On August 29, 2023, the Internal Revenue Service (IRS) issued new proposed regulations[1] regarding reporting obligations for parties engaged in certain digital transactions. The proposed regulations address the reporting responsibilities of brokers in the digital asset market and target transactions where digital assets are exchanged for cash or other property which requires broker reporting, such as for securities, real estate, or other digital assets under Section 6045 of the Internal Revenue Code.[2] Comments and requests to speak at the November 7, 2023 hearing on the proposed regulations are due by October 30, 2023.
Clarification of the Definition of “Broker”
Section 80603(a) of the Infrastructure Investment and Jobs Act (the “Infrastructure Act”) clarified that the term “broker” under Section 6045 includes anyone responsible for providing regular services effectuating digital asset transfers on behalf of another person. While the proposed regulations do not change the definition of “broker” under Reg. § 1.6045-1(a)(1), they modify the definition of “effect” under Reg. § 1.6045-1(a)(10)(i) and (ii) to hold that any person who provides services facilitating services to effectuate the consumer sales of digital assets can be considered a broker.
This modification of the definition of “effect” seeks to take into account whether a person has the ability to know a customer’s identity, not whether a person would ordinarily know the information. This specifically recognizes that some trading platforms may not request customer information, or only require limited information, but retain the ability to obtain it by updating internal protocols and the platform itself.
Specifically excluded as not providing facilitative services that could be considered within the definition of a “broker” are those solely providing distributed ledger validation services only, as well as those selling hardware or licensing software used only to control access to digital assets on a distributed ledger.[3] However, providers of digital wallet software are not excluded.[4]
Expanded Reporting Requirements
The proposed regulations expand how “sale” is defined for reporting purposes.[5] “Sale” will now include dispositions of digital assets for stored-value cards, different digital assets, or cash.[6] A “stored-value card” is either a physical or digital card that has a prepaid value in U.S. dollars, convertible foreign currency, or a digital asset.[7]
“Sales” will also include dispositions of digital assets in exchange for property, to include securities or real property, that is subject to reporting under Section 6045.[8] An example provided by the IRS includes a stockbroker accepting a digital asset as payment for a customer’s stock purchase. In such an example, the receipt of the digital asset by the stockbroker will be treated as a sale by the customer for Section 6045 purposes. The same rules will apply to purchasers of real estate who use digital assets as consideration.[9]
Accepting digital assets for broker services compensation will also be considered a disposition of the asset subject to reporting and tax.[10] However, “broker” status for this rule is determined without regard to if the person receiving the asset as payment for services regularly accepts digital assets as consideration.[11] The IRS provides the example of the difference between a stockbroker and a landscaper accepting a digital asset as compensation for services. In the former, the transfer of the digital asset is treated as a sale for Section 6045 purposes because the broker regularly effects stock sales; the latter is not a sale of digital assets for Section 6045 purposes because the “broker” determination is made without regard for the if the service provider regularly accepts digital assets as consideration in their trade or business.
The proposed regulations also seek to address the use of digital assets to pay for other services and payment obligations. As a result, a “sale” will include payment of a digital asset to a digital asset payment provider in return for the payment provider’s processing the payment to a different digital asset or cash to another person.[12] “Sale” will also include transfers directly to a second person under a processor agreement that temporarily fixes the exchange rate to be applied to the digital asset received.[13]
Further, the proposed regulations also seek to address customers entering into executory or derivative contracts.[14] To achieve this, the proposed regulations expands “sale” to include digital asset delivery pursuant to a settlement of a forward contract, option, regulated futures contract, any executory contract, or any similar instrument.[15] However, a digital asset contract requiring delivery of personal property, the initial purchase or grant of an option related to a digital asset, or exercising a call option of a digital asset for physical deliver is excluded from the definition of a “sale.”[16]
Also excluded from the definition of a sale are transactions where a customer receives a new digital asset without disposing of another digital asset or something else in exchange for it.[17] This exclusion also includes the receipt of digital assets from an airdrop, even if holding an existing digital asset was the reason the new digital asset was received.[18] As a result, according to an example given by the IRS, a “sale” does not include a broker’s customer receiving new digital assets as a reward for marketing-related services.
