Debate Over the New Digital Asset Broker Reporting Rules: Striking the Right Balance

It is no secret that the Internal Revenue Service (IRS) has been looking for ways to rein in the crypto industry for years. Its actions have included providing guidance for taxpayers who engage in transactions involving virtual currency, adding a question about cryptocurrency on Form 1040, issuing summonses to cryptocurrency exchanges, and hiring personnel with deep industry expertise. These efforts to enhance compliance intensified after Congress passed the Infrastructure Investment and Jobs Act — commonly known as the Infrastructure Bill or IIJA — in late 2021. The legislation officially assigned reporting responsibilities to digital asset brokers for their clients’ transactions. However, the passage of IIJA did not resolve compliance uncertainties; instead, it sparked another round of debate regarding how the rules should be implemented.

This issue brief reviews recent developments since IIJA passed into law, including proposed regulations from the Treasury Department and comments from industry stakeholders during a hearing in November 2023. It also addresses concerns regarding broadly defined terms and the potential for additional compliance costs and duplicative tax reporting.

Why Digital Asset Reporting Matters 

Digital assets such as cryptocurrencies have gained popularity in recent years not only as a payment method or an investment tool, but also as vehicles for speculation. In January 2023, the worldwide digital asset market value was estimated to be around $1 trillion. Although the U.S. share of the global market value is uncertain, many believe it is substantial. 

The IRS is interested in regulating digital assets because they could have a significant impact on tax revenue. Specifically, the growth of digital assets is often linked to the expansion of the tax gap, the difference between the taxes owed and the taxes actually paid on time. While it’s hard to pinpoint the exact amount of tax revenue lost due to digital assets, there are several estimates. For example, former IRS Commissioner Charles Rettig once suggested that the tax gap could be as high as $1 trillion, with cryptocurrencies serving as the main contributor. 

However, another estimate from an industry practitioner puts the figure at a more conservative $50 billion in tax revenue lost to the IRS as a result of cryptocurrencies. Most recently, the IRS estimated the tax gap to be $688 billion in 2021, an increase of 25% from $550 billion in 2017–19. The agency noted the tax gap figure does not capture the full noncompliance landscape in certain areas, including digital assets. This suggests that the tax gap could be even larger due to the underreporting of taxes associated with digital assets. Furthermore, the IRS acknowledged that due to the novelty of digital assets, it will take time to develop expertise to uncover noncompliance and conduct examinations. 

Experience shows that third party information reporting enhances transparency and effectively deters individuals from not reporting or underreporting their income, which can be a major contributor to the tax gap. As such, IIJA’s reporting requirement targets taxpayers who hide their taxable income in digital assets by making reporting responsibilities the same for digital assets as they are for traditional financial assets. 

Developments After the Infrastructure Bill 

The IIJA requires brokers to report digital asset transactions to the IRS by expanding the definition of “brokers.” The reporting rules were originally set to take effect in 2023, but in December 2022 — one month before the rules were slated to begin — the IRS delayed the start date to whenever the rules are finalized. 

The Treasury and the IRS subsequently issued proposed regulations for digital asset broker reporting rules in August 2023, and the reporting requirements are scheduled to start in 2026. This means in-scope brokers need to collect data for digital assets transactions taking place on or after January 1, 2025. 

Since the release of the proposed regulations, the IRS has received more than 125,000 comments. Although some of the comments were allegedly generated by AI chatbots, many of them were from industry participants, showing a high level of interest on the topic. The agency held a hearing in mid-November to understand industry participants’ concerns and recommendations. Three general concerns arose: 

1. Certain definitions in the proposed regulations are overly far-reaching, in particular the meaning of “brokers” and “digital assets.”
2. The IRS underestimates the compliance burden of these reporting responsibilities. 
3. There could be significant duplicative reporting of the same transactions, which could lead to both taxpayer confusion and increased compliance costs. 

These concerns are discussed in more detail in the following sections.

Are ‘Brokers’ and ‘Digital Assets’ Defined Too Broadly?

Many industry participants say the language in the proposed regulations is overly broad when it comes to defining “brokers” and “digital assets.” This has long been industry participants’ top complaint even before the IIJA became law. Over time, the Treasury did clarify that miners and validators are not in scope, and digital asset trading platforms, digital asset payment processers, and certain hosted wallet providers are the main targets regarding reporting responsibilities. 

