Proposed regulations for digital assets are here! Now what?

ARTICLE | September 14, 2023

Authored by RSM US LLP

Executive summary: Digital asset proposed regulations released Aug. 25, 2023

The highly anticipated proposed regulations for digital asset reporting under section 6045 have arrived and require brokers to report sales and exchanges of digital assets to the IRS and to customers as part of Treasury's broader effort to close the tax gap, reduce base erosion and curb tax evasion.

Proposed regulations for digital asset reporting issued

The Department of Treasury and the IRS have published the long-anticipated proposed regulations (REG-122793-19) governing reporting requirements for sales and exchanges of certain digital assets under sections 6045 and 6050W. The proposed regulations require reporting of transactions that occur on or after Jan. 1, 2025, and:

• Provide an even broader definition of “brokers” required to report sales of digital assets (but continue to exclude persons solely engaged in proof-of-work or proof-of-stake validation activity);
• Clarifies the definition of “digital assets”
• Clarify requirements for back-up withholding on sales of digital assets;
• Introduce new form 1099-DA for reporting these sales;
• Explain how to calculate the basis of digital assets;
• Confirm the delay of transfer statement and issuer reporting;
• Require reporting on real estate purchasers who use digital assets to acquire real property and requires sellers of real estate to include the fair market value of digital assets received by sellers in exchange for real estate; and
• Confirm that goods purchased with digital assets will be treated as payment card transactions that are subject to reporting under section 6050W.

The guidance interprets the broker reporting rules for digital assets that were part of the 2021 Infrastructure Investment and Jobs Act (the Infrastructure Act) and comes on the heels of the Organization for Economic Developments’ (OECD) adoption in June 2023 of the Crypto-Asset Reporting Framework (CARF) with amendments to the Common Reporting Standard. Collectively, these rules demonstrate a continued focus globally on increased transparency and information sharing for transactions involving digital assets.

According to the IRS, the two-year gap between when the proposed regulations were issued and when reporting actually begins should allow brokers more time to build appropriate reporting and basis retrieval systems. However, many in industry have criticized the proposed regulations as being extremely broad and overly burdensome arguing that companies may ultimately need several additional months of lead time to implement such sweeping changes.  

Key dates in the proposed regulations

• Jan. 1, 2023: Brokers to track cost basis on newly acquired digital assets in customer accounts
• Jan. 1, 2025: Brokers to track disposition of digital assets and tax withholding begins
• Jan. 1, 2026: Brokers begin to file Form 1099-DA (gross proceeds only)
• Jan. 1, 2027: Brokers add costs basis reporting (from Jan. 1, 2023) to sales of digital assets

Treasury has requested comments on the proposed regulations including 51 specific questions. A more detailed discussion of key highlights of the rules appears below.

Key changes proposed

Expanded definition of “broker”

Among the most notable changes presented in the proposed regulations is an even more expansive definition of the term “broker”. Under the proposed regulations, a “broker” includes “any person that in the ordinary course of a trade or business during the calendar year [that] stands ready to effect sales [of digital assets] to be made by others.” The proposed regulations focus on entities that are “in a position to know” the identities of the parties involved in digital asset transactions and extend the information reporting rules in section 1.6045-1 to brokers who, in the ordinary course of a trade or business, act as agents, principals or digital asset middlemen for others to effect sales or exchanges of digital assets. The proposed section 1.6045-1 regulations also require “brokers” to report the gross proceeds starting for sales and exchanges of “digital assets” effected on or after Jan. 1, 2025, though several of the proposed sections have rules that can, in certain cases, be applicable before 2025.

“Digital asset” is defined in section 1.6045-1(a)(19) of the proposed regulations as “any digital representation of value that is recorded on a cryptographically secured distributed ledger (or any similar technology), without regard to whether each individual transaction involving that digital asset is actually recorded on that ledger, and that is not cash.” Treasury notes in the Preamble to the proposed regulations that the “use of cryptography, through the use of public and private keys to transfer assets [is] an essential part of the definition [of digital assets].” Interestingly, the proposed regulations expand the meaning of “effect” within the definition of broker noting that a person can “effect” the transaction (and thus be a broker) if the person “knows or is in a position to know the identity of the party that makes the sale and the nature of the transaction potentially giving rise to gross proceeds from the sale.”

This new “in a position to know” standard is a departure from the usual “knows or has reason to know” standard used in other parts of the Code and regulations relating to reporting.  According to Treasury, “[t]he ability to modify the operation of a platform to obtain customer information” is considered as being “in a position to know” that information. This clarification of the proposed definition is expected to ultimately require operators of decentralized exchanges to collect customer information and report sales information about their customers, if those operators otherwise qualify as brokers.

