Reporting Requirements for Brokers (Part III)
This is the third part in a series of posts analyzing the new Department of Treasury regulation for crypto brokers. In part one of this series, we discussed the overarching standards for information returns and the definition of a “digital asset” in the new regulation. In part two, we reviewed the definition of a “broker”; focusing on classic exchanges, wallet providers and payment processing applications. These first two posts clarified what assets are subject to the regulation and what crypto platforms are required to report. In this third part, we will begin to drill down into the individual transactions. The goal of the DOT is to obtain efficient information from brokers on the potential tax liabilities associated with a given taxpayer. In that vein, the regulation ties its reporting requirements to taxable transactions. These transactions have been detailed in IRS notices in 2021 and revenue rulings in 2023. The DOT left these prior standards largely unchanged in the new regulation.
The Focus is Transactions with Tax Consequences
The federal government understands the volume of financial transactions conducted by United States’ citizens. They do not have the manpower, or the incentive, to request reports on every transaction. To combat this reality, the government focuses their reporting requirements on transactions that have value. The government does now wish to sift through millions of information returns to find the few notations that affect their bottom line.
Through this lens, it is clear why the DOT created special rules for stable coin transactions (they nearly always involve no relevant gain or loss). It is also clear the DOT is not going to request informative filings tracking the movement of cryptocurrencies that do not result in a taxable event. The DOT is searching for an efficient balance between voluminous paperwork and ensuring maximum tax revenue.
Under the new regulation, crypto brokers must report all “sales” of a digital asset. A sale is defined as a sale for cash, a swap for another digital asset, or the disposition of a digital asset for payment. This definition tracks the 2021 notice of a taxable transaction closely. The DOT views all three transaction categories as events that trigger a gain or loss calculation. Below, we will review each category.
Selling a Digital Asset for USD
This is the easiest transaction to follow as it mimics common transactions on legacy stock exchanges. If a user sells BTC for United States Dollars (USD), the user has conducted a taxable transaction. The taxpayer would be required to calculate their basis and proceeds from the sale. The gain or loss must be reported the gain or loss on that year’s tax return.
Under the information return regulation, the broker who facilitated the sale would be required to submit a return to the taxpayer and the IRS with these calculations. This information return would ensure the taxpayer is accurately reporting their gains to the government.
Swapping for Another Digital Asset
Though this rule was clarified in 2021, there continues to be confusion on this topic in the crypto space. The DOT has previously ruled that a taxable event occurs when one swaps a digital asset for another. For example, if a Coinbase user swaps 1 BTC for 20 ETH, they have conducted a taxable transaction that requires the calculation of the gain or loss in the underlying BTC. The government does not draw a distinction between fiat currencies and digital assets.
Numerous comments were submitted to the DOT requesting they exclude digital asset swaps from the definition of a sale. These comments sought to isolate digital asset to fiat currency sales as the sole avenue for taxable entries. As they did in 2021, the government shot down this request. Any time a taxpayer disposes of a digital asset via a token swap, they must calculate gains or losses on the underlying token.
Once the DOT reaffirmed their stance on the taxable nature of token swaps, they clearly stated crypto brokers are required to file information returns detailing these transactions.
Buying Things With Digital Assets
The final area is the tax implications of buying goods with digital assets. The DOT clarified in the regulation that purchasing goods with a digital asset results in a taxable event for the underlying token. For instance, if a taxpayer buys a pizza for .001 BTC, the taxpayer would be required to calculate their gains or losses on the .001 BTC sale. The payment processor would be required, subject to the rules discussed in the second post, to report the disposition and sales proceeds.
It is easy to understand why the DOT implemented this overarching rule. However, this rule will likely have to be tailored if/when digital assets become normal for everyday payments. If society regularly pays for goods with digital assets, the DOT regulation is going to result in millions of pages of information returns flagging miniscule transactions. This section can skew the balance between tax revenue generation and efficient reporting. We will see how this portion of the regulation evolves over time.
Carving Out Various Transactions
The three transaction categories above encompass digital asset sales under the new regulation. However, the token swapping definition became troublesome for the DOT when it was applied to certain unique situations. Multiple comments were put forward asking for the DOT to institute special treatment for staking rewards, LP rewards within liquidity pools, and wrapped assets. The DOT was not comfortable with making a final rule on any of these three transaction sets.
The DOT’s reluctance is understandable. The final set of comments highlight unique issues within the cryptocurrency space that do not lend themselves to the established rules.
Staking Rewards
On Proof of Stake chains, holders have the option to lock up their tokens into validator pools (or run their own validator). These validators are responsible for securing the network, validating transactions, and decentralization. In exchange for staking their tokens, the user receives token rewards. Normally, these rewards run from 5-15% APR yearly.
Staking rewards feel similar to dividends issued to stockholders. Under broker regulations, stockbrokers are required to issue 1099-DIV information returns to alert the IRS on the money paid to a taxpayer in that year. Even though this model seems straight forward for staking rewards, it is the logistics of staking that provide the complications.
Staking rewards do not have to involve any crypto broker. The reward values are issued to the validator who then disseminates the rewards to users within their pool. The validators are not crypto brokers that have facilitated a taxable transaction. The chain, and smart contracts, operate the service. It is difficult to imagine who would be responsible for the information return under that setup. For that reason, the DOT has punted on the question for now.
