Treasury and IRS Propose Regulations Requiring Brokers to Report Exchanges of Digital Assets and Withholding on Certain Payments
By: Matthew E. Foreman, Esq., LL.M., Michelle S. Kabel, Esq., Moish Peltz, Esq., and Davis Rosser
Introduction
On August 25, 2023, the Treasury Department and the Internal Revenue Service (the “IRS”) issued proposed regulations (REG–122793–19) that would extend the definition of a broker and existing information reporting and backup withholding rules to certain brokers of digital assets, including many DeFi Protocols and other exchanges. The changes to the broker reporting requirements will occur in multiple phases, with this first phase focused on requiring brokers to report, and potentially withhold part of the proceeds, on the sale of digital assets beginning in 2026.
Definition of Broker
Under Section 6045 of the Internal Revenue Code of 1986 (the “Code”), as amended by the Infrastructure Investment and Jobs Act,[1] the term “broker” includes a dealer, a barter exchange, and any person who effectuates transfers of digital assets on behalf of another person.[2] The proposed regulations refine and clarify the definition of broker to include any person[3] that, in the ordinary course of their trade or business, stands ready to effect sales to be made by others.[4] The term “effect” means either to act as (i) a principal with respect to a sale (e.g., a dealer who serves as a middleman to facilitate a sale between two customers) or (ii) an agent if the nature of the agency is that the agent ordinarily would know the gross proceeds of the sale.[5]
The present regulations do not address digital asset transactions, preventing the IRS from obtaining transaction information from centralized and decentralized intermediaries to determine whether taxpayers are accurately reporting their transactions. Currently, digital asset trading platforms (e.g., Coinbase, Binance, and Gemini) are not required to report sales or exchanges to the IRS and likely contributing to the significant noncompliance and underpayment of tax by taxpayers who engage in digital asset transactions.
Information that Brokers must Report on Digital Asset Sales or Exchanges
Under the proposed regulations, certain sales, dispositions, or exchanges of digital assets are subject to reporting requirements, which include filing information returns and furnishing payee statements. The information that digital asset brokers must report is similar to the information currently reported on Form 1099-B, which traditional brokerages use to disclose broker and barter transactions. The proposed regulations contemplate that traditional broker, as well as centralized and decentralized exchanges, must report information for each digital asset sale on a new form, Form 1099-DA. For each transaction that requires a Form 1099-DA, the broker must report the following information:
- Name, address, and taxpayer identification number of the customer;
- Name or type of digital asset sold, and number of units sold;
- Date and time of the sale;
- Gross proceeds of the sale;
- Transaction ID or hash;
- Digital wallet address from which the digital asset was transferred in connection with the sale;
- Description of the consideration (cash, other digital assets, etc.); and
- Other information required by the form and/or the instructions to the form.[6]
Broker Withholding Requirements
Presently, the IRS lacks a mechanism to force non-U.S. persons to pay taxes owed on certain transactions. As a result, there are provisions in the Code that require persons, such as payors and intermediaries, to withhold a portion of the purchase price in a sale with a non-U.S. person and remit to the IRS. This type of federal income tax is commonly referred to as backup withholding.[7] While the withholding rules extend to transactions involving digital assets, intermediaries generally do not exist in these types of transactions. Thus, the enforcement of the backup withholding requirements in digital asset transactions requires new rules. Under the proposed regulations, brokers are required, absent a beneficial owner withholding certificate,[8] to withhold 24%[9] of the purchase price and remit the withheld amount to the IRS.
Enforcement and Compliance Concerns Raised by the Proposed Regulations
As discussed above, the proposed regulations broaden the scope of the definition of a broker to include any person that acts as a middleman and provides facilitative services in a transaction that the middleman would ordinarily know the identity of the selling party and the nature of the transaction itself.[10] This definition casts a wide net over marketplace participants that may fit within the proposed broader “broker” definition, including decentralized exchanges[11], digital asset hosted wallet providers,[12] digital asset payment processors,[13] and other persons that regularly offer to redeem digital assets issued by them, such as stablecoin issuers.[14]
There are some exceptions for certain persons who are not otherwise dealers in digital assets,[15] but in general, the broad nature of the definition of a broker will pose enforcement challenges for the IRS and compliance challenges for those providing so-called facilitative services. Enforcement challenges, some of which were identified in the proposed regulations, stem from the fact that some transactions are not recorded on a public blockchain, there are difficulties differentiating between a sale or exchange that could trigger reporting and/or withholding, and that there are some transfers in which ownership does not change and would not trigger reporting and/or withholding.[16] Compliance challenges for those providing facilitative services will be numerous, and the most significant will be the design, development, and deployment of systems and processes that will be required to track transactions, collect information from those trading on their protocols, report the required information, and withhold where required by the eventual finalized regulations.
Conclusion
These proposed regulations address a variety of issues related to the taxation and reporting of digital asset transactions, representing a significant step forward in the development in the regulation of digital assets in the United States. However, these proposed regulations create significant challenges for service providers, as the increased requirements create significant headwinds for many business models and privacy concerns for users.
It is our expectation that the proposed regulations, and each phase that follow, will undergo many changes prior to being finalized and becoming effective in 2026.[17] At Falcon Rappaport & Berkman, we are actively monitoring the progression of these developments and preparing our comments on the proposed regulations that will be submitted to the Treasury Department and IRS prior to the public hearing that is scheduled on November 7, 2023.
[2] Code § 6045(c)(1).
[3] Under tax law, the word person includes individuals, partnerships, and associations, and is sufficiently broad to include any intermediary, even if unincorporated, such as a DeFi protocol or DAO. See Code § 7701(a)(1).
[4] Treas. Reg. § 1.6045-1(a)(1).
[5] Treas. Reg. § 1.6045(a)(10).
[6] Prop. Treas. Reg. § 1.6045-1(d)(2)(i)(B).
[7] See Code §§ 1441, et seq. and §§ 3401, et seq., and regulations thereunder.
[8] Such as a W-8BEN or W-8BEN-E.
[9] Treas. Reg. §§ 31.3406(a)-1(b)(1) and 3406(a)(1).
[10] Prop. Treas. Reg. § 1.6045-1(a)(21)(i).
[11] E.g., Uniswap, Curve Finance, and PancakeSwap.
[12] E.g., MetaMask, Exodus, Coinbase Wallet, and Phantom Wallet.
[13] E.g., Coinbase Commerce, Bitpay, Coingate, and Coinpayments.
[14] E.g., Circle, MakerDAO, and BitFinex.
[15] E.g., distributed ledger validation services (mining and staking), retailers that accept digital assets as payment, and NFTs sold by their creators.
[16] E.g., transfers between wallets held by the same person.
[17] We further note that finalization and implementation by 2026 itself is a significant hurdle.
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