Brokers

Under current language, “brokers” are people who are responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person. Brokers can act as agents, principals, or digital asset middlemen for others to effect sales or exchanges of digital assets for cash. 

Industry participants generally take issue with the inclusion of “digital asset middlemen” and people who “provide any service” in the transfer of digital assets. Some believe these terms would subject many non-custodial (also known as un-hosted or self-hosted) digital asset software providers, protocol development companies, non-fungible token (NFT) marketplaces, and other ancillary service providers to the reporting requirements, even though they are typically not involved in facilitating transactions.

Generally, commentators suggest either removing the concept of “digital asset middlemen” from the broker definition entirely or revising the language to include only people who directly carry out the sale of digital assets for fees. This means people who indirectly facilitate digital assets sales or only have an ancillary or indirect involvement would be exempted. 

Certain industry participants argue that since non-custodial digital wallets are merely software codes that help users manage their private key credentials, these revisions would also exempt providers of self-hosted digital wallets from the reporting rules. 

Some of industry’s concerns might be justified, but the Treasury also has valid reasons for keeping the current definition of brokers unchanged. The Financial Crimes Enforcement Network (FinCEN), a bureau within the Treasury Department, explains in a 2020 publication that un-hosted wallets are similar to anonymous bank accounts, identified only by codes. Determining the actual owner or user can be extremely difficult, if not impossible. 

Moreover, illicit financial activities, such as terrorism, drug and human trafficking, and cybercrime, are often associated with these kinds of concealed money flows. Therefore, maintaining a broad definition of broker helps enhance transparency and could limit some of these unlawful activities.

Finally, some industry participants point out that other similar reporting regimes, such as the Organisation for Economic Cooperation and Development’s (OECD) Crypto Asset Reporting Framework (CARF), are more limited in scope. This is not immediately clear, as the CARF provides a “functional definition” for in-scope intermediaries and certain other service providers. Specifically, service providers that facilitate exchanges between crypto assets, as well as between crypto assets and sovereign currencies for customers, are in scope. 

Digital Assets

The other definition that many industry participants consider too far-reaching is “digital assets,” which are generally known as assets that are digital representations of value. In particular, NFT marketplace providers claim that not all NFTs fall under the category of digital assets. NFTs that are connected with financial instruments or cryptocurrencies would qualify as digital assets, but some NFTs are associated with ownership rights of collectibles, art, or music. 

According to some industry participants, these NFTs do not meet the criteria of being a “digital representation of value” and should be exempted. The Treasury Department indicated that it did consider whether or not to exclude NFTs because of their non-fungible (i.e., unique) nature. However, the agency stated that the IIJA’s legislative intent did not show any indication to exclude NFTs. 

Finally, to the extent real estate purchasers sell digital assets and use the proceeds to buy real estate, brokers must report the fair market value of these transactions. In these settings, brokers are usually the people responsible for closing the transactions and may also include title companies, closing attorneys, mortgage lenders, and real estate brokers. This provision has not generated as much discussion as others, potentially because of the limited number of real estate transactions involving digital assets.

Will the New Rules Generate Significant Compliance Costs? 

The proposed regulations include estimated compliance costs. Specifically, the reporting rules will affect some 600 to 9,500 brokers (midpoint is 5,050 brokers) and approximately 13 to 16 million digital asset owners who are customers of these brokers (midpoint is 14.5 million asset owners). Assuming it takes a broker 7.5 to 10.5 minutes (midpoint is nine minutes or 0.15 hours) to complete the forms for each customer (known as Form 1099-DA), the IRS expects a typical broker to incur 425 hours of time, which translates to $27,000 annually to fulfill the reporting requirement. In aggregate, the total burden for all brokers nationwide is 2,146,250 hours, or $136,350,000 per year. 

Another factor to consider is the start-up costs, including system setup, hardware and software expenses, and labor costs. The agency estimates these costs to range from about three to eight times the annual costs, translating to 1,275 to 3,400 hours, or $81,000 to $216,000 per broker. Nationwide, total start-up costs amount to 11,804,375 hours, equivalent to $749,925,000. When combined with annual costs, brokers are expected to incur $886 million in compliance expenses in the first year. 

The IRS believes that although the regulations will impose burdens on brokers, there are several positive effects. Notably, the reporting requirements are expected to significantly alleviate compliance burdens for digital asset owners, as they will no longer be required to independently monitor or track their digital asset portfolios. In addition, asset owners can be assured of their compliance with tax laws. Such clarity would greatly benefit the industry and encourage participation.