The expanded definition of “broker” casts an extremely wide net to encompass nearly every business model imaginable for facilitating sales or exchanges of digital assets, including digital asset trading platforms, hosted wallets, digital payment processors, and others that critics argue may not align with the intent of the rules. The revised definition of “broker” would also include centralized and decentralized digital asset trading platforms, crypto payment processors, wallet providers that allow users to buy, sell, and trade digital assets, and bitcoin automated teller machines (ATMs) and other physical kiosks.

Despite this sweeping definition of “broker”, the proposed regulations do provide a few noteworthy exceptions that were excluded from the definition thereby affording much needed relief in industry including:

• Hardware wallets that do not directly allow users to trade, buy, and sell, digital assets (such as a wallet that must be connected to an exchange to complete these transactions)
• Node operators, pure miners, and others who are simply maintaining the blockchain
• Software developers who indirectly facilitate digital asset transactions (by developing code for a company for example)
• Smart contract developers who receive income from a smart contract they created, but don’t do anything to maintain or update it

RSM comments: Many entities that may not have been in scope for reporting under prior guidance will need to reevaluate the impact of this expanded definition of broker on their business models. Newly identified brokers should be prepared and may need to design and implement systems, procedures and controls for complying with reporting requirements, including development of processes for flagging and identifying reportable payments, calculating any required withholding and evaluating their product masters to ensure that products are properly coded may be appropriate.

Back-up withholding required

The proposed regulations also clarify that payments made to U.S. persons that are reportable under section 6045 of the code for which a broker fails to collect a valid IRS Form W-9 may also be subject to backup withholding under section 3406 unless an exception applies. Regulations applicable to backup withholding under proposed treasury reg. section 31.3406(b)(3)-2, 31.3406(g)-1(e) and 31.3406(g)-2(e)) are proposed to apply to sales of digital assets on or after Jan. 1, 2025.

RSM comments:  To the extent that sales or exchanges of digital assets are not associated with valid tax documentation, such as an IRS Form W-9, that is on file for the investor on or before the date of payment, the transaction may be subject to U.S. back-up withholding at a rate of 24%. Brokers that fail to deduct the required withholding tax may be liable for the withholding and may also be subject to penalties of up to 25% of any under withheld tax and 10% penalty for late deposit of any taxes due plus interest.  

In light of the risk associated with noncompliance, it is imperative that brokers design a process for collection, review and storage of tax withholding certificates now. Recognizably, given the nature of the industry – with real-time, paperless transactions by often anonymous investors on fast-paced digital trading platforms - it will be challenging for brokers to collect either official or substitute tax withholding certificates that can withstand the scrutiny of an IRS inquiry. As such, they should seek to understand business requirements now and request budgets as needed so they are better prepared to navigate the road ahead.

New Form 1099-DA Forthcoming

The proposed regulations introduce a new IRS Form 1099-DA that brokers must file with the IRS in order to report gross proceeds from sales or exchanges of digital assets that take place on or after Jan. 1, 2025. Form 1099-DA is the new tax form dedicated to digital assets. It will be issued to investors or traders annually by digital asset brokers beginning in January of 2026.

Under the rules, brokers must also provide payee statements to customers and may also be required to include gain or loss and basis information for sales that take place on or after Jan. 1, 2026, so that customers have the information they need to prepare their tax returns.

• The proposed treas. reg. section 1.6045-1 would require brokers to report gross proceeds from the sale of digital assets if the sale is affected on or after Jan. 1, 2025.
• Proposed treas.  reg. section 1.6045-1(d)(2)(i)(C) would require brokers to report the adjusted basis and the character of any gain or loss with respect to a sale if the sale or exchange is affected on or after Jan. 1, 2026. For assets that are commodities pursuant to the Commodity Futures Trading Commission’s certification procedures described in 17 CFR 40.2, the proposed regulations are proposed to apply to sales of such commodities on or after Jan. 1, 2025, without regard to the date such certification procedures were undertaken.

Since Form 1099-DA is a new form, brokers will need to evaluate the plausibility of building or buying an automated solution for complying with reporting requirements. Since the IRS has not published a draft copy of Form 1099-DA to date, it is challenging for brokers to know or to plan for what to expect. Most presume that exchanges will be required to report information to taxpayers similar to what IRS Form 1099-B captures (i.e., acquisition date, disposition date, cost basis, gross proceeds, etc.) that is sufficient for them to prepare their tax returns and report gains and losses from sales of digital assets, but we await further guidance.

