15 January 2025 Final regulations released on DeFi reporting and sales of digital assets
The Treasury Department and IRS have released TD 10021, the final regulations governing the reporting of sales of digital assets through decentralized platforms, commonly known as "DeFi" (the DeFi Regulations). The regulations were officially published in the Federal Register on December 30, 2024, just beating Treasury's self-imposed deadline to issue the DeFi regulations before the end of 2024. The DeFi Regulations impose the obligation to report on Form 1099-DA on one particular part of the DeFi world: "trading front-end service providers" that accept, encode and transmit orders to sell digital assets via DeFi protocols. As explained later, the government determined that trading front-end service providers know or are in a position to know the terms of sales and are capable of obtaining Forms W-9 from sellers and backup withholding on those who fail to provide such forms. The Preamble to the DeFi regulations explains the government's reasoning and notes several additional areas where the government intends to issue guidance. The DeFi regulations supplement the regulations governing custodial digital asset platforms (TD 10000, referred to as the July Final Regulations) published on July 9, 2024 (see Tax Alert 2024-1385) With the Final Regulations, the IRS released Notice 2025-3, with transitional relief for certain penalties and backup withholding during 2027 and 2028 for digital asset brokers providing trading front-end services. The Preamble compares how securities orders are placed and settled with how similar transactions are conducted through DeFi. In the securities industry, a customer will typically give an order to a broker, with whom the customer has a direct relationship, and who often is also the custodian of the securities. Customers often use mobile applications or websites to place orders. The broker typically sends the order to an exchange or other trading center to find a counterparty. Once the buyer and the seller in the transaction are matched, the trade is cleared and settled, meaning that the securities are moved from the seller to the buyer and money is moved from the buyer to the seller. As explained in the Preamble, the DeFi world has a similar separation of functions, sometimes referred to as the DeFi Stack. Relying largely on a paper published by the Bank for International Settlements, the Preamble describes three primary technology layers in the DeFi Stack, while noting that some of the layers may be further subdivided. The government calls the top-most layer the "interface" layer, which provides "front-end services." The interface layer allows DeFi users to see information regarding the market and the pricing of various pairs of digital assets. The customer will enter the desired transaction into the software through a mobile application or website. The front end converts the order into code that can be interpreted by a specific DeFi trading protocol. Upon authorization by the customer, the customer's wallet forwards the code to a communication node. The second layer is the application layer, which can provide a variety of services, including automated market making or communication of the trade to the most favorable DeFi protocol (also known as aggregation). The third layer is the settlement layer. Trades settle when they are written immutably on the blockchain under that blockchain's consensus mechanism, either proof of work (where the validators are miners) or proof of stake (where the validators have "staked" or frozen their holdings of that blockchain's token). Validators carry out the customer's coded instructions in the application layer and settle the trade by writing a block on the blockchain. Validators earn rewards for maintaining the blockchain. The statute provides that a broker includes "any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person." The Preamble explains that each of the layers in the DeFi Stack plays a role in effectuating transfers of digital assets, just as the various participants in the securities market are all necessary to effect sales of securities. The Preamble rejects the idea that a broker must be the customer's "agent," noting that brokers for Form 1099-B purposes go well beyond conventional securities brokers, including "middlemen" who provide certain services. The Preamble argues that the Code provided authority to treat centralized exchanges as brokers even before the digital asset provisions were added, and the amendment should not be read to "merely restate" prior law. Rather, the term broker "properly applies to persons that supply customers with services that are used by those customers to carry out digital asset transactions," according to the Preamble. The Preamble notes that a group of persons that act together may be treated as a broker if the group is treated as a partnership for tax purposes. EY observes: The DeFi Regulations do not change the treatment of foreign brokers, as established in the July Final Regulations . For digital asset sales, those regulations provide that a broker includes only a US digital asset broker and excludes both foreign entities and foreign branches of US persons. In earlier statements, Treasury and the IRS said that brokers that are not US digital asset brokers are eventually expected to report on US customers under the Crypto-Asset Reporting Framework (CARF), provided the United States joins CARF. To be considered a "broker" required to report transactions on Form 1099-DA or 1099-B, a person must stand ready to "effect" sales to be made by others. Under the July Final Regulations, the term "effect," with respect to a sale, includes acting as a digital asset middlemen for a party in a sale of digital assets. The July Final Regulations, however, reserved the definition of digital asset middleman and other definitions relevant to DeFi. The DeFi Regulations now define a digital asset middleman as any person who is responsible for providing an "effectuating service" with respect to a sale of digital assets. EY observes: The proposed regulations (REG-122793-19) had defined a digital asset middleman as any person who provides a "facilitative service" with respect to a sale of digital assets (see Tax Alert 2023-1513). Because Treasury and the IRS concluded that only trading front-end service providers that enable customers to interact with DeFi trading applications should be in scope for digital asset broker reporting, they have revised the regulations to refer to effectuating services, which more accurately describes the services provided by the brokers in scope than facilitative services. EY observes: The Preamble clarifies that the Treasury Department and IRS did not intend to include persons outside the DeFi industry, such as internet service providers, internet browsers, or computer or smartphone manufacturers, in the definition of broker. An effectuating service is any service that is a trading front-end service, where the person providing that service ordinarily would know or be in a position to know the nature of the transaction potentially giving rise to gross proceeds from the sale of digital assets. It also includes:
In response to comments regarding non-fungible tokens (NFTs), the Preamble states that persons that provide customers with trading front-end services to purchase or sell NFTs in exchange for other digital assets are considered to provide effectuating services and are digital asset middlemen and brokers under the DeFi Regulations. A trading front-end service is a service that 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. The services must be designed to: (1) enable a customer to input order details to be carried out or settled on a blockchain; and (2) transmit those order details so that the transaction can be completed. This includes transmitting the order details to the person's wallet in a form that allows the customer to have the trade completed simply by authorizing the order. A digital asset trading protocol is a distributed ledger application consisting of computer software, including automatically executing contracts, that exchange one digital asset for another digital asset based on user instructions. For these purposes, however, an operator of a digital asset trading protocol who does not provide a trading front-end service is not a broker. EY observes: The Preamble notes that the definition is intended to apply broadly to any front-end service that enables customers to input their order details for interaction with a digital asset trading protocol, regardless of the order of the steps necessary to carry out that transaction on the distributed ledger network. In addition, the intention is that it will apply to any front-end service that enables customers to interact with aggregation protocols as well as digital asset trading protocols. Under the definition, however, basic speech-to-text interface services that merely translate customer's voice commanded trade orders to written text orders is not treated as trading front-end services because basic text-to-speech interface services do not invoke the functions of the DeFi protocol. The DeFi Regulations clarify that services may be considered trading front-end services even if the digital assets involved in the transaction are received in the wallet of another person under the order details of the person entering into the transaction. To illustrate, the Preamble provides the following example: If party X uses services that are provided by party Z and otherwise meet the definition of trading front-end services to exchange digital asset A for digital asset B and the order details include an instruction to deliver digital asset B to a digital asset address in a wallet controlled or owned by party Y, for example, as a payment, Z's services will be treated as trading front-end services. A service provider is considered to provide effectuating services if it "ordinarily would know or be in a position to know the nature of the transaction potentially giving rise to gross proceeds from the sale of digital assets." Being "in a position to know" means maintaining control or sufficient influence over the trading front-end services to have the ability to determine whether and the extent to which the transfer of digital assets involved in a transaction gives rise to gross proceeds. Under the DeFi Regulations, a service provider maintains control or sufficient influence over service if it can:
The Preamble notes that the three examples are not intended to be the exclusive examples that would meet the position-to-know standard. The Preamble also helpfully provides that a front-end service provider that provides services that enable a website to be accessed on a computer or mobile device but does not translate the customer's trade order into coded trade order instructions that can be sent to the customer's wallet for authorization would not be considered maintaining sufficient control or influence over the services provided to know the nature of the transaction. The Preamble also suggests that trading front-end service providers that receive non-contingent fees for their services have the ability to determine whether a transaction created through their trading front-end services was carried out by, for example, including in the coded trade order instructions a direction to notify the trading front-end service provider when the transaction is settled on the distributed ledger, similar to the way the sender of an email can receive a read receipt. To prevent a service provider from artificially getting around the position-to-know standard, the DeFi Regulations disregard contractual or other non-legal restrictions on the ability of the person providing trading front-end services to amend, update, or otherwise substantively affect the terms under which the services are provided (including the manner in which any fees are collected) or the manner in which the order is processed. The DeFi Regulations provide several exclusions from the definition of trading front-end services or other effectuating services. First, distributed ledger transaction validation services (whether through proof-of-work, proof-of-stake, or any other similar consensus mechanism), including those services necessary to complete the validation, are not effectuating services. Therefore, a person engaged in validating distributed ledger transactions, including a person that provides services necessary to complete the validation, without providing other functions or services that are effectuating services, is not considered a broker for these purposes. According to the Preamble, Treasury and the IRS intended that block building and the operation of communication nodes would be included in the other services necessary to complete the validation, and thus excluded from the definition of effectuating services. Persons licensing software or selling hardware with unhosted wallet services that include both trading front-end services and other services are considered to provide