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The IRS Kills Crypto with Definitions (IRS Kills Crypto Part 1)

crypto tax Sep 21, 2023

The background

IRS proposed regulations titled, “Gross Proceeds and Basis Reporting by Brokers and Determination of Amount Realized and Basis for Digital Asset Transactions” were issued at the end of August 2023.  

There are 2 places you can view the proposed regs:

  1. PDF version of the proposed regs
  2. The Federal Register

The 282 page version is double spaced and much easier to read. The other version is a single-spaced 3 columnar format which is incredibly difficult to read. None of the content is easy to read but the latter format makes it even more challenging.

The amount of content is insane like a very long book. Here are some key takeaways to understand how this impacts your crypto taxes.

We knew it was coming

Overall, these changes are expected from the IRS and Treasury point of view for achieving their objectives and from the Infrastructure Investment and Jobs Act. From a taxpayer and DeFi power user perspective these changes are far from welcome for various reasons. As you know I’m a CPA, so I believe in and have a full compliance mindset. I’m talking about all this stuff from the lens of full voluntary tax compliance without consideration of any imposed laws and regulations.

What does that mean?

Well, it means anyone with this mindset ends up with the same tax return with OR without regulations forcing disclosure and compliance. I believe this is the case for most Americans and the percentage of non-compliance in crypto would be about the same as it is for overall tax compliance.

I don’t have any data to back this up, however based on the studies of Chainalysis and similar firms the percentage of money laundering in crypto is a tiny fraction of the amount of money laundering in the traditional banking system. As it turns out crypto is NOT the preferred tool of bad actors because transactions in crypto are more transparent and traceable.

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Guidance can be good

Taxpayers and professionals do need guidance on the character and timing of income.

In other words:

  • What kind of income is it? (The answer means different tax rates apply)
  • When to report the income? (Now or later, the current or a future tax return)

Guidance can also go from good to overly burdensome in the case of the proposed digital asset broker regs.

Key Takeaway
Most Americans are going to file their tax returns with the same diligence before and after the regulations, however the digital asset broker regs will substantially increase the taxpayer compliance burden. For example, the cost and headaches could go up by 2X rather than down by 50%.

Six key changes, modifications and/or definitions

The Infrastructure Investment and Jobs Act and the proposed regulations ushered in the following changes. It’s important to have a quick refresher because the rest of the content revolves around these changes.

Require digital asset brokers to file information returns. (I.e. Forms 1099-B/1099-DA)

“Require brokers, including digital asset trading platforms, digital asset payment processors, and certain digital asset hosted wallets, to file information returns, and furnish payee statements, on dispositions of digital assets effected for customers in certain sale or exchange transactions. 

Clarify definition of a broker

“First, section 80603(a) of the Infrastructure Act clarifies the definition of broker to include any person who, for consideration, is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.”

Modify definition of a specified security

“Second, section 80603(b)(1) of the Infrastructure Act modifies the definition of specified securities under section 6045(g) to explicitly include digital assets and to provide that these specified securities are treated as covered securities for purposes of basis reporting if they are acquired on or after January 1, 2023.”

Define a digital asset

“Third, section 80603(b)(1)(B) of the Infrastructure Act defines a digital asset broadly to mean any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary, except as otherwise provided by the Secretary.”

Brokers required to report transfers (not just sales)

Fourth, section 80603(b)(2) of the Infrastructure Act clarifies that transfer statement reporting under section 6045A(a) applies to covered securities that are digital assets, and also adds a new information reporting provision under section 6045A(d) to provide for broker reporting on transfers of digital assets that are covered securities.

Payment processors required to file information returns

“In the case of a transaction involving the exchange of digital assets for goods (other than digital assets) or services, these proposed regulations treat the provision of the goods or services as reportable under section 6050W and the disposition of the digital assets as reportable under proposed §1.6045-1 and not under section 6050W.”

The skinny on the definitional changes

The Infrastructure Act basically says digital asset brokers must file information returns just like securities brokers. It seems simple enough, however crypto and digital assets are not defined anywhere in existing regulations. Hence, a digital asset must be defined to know whether a digital asset broker (which also must be defined) is providing reportable digital asset services.