Purchase of goods with digital assets

Under the proposed regulations, transactions involving the exchange of digital assets for goods (other than digital assets) or services will be reportable as shown below:

• the provision of the goods or services would be treated as reportable under sec. 6050W. The proposed regulations applicable to payments made in settlement of payment card and third-party network transactions (proposed treas. reg. section 1.6050W-1) are proposed to apply to payments made using digital assets on or after Jan. 1, 2025;
• the disposition of the digital assets would be treated as reportable under prop. regs sec.1.6045-1 and not under sec. 6050W

According to the proposed regulations, the amount realized in a sale, exchange, or other disposition of digital assets will be determined under IRC Section 1001, specifically in proposed regulation section 1.1001-7(b)(1)(i). The regulations also clarify that calculating basis of digital assets will be determined under proposed regulation section 1.1012-1(h), which states that basis of digital assets acquired in an exchange is generally equal to the cost of the digital assets received at the date and time of the exchange, but will also take into account allocable digital asset transaction costs.

The IRS’ clarification of how the amount realized from the sale of digital assets is calculated is much needed in the industry as many have struggled with understanding requirements that are needed to manage data and program specifications for systems that will drive complex cost basis calculations. Additionally, due to the nature of the industry with anonymous investors and multiple wallet addresses, historical tracking of cost basis will be a daunting proposition.

RSM comments: These changes are expected to apply to all sales and acquisitions of digital assets on or after Jan. 1 of the calendar year after the date the proposed regulations are finalized. The regulations clarify that Taxpayers can rely on the proposed regulations under sections 1001 and 1012 for dispositions in tax years ending on or after the date the proposed regulations are published in the Federal Register (scheduled to be Aug., 29, 2023) if the taxpayer consistently follows the proposed regulations in their entirety and in a consistent manner for all tax years through the applicable date of the final regulations.

Real estate purchases with digital assets are reportable

Another interesting position taken in the proposed regulations is that real estate reporting persons (such as title companies and attorneys), who are treated as brokers with respect to reportable real estate transactions, will now be required to report information on buyers or purchasers of real estate who use digital assets to acquire real estate in a reportable transaction. The reporting changes on real estate transactions, are proposed to apply to real estate transactions with dates of closing occurring on or after Jan. 1, 2025.

Transfer statements

The proposed regulations delay transfer statement reporting under section 6045A(a) and issuer reporting under section 6045B until regulations or other guidance is issued. Accordingly, proposed section 1.6045A-1(a)(1)(vi) has been added to specifically exempt from transfer statement reporting any specified security that is also a digital asset. Transferors that nonetheless choose to provide a transfer statement reporting some or all of the information described in section 6045A are not subject to penalties under section 6722 for failure to report this information correctly. In addition, proposed section 1.6045B-1(a)(6) similarly exempts issuers from reporting on any specified security that is also a digital asset.

Accordingly, under these rules, the transfer of a specified security within the meaning of proposed section 1.6045-1(a)(14)(i) through (iv) or an issuer of a specified security within the meaning of proposed  section1.6045-1(a)(14)(i) through (iv) will not be subject to the section 6045A and section 6045B reporting rules if the specified security also falls within the definition of a digital asset under proposed  section1.6045-1(a)(19). Issuers that nonetheless choose to provide this reporting are not subject to penalties under either section 6721 or section 6722 for failure to report or furnish this information correctly.

Under the Proposed Regs, these changes effecting transfer statements are proposed to apply on or following the date the proposed regulations are finalized. Proposed Sections 301.6721-1(g)(3)(iii) (failure to file correct information returns) and section 301.6722-1(d)(2)(viii) (failure to furnish correct payee statements) have also been modified to include the form prescribed by the Secretary pursuant to proposed section 1.6045-1(d)(2)(i)(B) in the list of forms subject to those penalties.

The proposed regulations applicable to the penalties for failing to file or furnish an information return (proposed Treas. Reg. section 1.6721-1 and 1.6722-1) are proposed to apply to information returns required to be filed with respect to sales effected on or after Jan. 1, 2025.

What’s next?

The risks and implications associated with the proposed regulations extends beyond the mere creation of yet another type of financial product or class of assets that generate reportable income. By introducing these rules, the Service has created a new population of reporters and reporting entities that will undoubtedly provide it with greater insight on and access to data about transactions for investors to which it previously had only limited access. For this reason, it is imperative that brokers and others affected by these rules take steps now to understand the implications for their businesses.    

A public hearing is scheduled for Nov. 7, 2023, at 10 a.m. ET. All comments on the proposed regulations, as well as requests to speak, are due by Oct. 29, 2023, requests to attend the hearing must be received by Nov. 3, 2023, and a second public hearing will be held on Nov. 8, 2023.