Certain transactions are also left unaddressed by the proposed regulations. Included in these is whether loaning digital assets is subject to the reporting requirements, or transfers to and from a liquidity pool. For transactions such as these, the IRS specifically is asking for comment on the proposed regulations.
Information to be Reported
Most required information is similar to what is required on the IRS Form 1099-B for securities.[19] Under the proposed regulations, an information return is required to be filed by a broker for the sale of a digital asset, and must provide the customer’s name, address, and taxpayer identification number; name or type of asset sold; number of units sold; date and time of the sale; gross proceeds; and any other information required by the form or its instructions.[20]
Similarly, the proposed regulations also require information to aid in the verification of valuations. This information includes the transaction identification number (if any); the addresses from which the digital asset was transferred (if any); and what form of consideration was received, such as cash, other digital assets, property, or services.[21] Further, if the digital asset’s sale also meets the requirements of the sale of a security, then information required for securities reporting purposes is also required.[22] Forms for reporting these transactions will also be made available by the IRS.
Determining Gross Proceeds in Digital Asset Transactions
Generally, the proposed regulations and reporting rules follow the calculations provided by Section 1001 of the Code and the regulations promulgated thereunder. “Gross proceeds” is the sum of the total U.S. dollars paid to a customer or credited to their account as a result of the transaction, the fair market value of any property received for the digital asset, and the fair market value of any services received for the digital asset reduced by the amount of costs for the transaction.[23]
Fair market value of the property or services received is calculated pursuant to proposed regulations under Section 1001.[24] The date for determining the fair market value is set as the day the transaction is affected.[25] For services provided in exchange for a digital asset, brokers must use a reasonable valuation methodology, which includes a requirement that the broker look to the fair market value of the digital asset in determining the fair market value of the services.[26]
When one digital asset is exchanged for another, brokers may rely on a valuation from a digital asset data aggregator.[27] Because the number of exchanges, among other factors, may affect valuation using this method, the proposed regulations hold that using this method is unreasonable if it results in over-weighing prices associated with digital asset exchangers with low trading volumes, or under-weighs prices near the median value.[28]
“Digital asset transaction costs” are defined as the amount paid to effect a transaction resulting in the disposition or acquisition of digital assets.[29] The transaction costs for the sale of digital assets are generally just those paid by the customer which can be generally allocated to the disposition of a digital asset.[30] However, an exception applies if the digital asset is exchanged for another digital asset effectively in-kind.[31] In such instances, half of the transaction costs paid in cash or property to effect the transaction should be allocated to the disposition of the transferred asset, and the other half to the received asset.[32]
Adjusted Basis in Digital Asset Transactions
The existing rules in Treasury Regulation § 1.6045-1(d)(6)(i) and 1.6045-1(d)(6)(ii)(A) still apply in determining the adjusted basis of securities subject to broker basis reporting rules, even if it does not meet the existing definition of a “security.”[33] Specifically modified are the rules regarding the sale of a digital asset, where the transaction costs are added to the initial basis.[34]
The proposed regulations do add special rules for the determination of the initial basis of digital assets exchanged for property, such as real property or other digital assets. The initial basis of digital assets exchanged for property (excluding certain debt instruments under proposed reg 1.102-1(h)(1)(v)) is the fair market value of the asset received at the time of the exchange plus any transaction costs allocable to acquiring the digital asset.[35]
Ordering Rules
The proposed regulations under Sections 6045 and 1012 deal with the sale of digital assets when the customer previously acquired or transferred multiple units of the same asset for different prices or on different dates.[36] Brokers are required to report sales of less than a full position in an account pursuant to a customer’s identification of the digital assets to be disposed of.[37] The rules are similar to when lots of stock are to be sold, but less than all of the shares are sold.[38]
If the broker does not receive an adequate identification from the customer by the time of the sale, then first-in-first-out ordering applies.[39] Once rules under Section 6045 of the Code are released, it is expected that brokers receiving transfer statements regarding transferred-in digital assets may use the actual purchase date of such digital assets in determining which units were first transferred into the customer’s account with the broker.