Specified securities were modified to include digital assets so cost basis is required to be reported along with gross proceeds from sales. Transfers between digital asset brokers must be reported. If transfers weren’t required to be reported, then cost basis reporting wouldn’t be possible. Finally, payment processors and merchants may become brokers under the new rules.

The rules appear so broad everyone’s now a digital asset broker. The reporting requirement for “pure” brokers, the ones most people would think of as brokers, is going to be a nightmare as I have elaborated on before. If every payment processor becomes a digital asset broker, then there’s not a word to describe the reporting chaos on behalf of the taxpayer.

1099-DA insanity

If crypto adoption including stablecoins is more widely used than fiat in everyday transactions, then taxpayers would have a wheelbarrow full of 1099-DAs to report on their tax return turning it into the worst-case scenario.

Key Takeaway
Bottom line it would make no sense if taxpayers got 1099-DAs from the payment processors of merchants like Rite Aid, Acme and Home Depot. This is the pure definition of overly burdensome for both taxpayer and payment processor.

IRS Reasons for new information reporting regs for digital assets

This section is an IRS statement followed by my response.

IRS: “Digital assets may also be popular, however, because the distributed ledger record of transactions does not include the identity of the parties involved in the transactions. This pseudonymity creates a significant risk to tax administration.”

Pseudonymity on the crypto spectrum is far closer to being fully doxed than being anonymous. I already discussed how money laundering in crypto in a tiny drop compared the legacy financial system. Public blockchains are not the best tool of choice for people who want to hide transactions.

A taxpayer’s entire crypto transaction history is linked together like a cobweb and nothing can really be hidden in isolation. The tax administration risk is much lower because taxpayers fear the IRS and know they have subpoena power to reconstruct transaction histories. 

IRS: “According to the Government Accountability Office (GAO), limits on third party information reporting to the IRS is an important factor contributing to the tax gap, which is the difference between taxes legally owed and taxes actually paid.”

The “tax gap” is the number one driving force of all IRS activities. The IRS always collects less then they’re owed and they want to get more uncollected tax. This is also the number one reason the proposed regulations were issued. From the IRS point of view the regulations make sense.

IRS: “An information reporting regime requiring reporting to the IRS on digital asset transactions would benefit tax compliance by helping to close the information gap with respect to digital assets.”

Information matching is the holy grail of the IRS. Third parties file information returns like 1099s, W-2s and so on. Then the IRS waits for you to file the same information so when you don’t, they automatically know you’re not incompliance. (Assuming the information was correct)

IRS: “Expanding information reporting for digital assets also benefits taxpayers. First, taxpayers use information provided to them by brokers to prepare their tax returns.”

Taxpayers already use crypto tax software to include all their transactions and calculate gains and losses. The taxpayer is the best person to act as their “own third-party” for purposes of calculating crypto tax. This means one person, the taxpayer, does the work.

Key Takeaway
The new rules mean if a taxpayer gets 23 1099-DAs, for example, then there are 24 people doing the work instead of one, the taxpayer (23 digital asset brokers” + the taxpayer = 24). Twenty-three extra hands in the pie equals one thing, mistakes. Mistakes equals monster headaches and the burden of unnecessary cost and time for taxpayers.

IRS: “A second benefit to taxpayers from information reporting is that it enables the IRS to focus its audit efforts on taxpayers who are more likely to have underreported their income from digital asset transactions.”

Ironically, this appears one of the few good things. If 1099-DA taxpayers are automatically considered compliant taxpayers rather than the view that all crypto taxpayers are underreporting candidates. At the same time, I don’t know what “more likely to underreport” means. It is a crypto influencer with no 1099-DAs? Does getting just one 1099-DA mean you’re not an IRS target?

I’m going to end Part 1 on this note and pick up with the more troubling parts of the proposed regulations around the DeFi logic and decentralized exchanges. Stay Tuned.

Good luck and remember your goal is always to get a Crypto Bullseye™.

Yours in Crypto, 

Kirk David Phillips, CPA, CMA, CFE, CBP 

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