Proposed Crypto Regs Go Too Far, Industry Reps Tell IRS

At a public rulemaking hearing, the IRS heard reoccurring themes in testimony from tax practitioners and stakeholders from the digital asset community that the agency’s proposed crypto tax and reporting framework overreaches and imposes undue burdens on those considered brokers.

The hearing saw comments from over a dozen presenters on the IRS’ proposed digital asset regs issued in August. During the comment period, the IRS received over 44,000 correspondences on how to best implement digital asset provisions of the Infrastructure Investment and Jobs Act two years after the bill’s enactment. Those provisions, which set forth reporting requirements and applicable definitions for digital asset brokers, were delayed until reg finalization.

In the proposed regs, the IRS sought to clarify the definition of a digital asset broker, applying it to centralized exchanges, digital asset payment processors, and certain decentralized protocols providing a “facilitative service” that would or be in a position to know identifying information about sellers and the nature of transactions.

Several commenters took issue with the regs’ interpretation of the statutory term “effectuate” and argue reporting obligations as currently written would capture those indirectly involved in digital asset transactions. “The proposed regulations far exceed congressional authorization,” testified Lawrence Zlatkin of CoinBase.

“The rules inappropriately assign” broker status “for reporting purposes to certain industry participants based on the theory that they indirectly effectuate transfers of digital assets,” he continued. “The rules improperly grant” intermediary status “to certain industry players for reporting purposes on the theory that they indirectly influence the transfer of digital assets. This overly broad definition of an intermediary includes persons who may participate in or lead to a transaction even if they do not perform it.”

Several commenters raised concerns over the regs’ effect on decentralized finance, or “DeFi,” with some claiming the government is showing technological preference toward centralized exchanges, or in other words, picking winners and losers. There is not a one-size-fits-all approach for the IRS to obtain customer identifying information and transactional data, the agency was told. Sean McElroy of Fenwick & West LLP suggested there be different regimes for centralized and decentralized exchanges and embrace a “principle of technology neutrality” and the regs be redrafted with a better understanding of DeFi. A centralized broker system cannot be applied to DeFi, he said, which would create an “impossible to meet burden.” Thus, DeFi software engineers and creators of autonomous protocols acting as indirect middlemen should not be subject to the same broker rules akin to a 20th Century financial system, McElroy argued.

Carlo D’Angelo of DeFi Defense Law asserted the reporting requirements pose a threat to consumer privacy. “[I[f approved in its current form, these proposed asset reporting requirements significantly burden growth and innovation in the digital assets sector and expose consumers to very serious data privacy risks,” he said. “Stated simply, these proposed regulations pose an existential threat to the future of crypto and DeFi in the United States. Although these proposed IRS Treasury regulations seek to enhance tax compliance in the United States digital assets sector … they do so at the expense of personal taxpayer user data and privacy. These regulations impose an unprecedented … unworkable asset reporting regime on both consumers and qualifying brokers, that goes far beyond any regulatory framework ever proposed to date.”

Multiple commenters addressed the matter of what happens when the IRS does obtain this information, which will be reported on a Form 1099-DA. They cited a projection from an IRS official that the agency will receive 8 billion Forms 1099-DA annually, and questioned the IRS’ ability to handle such a massive influx of data. Some anticipate much of the data will be either incomplete, inaccurate, or duplicative based on other information returns.

Specifically, Jessalyn Dean of Legible addressed how the regs would impact mutual funds, the sales or exchanges of which are reportable on Form 1099-B. She explained how “tokenized mutual funds” would need to be reported on Form 1099-DA but stated that “1940 Act Mutual Funds that are already reportable on a Form 1099-B should remain so.”

“Most alarmingly, the proposed regulations requiring Form 1099-DA reporting instead of the B reporting would cause tokenized money market funds to lose their exception to reporting and would therefore create a real de-incentivization to the mutual fund industry to tokenize their mutual funds,” she added. “For many decades, shareholder record keepers have invested significant amounts of their operating budget into software and infrastructure that is adapted to these existing 1099-B tax form structures. The cost to these brokers would be enormous to overhaul their cost basis and 1099 reporting software and infrastructure for a specific subset of their mutual funds, even though they are economically identical to and regulated in the same way as their non-tokenized counterparts.”