Reporting Exceptions
The exceptions under the existing language of Treasury Regulation 1.6045-1(c) apply for tax-exempt recipients and exempt sales. Additionally, the special “multiple broker rule” under the Treasury Regulation 1.6045-1(c)(3)(iii) remains, which permits brokers to not file an information return if instructed to sell by certain exempt recipients on behalf of a customer.[40]
Foreign Sales
The proposed regulations do not base the determination of whether a sale is effectuated at an office in or outside of the United States on physical location where the acts effecting the digital asset sale take place.[41] Rather, the proposed regulations parse “broker” into one of a series of categories: a U.S. digital asset broker, controlled foreign corporation (CFC) asset broker, or non-U.S. digital asset broker.[42]
As a result, the determination on where a sale is effectuated starts by referencing the broker’s classification under the proposed regulations, not based on the location of the broker’s activities.[43] Generally, sales by U.S. digital asset brokers are considered effected inside the United States; sales by CFC asset brokers and non-U.S. brokers are treated as being effectuated outside of the United States.[44]
Generally, U.S. and CFC digital asset brokers must report digital asset sales unless the customer can be treated as an exempt foreign person or another exception applies.[45] Similarly, for sales considered effected in the Unites States, non-U.S. digital asset brokers must report the sale unless the customer can be treated as an exempted foreign person. Generally, brokers may treat a customer as an exempt foreign person based on documentation provided by the customer, or even on a presumption of the customer’s exempt foreign status in some situations. However, if the customer is a U.S. person, or presumed to be, that is not an exempt recipient, then the broker is required to report information on the customer’s sale until documentation can be provided which proves otherwise.[46]
The transition period given to allow time for digital asset brokers to secure documentation from existing customers, digital asset brokers may treat an customers as exempt foreign persons if the customer was not previously classified as a U.S. person and the address provided by the customer in opening the account includes a residence outside the U.S.[47] This transition period covers all digital asset sales effectuated before January 1, 2026 where the asset(s) where held in an account established before January 1, 2025.[48]
Real Estate and Digital Asset Transaction Reporting
Reporters of real estate transactions should also report the fair market value of assets received by sellers of real estate.[49] Where payment for real estate is made with digital assets, real estate reporting persons should report the number of units and name of the digital asset, the date of the payment, the transaction identification number, and the digital asset address(es) to which the digital asset was transferred.[50]
The definition of gross proceeds for real estate transactions is also expanded by the proposed regulations. First, total cash received by or on behalf of a transferor in exchange for digital assets is specifically included.[51] Second, “cash . . . to be received” in Treasury Regulation 1.6045-4(i)(1) is replaced by “consideration treated as cash” in the proposed regulations.[52] Last, the proposed regulations hold that gross proceeds include the value of digital assets received by or on behalf of the transferor.[53]
The proposed regulations also update language related to Section 6045(e)(3) of the code.[54] Under these provisions, it is not lawful for a real estate reporter to charge a customer separately for complying with reporting obligations under Section 6045.
Effective Dates
The final version of the proposed regulations to take effect will be subject to modification after the review and comment period, which includes a public hearing scheduled for November 7 and 8, 2023. Subject to any change as a result of those hearings and the comments received, the portions of the proposed regulations addressing calculation of gain, loss, or the adjusted basis of assets are set to apply to sales and acquisitions of digital assets effectuated on or after January 1, 2024. The remainder of the proposed regulations are to apply to transactions effectuated on or after January 1, 2025, including gross proceed reporting requirements, the regulations applicable to assets subject to Commodity Futures Trading Commission certification, real estate transactions reporting requirements, withholding for digital asset transactions, and penalties for failing to file or furnish the required information.