To be clear, the DOT still holds that staking rewards are income in the year received. Every crypto user should report their staking rewards in USD value for the tax year. The DOT’s complications in this area relate to the requirements for information filings from brokers.
LP Rewards within Liquidity Pools
In most DeFi protocols, users can lock their tokens into liquidity pools to balance the platform’s swap features. The protocols require sufficient liquidity to ensure they can swap tokens for users without enormous slippage in token price. To be effective, DeFi platforms need millions in liquidity.
Given this requirement, DeFi protocols offer incentives for users to provide liquidity. For instance, a user could provide 10,000 XRD and 10,000 USDT to a liquidity pool. In exchange for the token lock up, the protocol would provide the user with rewards in digital assets. It could be XRD or some other local token. The DOT struggled with the logistics of requiring anyone to submit information returns on such transactions.
The new regulation in this area suffers from numerous problems. First, the DOT has failed to determine whether a DeFi protocol is a “broker” under the regulation. They overtly chose not to address this issue without further guidance. Second, the transactions within the liquidity pools are often dictated by smart contracts, not a centralized business. There is no person or company facilitating the transactions. Under those facts, it is unclear who would be required to submit any forms to the government.
Based on these issues, the DOT chose to carve out LP rewards from the term “sale” in the new regulation. For now, there are no reporting requirements for these transactions (though they are still items of income to report on a taxpayer’s return).
Wrapped Assets
One of the leading issues in the crypto space involves the siloed nature of ecosystems. Assets deployed on Ethereum cannot be transferred to the Bitcoin blockchain. Assets on Solana cannot be easily transferred to Radix. Each ecosystem defines their own rules for token generation.
For years, blockchain projects have been trying to address this problem. One of the solutions appeared in 2020 through wrapped assets. Using a crypto bridge, a user can swap 1 BTC for 1 WBTC. The wrapped BTC can now be deployed on the Ethereum network. This allows a user to access Ethereum projects using their BTC assets. Similar examples exist across the crypto space with various chains.
The DOT struggled with how to handle a swap to a wrapped asset. While the ticker for WBTC is different than BTC, it is still the same asset. The value is identical. In markets, BTC and WBTC are traded at the same prices.
Understanding the unique nature of a wrapped transaction, the DOT decided to exclude this transaction from the definition of “sale” for now. They will revisit following additional comments and guidance.
Conclusion
The DOT’s definition of a sale is unsurprising. The IRS has laid out these taxable transactions via notice letters since 2021. By now, most crypto users should know that any token swap, staking reward, or digital asset sale results in a taxable event. It only makes sense that these same events would trigger reporting requirements.
While the regulation makes sense, the nuances of crypto trading will continue to provide obstacles to the DOT’s long term goal of tax compliance. The DOT seems to understand the pitfalls in applying old regulatory rules to the fringes of the space; including, DeFi, wrapped assets, and other transactions unique to crypto. What they still fail to understand is the inefficiencies that are going to result from the “simple” brokers such as Coinbase.
The DOT is assuming that a crypto user will buy BTC on Coinbase and then sell BTC on Coinbase a year later. This will result in a nice tidy report akin to the ones they receive from Fidelity or Charles Schwab. However, digital assets are not stocks or commodities. Digital assets can be bought and sold from numerous exchanges, including DeFi protocols. They can be swapped for other assets, back again, and then sold on a different exchange.
Let’s look at an example to highlight the issue. Let’s assume a taxpayer buys 1 BTC for 20 ETH on a DeFi platform. This user does so by buying .1 BTC per transaction over the course of a year. A year later, the person transfers .5 BTC to Kraken (a centralized exchange clearly subject to the regulation) and sells it. How is Kraken supposed to know the basis in the .5 BTC? They will never have access to the multiple .1 BTC transactions that took place on a DeFi platform. Kraken will only know the proceeds from the sale. Determining gains will be impossible. The taxpayer will likely struggle to calculate their basis as it requires knowledge of complicated rules and accounting methods. If the goal is to obtain accurate reports from established brokers, the current regulation has some serious issues.
Keep in mind that the example above is pretty simple. The crypto market is full of far more complicated behavior. We could quickly take this example, and make it mind blowing, by adding LP rewards, staking rewards, and multiple exchanges. To accurately report the tax obligation, one person must know the basis and proceeds from each sale and correctly apply the capital gains rules. This would be a hard job for a CPA. For a regular taxpayer, it is nearly impossible.
By instituting base line rules, and punting on the complicated questions, the DOT is going to struggle to fix the tax compliance gap in this space. The users that solely use Coinbase or Kraken are likely already reporting their taxable gains through those exchange’s applications. Both exchanges provide information on taxable events already. The inaccuracies in their current reports will not be fixed by dragging the stockbroker regulations over the space.
As the DOT wades into these waters, they are going to find that half measures will offer little assistance. They need to review the entire space as a unit and craft regulations that can accurately take the guesswork out of crypto gain calculations. Otherwise, they are going to be reviewing millions of information returns that provide little to no insight on the actual gains in the space. It is obvious that these new rules are the government’s first iteration of a regulatory framework. They will need to evolve their understanding and rules to achieve a system similar to the current stock model.
In the next post, we will review the exact information that will be required on the information returns.