Deciphering the Fresh Tax Guidelines for IRS and DeFi Brokers
Today, the Internal Revenue Service (IRS) unveiled the anticipated and contentious Decentralized Finance (DeFi) trading platform tax guidelines. If you're involved in the DeFi scene, major modifications are coming your way.
Note: Primarily, these new rules impact DeFi trading platforms. At this stage, individual taxpayers don't need to fret. Nonetheless, DeFi users may experience consequences such as sharing personal information with platforms and receiving incomplete tax documents.
Fundamentals of Broker Regulations
Initially, under §6045 of the tax code, stock brokers were mandated to collect customers' Know Your Customer (KYC) details, evaluate gains and losses, and submit this information to the IRS. This is why you receive a Form 1099-B from brokers like Robinhood or Charles Schwab at year's end, listing your annual gains and losses.
Last year, the IRS expanded these regulations to centralized crypto brokers, otherwise known as CeFi exchanges. Today, the IRS clarified how these restrictions will extend to DeFi.
The Three Layers of the DeFi Structure
The IRS acknowledged three distinct layers within the DeFi niche.
- Interface Layer: This includes user-oriented elements, like screens, buttons, forms, and other visual elements within websites, mobile apps, and browser extensions. This layer facilitates interaction between users and DeFi participants.
- Application Layer: This layer carries out trade orders in the transaction validation process.
- Settlement Layer: This layer records financial transactions on the distributed ledger, including trades made using DeFi protocols.
Classification of the Interface Layer as a Broker
The IRS decided that solely the Interface Layer, particularly "Front-end trading services", will be considered "brokers" moving forward. The reasoning is straightforward: front-end trading services interact most closely with customers and, consequently, have the ability to collect KYC information and report relevant data to the IRS.
Implications for DeFi Platforms
The IRS suggested that Front-end trading services encompass websites, unhosted wallets, and browser extensions that enable users to exchange digital assets through their interface.
If you operate such a service, you will be required to collect KYC information from your customers, monitor transactions, and report profits to the IRS and customers using Form 1099-DAs for transactions after January 1, 2027. You won’t have to record or report cost basis.
Note: Unhosted wallets that only manage private keys (basic wallets) are not considered brokers.
Implications for DeFi users
If you utilize Front-end trading services, you can anticipate the following changes in the coming years. Initially, you will need to share your KYC information with the front-end service platforms during the registration process. Secondly, you will receive tax forms that disclose only the profits generated by digital asset sales.
Note: These tax forms will not display your cost basis information. You'll still need to employ crypto tax software or rely on your records to track your cost basis and report precise gains and losses on your tax returns.
Possible Directions for DeFi Players
Given these new regulations, DeFi platforms have three primary choices:
- Adhere to the new guidelines.
- Litigate or hope that the DeFi regulations are abolished by the incoming administration – a plausible possibility with the incoming pro-crypto administration.
- Shift operations outside the U.S., but this strategy comes with its own challenges, as platforms might still encounter other international tax regulations, such as the crypto assets reporting framework (CARF) and Markets in Crypto-Assets Regulation (MiCA).
These DeFi regulations mark a substantial transformation for the DeFi sector. Although they aim to promote accountability and transparency, they also present challenges for both platforms and users. Remaining informed and prepared is crucial as the DeFi ecosystem navigates these changes.
Disclaimer: this content is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.
In light of the new tax guidelines for Decentralized Finance (DeFi) trading platforms, DeFi brokers will now be required to implement Know Your Customer (KYC) procedures, similar to how traditional stock brokers do, as per the regulations set by §6045 of the tax code. Additionally, the Internal Revenue Service (IRS) has clarified that regulations for centralized crypto brokers, or CeFi exchanges, will also apply to DeFi, possibly leading to DeFi users sharing personal information with platforms and receiving incomplete tax documents. [defi broker kyc, broker regs tax]