Conclusion
As digital assets become more commodified and their use as both investments and currency increases, regulators and taxing authorities will continue to add digital assets to the currently existing framework of regulation and taxation. As such, the policy and principles underlying the proposed regulations remain the same as for other asset and transaction types, with the goal being to adapt the Code and regulations to fit a new type of asset and transaction model.
Nelson Mullins will continue to monitor the status of the proposed regulations and provide updates as appropriate.
[1] REG-122793-19, 88 F.R. 59576-59659.
[2] References to “Section” in this Report refer to Sections of the Internal Revenue Code of 1986 (the “Code”) and references to “Reg. §” refer to Proposed and Final Regulations promulgated under the Code.
[3] Prop. Reg. 1.6045-1(a)(21)(iii)(A).
[4] Id.
[5] See Prop. Reg. 1.6045-1(a)(9)(ii).
[6] Prop. Reg. 1.6045-1(a)(9)(ii)(A)(1) and (2).
[7] Prop. Reg. 1.6045-1(a)(25).
[8] Prop. Reg. 1.6045(a)(9)(ii)(B).
[9] See Id. and Reg. 1.6045-4(e) (defining a real estate reporting person).
[10] Prop. Reg. 1.6045-1(a)(9)(ii)(C).
[11] See Id.
[12] Prop. Reg. 1.6045-1(a)(9)(ii)(D).
[13] See Id.
[14] See Prop. Reg. 1.6045-1(a)(9)(ii)(A)(3).
[15] See Id.
[16] Prop. Reg. 1.6045-1(a)(9)(ii)(A).
[17] See Prop. Reg. 1.6045-1(a)(9)(ii).
[18] See Id.
[19] See Prop. Reg. 1.6045-1(d)(2)(i).
[20] Prop. Reg. 1.6045-1(d)(d)(i)(B).
[21] Prop Reg. 1.6045-1(d)(2)(i)(B).
[22] See Id.
[23] Prop. Reg. 1.6045-1(d)(5)(ii)(A).
[24] See Prop. Reg. 1.1001-7(b).
[25] Prop. Reg. 1.6045-1(d)(5)(ii)(A).
[26] See Prop. Reg. 1.6045-1(d)(5)(ii)(A).
[27] Prop. Reg. 1.6045-1(d)(5)(ii)(A).
[28] Prop. Reg. 1.6045-1(d)(5)(ii)(A).
[29] Prop. Reg. 1.6045-1(d)(5)(iv).
[30] Id.
[31] See Id.
[32] See Id.; Prop. Reg. 1.1001-7(b) and Prop. Reg. 1012-1(h).
[33] Prop. Reg. 1.6045-1(d)(6)(i) and 1.6045-1(d)(6)(ii)(A).
[34] Prop. Reg. 1.6045-1(d)(6)(ii)(A).
[35] Prop. Reg. 1.6045-1(d)(6)(ii)(C)(1).
[36] See Prop. Reg. 1.6045-1(d)2)(ii)(B) and Prop. Reg. 1.1012-1(j)(3).
[37] See Id.
[38] See Prop. Reg. 1.1001-7, 1.1012-1(h), and 1.1012-1(j).
[39] Prop. Reg. 1.6045-1(d)(2)(ii)(B).
[40] See Regs. 1.6045-1(c)(3)(i)(B)(6), 1.6045-1(c)(3)(i)(B)(7), and 1.6045-1(c)(3)(i)(B)(11).
[41] See Prop. Reg. 1.6045-1(g)(4).
[42] See Id.
[43] See Id.
[44] See Id.
[45] See Id.
[46] See Prop. Reg. 1.6045-1(g), Reg. 1.6045-1(c)(3).
[47] Prop. Reg. 1.6045-1(g)(4)(vi)(F).
[48] See Id.
[49] See Prop. Reg. 1.6045-1.
[50] Prop. Reg. 1.6045-4(h)(1)(vii).
[51] Prop. Reg. 1.6045-4(i)(1).
[52] Id.
[53] Id.
[54] See Prop. Reg. 6045-4.
