The IRS has issued final regs that include participants in the decentralized digital asset space that provide trading front-end services in the definition of a broker for gross proceeds reporting purposes while providing transitional penalty relief. (TD 10021; Notice 2025-3, 12/27/2024).
Background
Digital assets are generally treated as property for tax purposes. Previously known as virtual currencies, digital assets are defined as any digital representation of value that is not cash and is recorded on a cryptographically secured distributed ledger or any similar technology.
Pursuant to the Infrastructure Investment and Jobs Act (IIJA, P.L. 117-58), digital asset brokers are persons responsible for regularly providing services effectuating transfers of digital assets. Prior to the IIJA, Code Sec. 6045(c)(1)‘s definition of a broker included a dealer, a barter exchange, and a person who (for consideration) regularly acts as a “middleman” with respect to property or services.
The IRS reasoned that the “middleman reference in section 6045(c)(1)(C) can be understood as broad enough to cover a person that is not an agent or principal to a transaction but brings parties together so that those parties can negotiate and finalize the transaction.”
The IRS clarified that the IIJA’s definition of a digital asset broker is a “new clause” to the Section 6045(c)(1) broker definition.
Proposed broker guidance
In August 2023, the IRS issued proposed regs requiring digital asset brokers to report customer transactions on a new information return — Form 1099-DA, Digital Asset Proceeds From Broker Transactions — for transactions occurring on or after January 1, 2025. Reported information entails customer names, addresses, and gross proceeds. (NPRM REG-122793-19)
The proposed regs clarified types of entities in-scope of the definition of a digital asset broker, including centralized exchanges and “wallet” providers. They also clarified basis calculations and gain/loss recognition rules.
Under the proposed regs, a digital asset middleman may also be considered a broker. This category would have applied to participants in the decentralized finance (DeFi) segment of the industry, which involves the use of automatically executing software.
Called “smart contracts,” DeFi software independently functions without DeFi participants taking custody of the private keys used for accessing the digital asset customer’s digital assets on a distributed ledger. These applications “involve multiple DeFi participants performing various functions throughout the process in order to complete a customer’s transaction,” according to the IRS.
Some stakeholders told the IRS during the open comment period and at a public rulemaking hearing held in November 2023 that the regs reflected a preference toward centralized exchanges. The agency lacked a full understanding of DeFi and that the regs should not apply the same reporting standard to autonomous protocols, several commenters said.
Final custodial broker regs
The IRS considered over 44,000 comments and published final regs in the Federal Register on July 9, 2024 (TD 10000). A comprehensive guidance suite implementing the IIJA digital asset provisions, the final regs adopted rules on information reporting and realization and basis determination for certain sales and exchanges.
But the final regs primarily apply only to custodial brokers who take possession of the digital assets sold by their customers. These brokers include operators of custodial digital asset trading platforms, certain digital asset hosted wallet providers, digital asset kiosks, and certain processors of digital asset payments (PDAPs).
PDAPs have an obligation to report if they know of or ordinarily would know the nature of a transaction and the gross proceeds. The regs reserved on the definition of the “ordinarily would know or position to know standard,” as well as the definition of a facilitative service. Five specific services in which a broker acts either as an agent or a counterparty in a digital asset sale are identified as facilitative services.
Further, the final regs added the following to the definition of “effect:” to act as a digital asset middleman for a party in a sale of digital assets. Here, a middleman means any person who provides a facilitative service for digital asset sale purposes.
Despite flirting with the concept of a middleman, the IRS said in a news release (IR 2024-178) it intended to focus on the “majority” of digital asset transactions. Given the high volume of comments weighing in on the treatment of non-custodial brokers, the IRS decided to address DeFi and middlemen in separate regs.
Front-end services
Issued December 27, the new final regs provide that only DeFi participants providing “front-end” services will be treated as brokers and required to report transactions.
Generally, a trading front-end service receives a person’s order to sell and processes that order for execution by providing user interface services, including graphic and voice user interface services.
With respect to a sale of digital assets, these service providers help customers assess options relating to their proposed trades and initiate the additional steps necessary to trade their digital assets by interacting with other DeFi participants operating within the distributed ledger network.
In an accompanying press release, the Treasury Department stressed that the rules do not change or impose any new tax obligations on digital assets. Importantly, operators of digital protocols or developers of protocol software are not brokers. The final regs “modify the proposed regulations in ways that limit burdens on brokers while ensuring taxpayers and the IRS receive the information they need,” according to Treasury.
Regarding facilitative services, the IRS replaced the term with “effectuating services” so the rules do not capture entities outside the scope of a Section 6045(c)(1) broker.
The IRS agreed with commenters to the extent that the proposed facilitative services definition’s reference to services that indirectly effectuate sales of digital assets could, theoretically, expand to irrelevant entities like internet service providers or computer manufacturers.
Applicability date and transition relief
The regs become effective February 28, 2025. However, the IRS also agreed with concerns that DeFi brokers would need time to implement necessary systems to collect and store customer identity information or partner with third parties.
Accordingly, trading front-end service providers are given a grace period and the final regs apply to sales of digital assets occurring on or after January 1, 2027.
The IRS also issued Notice 2025-3 on Friday, which provides transitional relief from penalties for DeFi brokers who fail to report sales of digital assets on Form 1099-DA or fail to furnish payee statements under Code Sec. 6045. The relief applies to brokers demonstrating a good-faith effort to file and furnish the returns and statements in 2028 for sales effected in calendar year 2027.
Additionally, the transitional relief applies to payments of backup withholding tax required to be withheld under Code Sec. 3406. Penalties will not apply to 2027 digital asset sales, nor digital asset sales effected in calendar year 2028 if the broker sends the IRS payee names and Taxpayer Identification Numbers (pending confirmation).
Finally, the penalty relief applies for DeFi brokers who fail to backup withhold and pay the full backup withholding tax due if such failure is due to a decrease in the value of withheld digital assets in a sale of digital assets in return for different digital assets effected on or before December 31, 2028, and the broker immediately liquidates the withheld digital assets for cash.
For more information regarding the reporting the sale or exchange of digital assets under current law, see Checkpoint’s Federal Tax Coordinator ¶ S-3708.
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