effectuating services only for the sales of digital assets that use the trading front-end services. However, a broker does not include a person engaged in selling hardware or licensing of software, where the sole function is to permit a person to control private keys that are used for accessing digital assets on a distributed ledger, without providing other functions or services that are effectuating services. EY observes: According to the Preamble, this means that persons providing unhosted wallet services must file Form 1099-DA for customer sales using the wallet's trading front-end services. They are not, however, required to file Form 1099-DA for customer sales using the trading front-end services of a third-party front-end service provider. Similar to the transitional relief previously provided to custodial brokers in Notice 2024-56, Notice 2025-3 provides relief to DeFi brokers from information reporting penalties, backup withholding and customer due diligence. Notice 2025-3 provides DeFi brokers with a "good faith effort" period during the first year of the reporting requirements. DeFi brokers that make a "good faith effort" to perform digital asset reporting on sales effected in 2027 will not be subject to a penalty for failure to file timely and correct information returns with the IRS (IRC Section 6721) or failure to furnish timely and correct payee statements (IRC Section 6722). The IRS noted that the relief is "to provide DeFi brokers with additional time to develop appropriate procedures to comply with these new reporting requirements." Notice 2025-3 does not define what a "good faith effort" is, but does specify that a good faith effort does not include any reporting by the DeFi broker after the later of the date (1) the IRS first contacts the DeFi broker about an examination, or (2) one year after the original reporting due date. For sales transactions, a broker generally must backup withhold (currently at the rate of 24%) on gross proceeds of sales by US nonexempt recipient customers that have not provided a valid US taxpayer identification number (TIN) in the manner prescribed by the IRS (i.e., certified on a Form W-9) before the sale. Notice 2025-3 provides a phased-in approach and timeline for DeFi brokers to implement the backup withholding tax requirements on undocumented US nonexempt recipient customers:
Notice 2025-3 also includes guidance on how to calculate the backup withholding when a digital asset is sold for different digital assets. The guidance is intended to address valuation and timing considerations that can impact withholding and depositing the correct amount. For sales effected before January 1, 2029, the following backup withholding tax procedures apply for DeFi brokers:
The Notice generally clarifies that a liquidation is considered "undertaken immediately" if the DeFi broker "systemically liquidates" the received digitals assets as part of its "services effectuating sales." EY observes: The value of digital assets can quickly change (and by large amounts), creating operational challenges when a digital asset is sold for other digital assets. For example, the value of digital assets received could significantly change between the time of the exchange of digital assets and when a portion of the assets received by the customer is liquidated to satisfy the backup withholding tax liability. The proceeds of the liquidation could be less than 24% of the US dollar value of the assets received as of the time of the sale. Implementing the backup withholding requirements may require substantial system builds and/or enhancements. The Notice also generally provides that DeFi brokers will not be subject to the penalties under IRC Sections 6651 (failure to file tax returns or to pay tax) or IRC Section 6656 (failure to deposit) tax if the preceding procedures are applied. The relief applies regardless of any decrease in the value of digital assets between the time of the transaction and the liquidation. Non-US resident customers are not subject to the digital asset reporting requirements or backup withholding. Forms W-8 are generally used to establish non-US resident status. Notice 2025-3, however, includes a transition rule for DeFi brokers establishing non-US resident status. A DeFi broker can treat a customer as an exempt foreign person for sales effected before January 1, 2029, if the following are all satisfied:
In response to the DeFi Regulations, certain affected blockchain industry participants filed a complaint in the US District Court for the Northern District of Texas against the IRS and Treasury to prevent the DeFi regulations from going into effect and enjoin their enforcement. Treasury and the IRS noted certain instances where they may release additional guidance. One of the open issues concerns whether parties that provide trading front-ends to liquidity and staking pools are considered brokers subject to Form 1099-DA reporting. Notice 2024-57 does not require brokers to file Form 1099-DA for those type of transactions (as well as certain other transactions). The Preamble states that Treasury and the IRS anticipate providing a transition period after any termination of the no-reporting relief in Notice 2024-57 for liquidity and staking pool transactions to allow brokers time to build or buy systems to comply with the reporting requirements. The Preamble also discusses the possible application of the multiple broker rule in Treas. Reg. Section 1.6045-1(c)(3)(iii)(B), which is designed to ensure that only one Form 1099-DA is issued for any given sale even when multiple brokers are involved. If such a case did exist in the DeFi space, the Preamble says, the existing multiple broker rule would apply. The Preamble also says that Treasury and the IRS intend to issue a notice of proposed rulemaking with examples illustrating how the existing multiple broker rule would apply to transactions effected by both a front-end service provider and a custodial broker so that the public can comment. The Preamble also says that Treasury and the IRS intend to publish a notice of proposed rulemaking under Treas. Reg. Section 31.3406(h)-2(b) that would provide greater flexibility to trading front-end service providers to satisfy their backup withholding obligations. Additionally, Treasury and the IRS stated that they will consider future guidance to clarify that no reportable sale occurs when a Decentralized Autonomous Organization redeems receipt tokens used merely to keep track of voting history.
Document ID: 2025-0242 | ||||||||||
