By Miles Fuller, Head of Government Solutions, TaxBit
The collapse late last year of FTX, one of the largest centralized cryptocurrency exchanges in the world, and the resulting contagion has garnered the interest of U.S. lawmakers and regulators. After years of talking about crypto, they now seem to be interested in more than just hinting at regulations and standards for digital assets.
That’s a good thing. Far from being limiting factors, regulations safeguard consumers’ assets, eliminate the threat of noncompliance, mitigate illegal activities, reduce transaction costs and market uncertainty, and stimulate robust business operations. They also protect investors from unwitting managers and consumers from nefarious business practices while providing clarity to entrepreneurs so products and business systems can be developed with less risk or uncertainty.
The Federal government agrees with the need for regulations for blockchain. The IRS’s recent pivot to using Congress’ term of art “digital assets” to describe virtual currency is a great example. The IRS defines digital assets as all crypto assets, including NFTs and stablecoins. Congress and the Treasury Department are merely imposing on the digital-asset ecosystem the same tax reporting rules that have long existed for traditional finance.
The agency’s position complements the requirements of the Infrastructure Investment and Jobs Act (IIJA), which details clear tax reporting rules for digital asset brokers, transfer statement reporting, and more, that were scheduled to go into effect on Jan. 1, 2023. But what will those regulations be, and how will they impact organizations engaged in the exchange of digital assets?
Lessons From Traditional Finance
In the wake of the FTX collapse, SEC Commissioner Hester Peirce stated that the crypto market needs to “take some basic lessons from traditional finance.” Fittingly, the rules imposed through the IIJA are already taking that approach in the tax world.
The rules are designed to reduce the tax-reporting burden on individuals by requiring brokers to provide easy-to-understand information about the tax impact of transactions conducted on their platforms. This information is shared with the IRS to streamline the review of tax returns filed by individuals and promote transparency and compliance.
For example, under the IIJA digital asset brokers are required to file Forms 1099 with the IRS and provide copies to customers. The forms will include specific tax information about digital asset transactions that the customer engaged in during the year.
This type of information sharing has never really existed in the digital asset space. Platform users generally do not receive any periodic statements and are only able to download data files for use in year-end tax calculations.
The new IIJA provisions completely change this and bring information reporting for digital assets in line with longstanding rules for traditional finance. Traditional financial investors receive Forms 1099 from their brokers summarizing what assets they bought and sold and the tax impact of those transactions. Digital asset investors will receive the same information.
As with securities, IIJA also requires digital asset brokers to share acquisition cost information with other brokers when assets are transferred. This allows the broker receiving the transferred asset to properly complete a Form 1099 when the asset is sold by including accurate purchase price information.
This will be a massive step toward reducing the tax-reporting burden on individuals in the digital asset space. This type of transfer reporting has been a stock market staple for more than a decade and has significantly reduced the burden of tax preparation in that space because all of the information is provided to the taxpayer from the broker. In the digital asset ecosystem, where transfers among brokers and platforms are more frequent, this type of reporting will have a similar impact.
However, certain hurdles remain.
Defining who is a Broker
One of the biggest issues is how to appropriately define who or what constitutes a digital asset broker that is subject to these reporting rules. In traditional finance, brokers are relatively easy to spot – they facilitate the transfer or trade of securities on behalf of their customers. But the digital asset ecosystem functions differently.
The nature of blockchain technology means that transactions can occur or marketplaces exist where assets are traded without the need for an actual business or individual to facilitate those transactions. In these situations, transactions are facilitated by a computer protocol that operates autonomously without any human oversight. Developers of these protocols argue that IIJA compliance is impracticable. The argument is that without any human involvement or oversight, there is no “broker” who can be held responsible for meeting the requirements.
It is unclear how the Treasury Department will address these situations or to what extent they will impose reporting requirements on platforms that operate autonomously in the decentralized finance space. This is not an easy problem to solve and regulatory overreach may negatively impact growth and development in the decentralized financial market. Of course, limiting the application of IIJA rules will be equally problematic because the goal of the regulations will not be met and taxpayers will continue to be left with limited or unhelpful information for tax purposes.
Digital Asset Functionality
Further, if an individual taxpayer personally holds digital assets and moves those holdings into and out of digital asset broker platforms, the effectiveness of IIJA reporting will be reduced, since individuals are not required to report personal transfers. However, requiring brokers to report transfers that are not sent to other brokers should help the IRS and taxpayers understand how to account for these units and properly file their taxes.
There are other IIJA requirements pertaining to the ability of digital assets to function like currency in some settings. For example, the transfer of digital assets exceeding $10,000 has its own reporting requirements that mirror the rule governing the receipt of physical cash by businesses. By imposing rules requiring the disclosure of high-value transfers of digital assets, Congress is seeking to put up informational guardrails around digital assets.
A Good First Step
While questions remain, the requirements contained in the IIJA are a first step at imposing needed regulations around digital assets. The reporting requirements will undoubtedly help the ecosystem continue to mature.