file 1099 tax reports. The IRS also thinks that better tax reporting for DeFi users will simplify the tax filing process for filers, reducing underreporting of taxes owed on cryptocurrency.

The document also warns that CeFi trading platforms may change their operations (so they behave like DeFi) in order to avoid reporting at all if certain DeFi platforms are exempt from the requirement to file 1099 tax reports. The IRS also thinks that better tax reporting for DeFi users will improve the tax filing process for filers, reducing underreporting of taxes owed on cryptocurrency.

Brokers are not considered to be individuals that exchange physical products or services for digital assets, provide Proof of Work (PoW) or Proof of Stake (PoS) validation services, or offer hardware or software wallets without any capabilities for crypto exchange.

What transactions are subject to tax?

Crypto sold for cash and crypto-to-crypto trades, including the payment of transaction fees in crypto, are subject to information reporting under the proposed regulations. Transactions using non-fungible tokens (NFT) must also be reported. Brokers are required to provide Form 1099-DA, a new tax form, to the IRS and users in order to record gains and losses resulting from these activities.

It should be noted that the proposed laws do not cover gains and losses related to loan transactions, asset transfers into liquidity pools, or wrapping and unwrapping activities, and it is likely that these transactions won’t be reported on 1099-DAs. However, it’s possible that these transactions will appear in upcoming versions of 1099-DAs or other documents. Even though these transactions are not immediately reported on 1099-DAs, they are yet reportable on your tax return and can be taxable.

Timing

The IRS and the Treasury published new regulations, and the industry has 60 days to comment on them before the comment period expires on October 24, 2023. Following the conclusion of the comment period, the IRS will review all comments, take any necessary action in light of them, and publish the final regulations, most likely in 2024.

If implemented properly, these regulations could assist in giving common cryptocurrency users the knowledge they need to correctly comply with tax laws. Kristin Smith, CEO of the Blockchain Association, said in a statement.

Impact on taxpayers

Brokers must only disclose gross proceeds on Form 1099-DAs for the 2025 tax year, according to the proposed regulations. Gross profits, cost basis (if known), and gain and loss amounts must all be included on 1099-DAs starting with the 2026 tax year.

The introduction of 1099-DA reporting will undoubtedly simplify tax compliance for crypto users, making their lives easier. If handled correctly (as in the stock market), taxpayers can use the gains and losses recorded on these forms to complete their taxes without having to use manual computations or other software.

Taxpayers, on the other hand, will be required to provide personally identifiable information (PII) via know-your-customer (KYC) to DeFi platforms that will be categorized as brokers. This new restriction, which goes against the core principles of crypto, may not be welcomed by privacy-conscious and pseudo-anonymous DeFi users.

Impact on brokers

For all brokers, putting information collection and tax calculating systems into place will be a time- and money-consuming exercise. Given that DeFi exchanges, Automated Market Makers (AMMs), self-custodial wallets with swap functionality, and payment processors will likely need to take these additional expenses into account going forward, the increased cost of compliance could impede some innovation in the US.

Additionally, some of the DeFi platforms’ core business models, which are based on privacy and pseudo-anonymity, may potentially suffer from the collection of PII. Some DeFi platforms might even decide not to cater to any US clients in order to avoid having to adhere to these onerous tax regulations.

Impact on the IRS

The IRS intends to close the tax gap by requiring brokers to submit users’ earnings and losses to the IRS directly. Additionally, this will help the IRS recognize non-compliant users clearly, allowing them to focus their auditing efforts on the bad actors.

Next Steps

  • Watch how the sector responds to the new regulations over the next few weeks.
  • Consider how these new regulations may affect the way you now record your cryptocurrency trading operations.

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