INTRODUCTION

The I.R.S. recently issued the first of a set of what is expected to be several sets of proposed regulations to provide greater clarity on the application of information-reporting rules.

EXISTING LAW

I.R.S. Notice 2014-21 provides guidance on reporting digital assets received as compensation. However, the notice is silent on reporting the sale or exchange of digital assets or the use of digital assets to purchase product or services. The Proposed Regulations aim to fill that gap.

As the preamble explains, "digital assets" are digital representations of value that use cryptography to secure transactions that are digitally recorded using distributed ledger technology such as blockchains. Individual units are sometimes called coins or tokens. Digital assets include cryptocurrency (also known as virtual currency). Owners of digital assets can access their digital assets and conduct transactions with them using what is known as a wallet.

The following provisions of the Code already apply to sales of digital assets:

  • Code §1001 and §1012 set the basic income-tax rules for applying cost basis and calculating gain apply to sales.
  • Code §6041 requires a person who makes payments of $600 in fixed or determinable income in the course of a trade or business to file information reports and furnish payee statements to the payee.
  • Code §6045 requires brokers to file information returns and furnish payee statements for customers on whose behalf the broker sold shares of stock, certain commodities, options, regulated futures contracts, securities futures contracts, forward contracts, or debt instruments in exchange for cash.
  • Code §6045A requires certain persons who transfer certain securities to a broker to furnish statements to the broker.
  • Code §6045B requires certain securities issuers to provide reports to the I.R.S. and to shareholders regarding the effect on basis of certain organizational actions, such as stock splits, mergers, and acquisitions.
  • Code §6050W requires banks and other entities to file information returns and furnish payee statements regarding certain payments in settlement of reportable payment transactions.

The Infrastructure Investment and Jobs Act

The Infrastructure Investment and Jobs Act of 2021 provided some guidance on the application of §6045 and §6045A:

  • The term 'broker' specifically includes any person who regularly provides services effectuating transfers of digital assets on behalf of another person.
  • "Specified securities" under §6045(g) (which requires that the information reported include basis and the character of the gain) explicitly include digital assets. The requirements under §6045(g) apply to digital assets acquired in 2023 or later
  • A "digital asset" is defined as any digital representation of value recorded on a cryptographically secured distributed ledger or any similar technology.
  • Code §6045A specifically applies to digital assets and adds more reporting requirements for transfers of digital assets.
  • These new provisions are not applicable for periods prior to the effective date of the new provisions.

NEW RULES

The proposed regulations are focused on Treas. Reg. §1.6045-1. Later rulemaking will focus on Code §6045A.

Expansion of Reporting Obligations

As it currently exists, Code §1.6045-1(a)(9) provides that Code §6045 comes into play only if the property disposed of is a security, commodity, option, regulated futures contract, securities futures contract, or forward contract in exchange for cash.

The proposed regulations add to this list a disposition of digital assets in exchange for cash, other digital assets, stored-value cards, broker services, or other property subject to Code §6045.

Defining Digital Assets

The proposed regulations use the same definition of "digital asset" as in the Infrastructure Investment and Jobs Act, underlining the importance of cryptography in the definition.1 But an asset can be a digital asset even if not all transactions involving that asset are actually recorded on such ledgers. The example given in the preamble is a broker who carries out transactions between customers in its internal ledger and only uses the secured ledger to execute net purchases.

The definition is meant to capture traditional cryptocurrency as well as newer technologies, such as stablecoins or N.F.T.'s. However, the new rules do not cover tokens that can only be used in a computer game or digital representations of fiat currency (e.g., U.S. dollars sitting in an online bank account).

The preamble explains that the classification of digital assets as securities is for the limited purpose of information reporting. A digital asset that might also be a security or commodity is to be treated as only a digital asset for reporting purposes.2 One area left unresolved is conventional broker transactions that are carried out on blockchain technology. The proposed regulations decline to carve out an exception because of uncertainty over the frequency of such transactions, but that may change with the final or future regulations.

Defining Brokers

The proposed regulations expand the circumstances in which a person is a broker. The definition now covers a person that provides facilitative services that effectuate sales of digital assets by customers in the course of its trade or business. Whether someone effects transactions in digital assets on behalf of others depends on whether the person is in a position to obtain identity information.3 This phrasing reflects the fact that certain digital-asset trading platforms allow for a great deal of anonymity for its users. But the ability to modify the operation of a platform to obtain user information is treated as being in a position to know a user's information. This is designed to prevent operators of platforms from deliberately raising the level of anonymity in their platforms in order to avoid reporting obligations.

The regulations are not intended to cover persons engaged in the business of providing distributed ledger validation services, such as proof-of-work or proof-of-stake mechanisms. Such persons are conventionally known as miners. Because miners are typically not in a position to know the identity of transacting parties, engaging solely in mining is excluded from the definition of brokers.4 For similar reasons, persons who are solely providers of wallet software are also excluded. But the exclusion is not available if the wallet software provides direct access to trading platforms from the wallet.

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Footnotes

1. Prop. Reg. §1.6045-1(a)(19)(i).

2. Prop. Reg. §1.6045-1(c)(8)(i).

3. Prop. Reg. §1.6045-1(a)(10).

4. Prop. Reg. §1.6045-1(a)(21)(iii)(A).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.