Reporting Requirements for Crypto Brokers
Over the last six years, the federal government has been attempting to craft regulations in the cryptocurrency market. These attempts have been slow as politicians and regulators climb the learning curve that comes with a new technology and nascent asset class. One area where the federal government has made strides is within the Department of Treasury (DOT). The DOT is the main department that houses the Internal Revenue Service, the Office of Inspector General, and FinCEN. These agencies are at the forefront of criminal enforcement for various financial crimes, including criminal tax, bank secrecy violations, and financial reporting fraud. Since 2017, the DOT has issued a host of notice letters and regulations aimed at clarifying the rules in the crypto market. These regulations have, in large part, been focused on capturing tax dollars and preventing illicit use of distributed ledger technology. Their hope is to bring the cryptocurrency market in line with traditional asset markets.
In prior posts, we have reviewed specific IRS guidance outlining the treatment of crypto transactions and given an overview of the federal task forces who focus in this area. In June 0f 2024, the DOT added another important building block in their road to full regulation – reporting requirements for crypto brokers. This regulation may be the most important step in bringing crypto investing out of the wild west. This new regulation uses the current stock broker blueprint to clarify the demands for crypto brokers in reporting transactions. This post will review the DOT notice letter on this topic and analyze some of the holes in the DOT’s plan to treat crypto brokers the same as well-known online stockbrokers.
When I started writing this post, I felt a two-part series would be sufficient to cover both the contents of the regulation and an analysis of the pitfalls in the DOTs stance. However, the DOT received numerous comments to the regulation as initially proposed. The government spent a great deal of time answering these comments, including instances where the DOT agreed with the complaint and amended the statute. Nearly all the comments and finalized language is vital to understanding the current regulatory environment. For that reason, this series may contain four or five parts to ensure everything is covered.
To be clear, the importance of this regulation is two-fold: 1) the regulation will have impacts on nearly every aspect of the crypto market from centralized exchanges (like Coinbase and Kraken) to decentralized finance platforms (like Aave and Uniswap) and 2) these regulations are likely to give the IRS and FinCEN the foundation to begin pursuing criminal cases on companies and investors.
Information Returns in Classic Asset Classes
The regulation focuses on creating a network of information returns to track crypto transactions across the market. Information returns are an important tool within the DOT’s regulatory arsenal. Most people are familiar with common information returns such as 1099s, W-2s,1099-Bs, and 1099-DIVs. These returns are filed by employers or brokers to advise the IRS of income for workers and gains realized by investors. The 1099-B and 1099-DIV are the most relevant here as those are the filings current stock brokers submit to the IRS to calculate capital gains, dividend income, and other taxable events on behalf of their customers. These returns serve two main purposes. First, they alert the IRS that certain taxable events have occurred that are tied to a specific taxpayer. This information makes it far more likely the taxpayer will accurately report their income and gains on their yearly return. If the taxpayer does not, it creates an easy route to flagging a particular taxpayer for audit or recalculation of amounts owed. Second, the form simplifies the often-complicated process of determining gains and dividend yields. Many taxpayers are not equipped to accurately calculate their basis and gains when multiple trades in a similar asset exist. The reporting requirement forces the broker to make those complicated calculations and submit the final numbers to the taxpayer. The 1099-B and other information returns ensure accuracy in the taxes owed and serve as a safety net to ensure taxpayers are not cheating the federal government. The framework outlined above is now being applied to cryptocurrency brokers under the new notice from the DOT.
What is a Digital Asset under the New Regulation?
The new regulation only applies to digital assets as defined under the amended regulation. Though the DOT decided to define digital assets broadly, encompassing most cryptocurrencies in the market, they carved out some areas for exclusion or special consideration. These highlighted assets were chosen because they either do not meet the definition of a “digital asset” or reporting requirements would be absurd considering the expected revenue. The following will review areas where comments were submitted and the impact of their decisions:
- Stable Coins Receive Special Treatment
Stable coins are cryptocurrencies that are tied to the United States Dollar at a 1:1 ratio. These coins serve as a low-risk route for users to hold digital dollars that can be easily swapped for other crypto tokens. Most trades on Coinbase, and any other crypto exchange, come from trading USDT/USDC for another crypto token with more volatility. For instance, if a crypto trader wants to quickly buy Bitcoin or Ethereum, they will often hold USDC on Coinbase. They can set their spot orders, wait for the trade to execute, and now hold the equivalent value of a token that will result in a significant gain or loss over time. In addition, if the taxpayer wants to buy a token that is unavailable on Coinbase, they can quickly transfer their stable coin to a new exchange to execute the transaction. A similar feat cannot be easily performed when a user is holding actual USD.
Though these scenarios above are common, the actual trading of the stable coin is unlikely to ever result in a significant gain or loss due to the value remaining stagnant. It is the subsequent trade of the more volatile crypto token that will result in relevant gains or losses for the DOT’s purposes.
Given these realities, the DOT decided to provide special broker reporting requirements for stable coin transactions. The special requirement allows the broker to aggregate all stable coin transactions in the information return. Additionally, if the aggregate gain or loss is de minimis, the regulation dispenses with the reporting requirement altogether. This decision makes a ton of sense. It would be cumbersome and unproductive to force a crypto broker to report the basis and sales proceeds for a user that bought and sold USDC in the example above. The information return would likely contain numerous transactions stating User A bought 1,000 USDC for $1,000 then swapped 1,000 USDC for $1000.02 worth of Bitcoin. The resulting gains or losses would be de minimis or nonexistent. For these reasons, the DOT took the intelligent step and provided special rules for stable coin transactions. (you can read more on when a crypto transaction becomes a taxable event, here).
- NFTs are Digital Assets and Must Be Reported
NFT is an acronym for “non-fungible token.” These are tokens held on a blockchain that represent ownership in a specific item that has value. Unlike other crypto tokens, NFTs are used to prove ownership in a singular item. The value does not come from the actual token, but rather, the item that is owned by holding the NFT.
An example will likely assist in understanding this topic. Let’s assume a taxpayer owns a piece of art that is valued at $1,000,000. This taxpayer does not hold the art in his home. He holds ownership through an NFT that exists in his crypto wallet. That NFT is now worth $1,000,000. If he wanted to sell that piece of art, he could transfer the NFT to another person’s wallet instead of transferring the physical art or transferring a paper title. This same logic could be used to prove home ownership (doing away with the archaic deed system where things are easily forged). Projects applying this logic are all over the crypto space as the use of NFTs to prove ownership of real world items is a more secure, efficient process than the current system.
Right now, the most well-known NFT use case involves holding digital art. In 2017, following Ethereum going live, multiple people created digital art projects. These included the Ape Yacht Club, Crypto Kitties, and others. Ownership of these pieces of digital art was verified by holding the NFT tied to a particular piece. The value of the NFT was entirely reliant on the perceived value of the digital art underlying it.
Multiple comments were submitted to the DOT requesting they exclude NFTs from the definition of a “digital asset.” Their argument was NFTs are not a representation of value as required under broker regulations, but rather, the value is derived from the underlying asset. The DOT shot down this argument noting the absurdity that would result from such a stance. If NFTs were excluded under that logic, the DOT would have to exclude tokens that represent securities and other assets that have clearly fallen under the broker regulations for forty years. Under the regulation, a broker is required to report gains in NFT projects bought and sold on their platforms.
This stance by the DOT makes some sense. In 2024, there is a push by numerous venture capitalists to tokenize securities, commodities, and real property through NFTs. Many platforms already offer this service. If these platforms gain acceptance, a taxpayer could hold 20 shares in Apple by holding an NFT token tied to the security. The sale of 20 shares of Apple is clearly a taxable event that falls under the broker reporting requirements. This logic led the DOT to refuse any changes or exceptions for NFTs.
- Closed Loop Assets
A closed loop is a class of virtual assets that can only be transferred within a closed loop network. Put differently, the virtual asset cannot be traded on an exchange and are generally not bought and sold for gains. These assets include digital entries for supply chain and other industrial use cases.
The DOT acknowledged the regulations should not apply to these closed loop assets as they are not sold on exchanges or generally swapped for monetary gain. The regulation clearly excludes closed loop assets from the definition of “digital asset” within the regulation.
- Fund Holdings are Not Digital Assets
In early 2024, the SEC approved various ETFs in Bitcoin. The expectation is that other cryptocurrency ETFs will be approved shortly. The DOT noted that a taxpayer that holds a unit in an ETF does not actually hold any cryptocurrency. Instead, the underlying digital asset is held by the owner or producer of the fund. Based on this reality, the DOT clarified that ETF units based on a digital asset are not themselves “digital assets.”
This distinction has little effect on the reporting requirement as there are established regulations for reporting gains and losses in an ETF unit. However, the DOT found it important to provide guidance to brokers on which form should be used when reporting these transactions.
Conclusion
Aside from the specific issues discussed above, nearly every crypto token falls under the definition of a digital asset. It is important to remember the DOT is not taking a position on whether the digital asset is a security, commodity, or something else. Those issues will be resolved by the SEC, CFTC, and the federal courts. This regulation is designed to clarify reporting requirements for brokers who facilitate trading any digital asset. Their status before the SEC is irrelevant to that charge. For crypto exchanges or facilitators that fall under the “broker” definition, it is clear that nearly every transaction will trigger a reporting requirement under this new regulation.
In the next post, we will review the definition of a broker under the statute. The DOT was faced with some difficult questions in this area as they addressed the status of decentralized exchanges and DeFi platforms.