Industry operators believe the compliance burden is too high, and the IRS estimate is not accurate. They claim that the projected $886 million in first-year compliance expenses is a vast underestimation of the actual expenses. Some observers reference a statement from the IRS indicating that the agency expects to receive 8 billion copies of Form 1099-DA, the new digital asset reporting form. This figure is double the number of information returns from all other 1099 forms combined and significantly higher than what some analysts had expected. 

Industry participants therefore argue that with the IRS projecting to receive 8 billion copies of information returns and an estimated 13 to 16 million taxpayers affected by the reporting rules, each taxpayer would potentially receive about 500 to 615 copies of Form 1099-DA. This calculation is derived from dividing 8 billion copies by the respective numbers of taxpayers, 16 million and 13 million. 

The projected annual compliance cost of $136 million was built on the assumption that each of the 5,050 brokers would spend nine minutes on each of the 14.5 million taxpayers. However, if each customer receives over 500 copies of Form 1099-DA, the nine-minute assumption becomes invalid and would likely need to be increased. An industry participant estimates that each additional minute of compliance time would add approximately $100 million to the overall compliance costs.

Will Duplicative Reporting Become an Issue?

The surprisingly large estimate of 8 billion copies of Form 1099-DA that the IRS anticipates receiving confirms worries over duplicative reporting and highlights concerns regarding security, privacy, and data integrity. This inundation of data poses challenges for the IRS, as much of it may either be duplicative or unusable. 

In an example provided by practitioners, multiple parties involved in a transaction, including a non-custodial executing broker (acting as an agent for customers), a decentralized exchange aggregator (digital asset middleman), and the decentralized exchange where the trade is finally settled, may all be required to file Form 1099-DA for the same transaction. When a taxpayer receives the form, it is not immediately clear whether there is duplicative reporting and which form to use if so. 

Some practitioners therefore suggest implementing coordination rules or tiebreakers or setting priorities to reduce duplicative reporting. Others recommend adding thresholds, such as exempting transactions below a certain amount from reporting responsibilities. However, it is debatable whether this is consistent with the idea of putting financial and digital assets on the same footing in terms of information reporting. Although traditional financial assets are typically not subject to minimum thresholds, some practitioners argue that the proposed rules encompass lots of small transactions with negligible tax implications, exceeding the scope of the congressional mandate. 

One concern regarding basis tracking pertains to inconsistencies between previous guidance and the proposed regulations. Typically, when an asset is sold, asset owners have the ability to designate which unit of the asset (e.g., cryptocurrency) is sold. If no specific unit is identified, the broker will use the first in first out (FIFO) method, whereby the unit purchased earliest for the account is assumed to be the one sold. Importantly, there are no restrictions requiring these specifically identified units to be within the same wallet or account. In other words, a universal or multi-wallet approach is acceptable. 

Some observers indicate that the proposed regulations seem to require specific identification on a wallet-by-wallet or account-by-account basis. In other words, a universal or multi-wallet approach is prohibited. While identification on a wallet-by-wallet basis would definitely streamline information reporting, industry practitioners recommend that the Treasury clarify this potential discrepancy. 

Some Lawmakers Think the Rules are Just Right, Others Concur With Industry

Contrary to industry feedback, some lawmakers have applauded the release of the proposed regulations. They indicate that although the broker definition is broad, it ensures information gets reported even if one broker “chooses to turn a blind eye to customer information in an effort to escape regulatory scrutiny.” These lawmakers also believe that the term “digital assets” should be broadly defined given the sector’s dynamic nature. They assert that the current language in the proposed regulations aligns with the objectives of the IIJA. 

When the IIJA passed into law, the Joint Committee on Taxation (JCT) estimated the requirement would generate approximately $28 billion over a 10-year period. In response to the proposed regulations, several industry operators recommended further delaying the effective date (e.g., to 36 months after the finalization of the proposed regulations), offering a two-year grace period, or implementing a phased rollout. 

Contrary to the industry’s request to delay, these lawmakers have urged the IRS to move the effective date earlier. They believe that waiting until 2026 would not only generate revenue losses as brokers attempt to circumvent the rules, but it could also give the industry time to lobby against the rules. 

Not all lawmakers support the current scope or an expediated timeline. Some members of the House Ways and Means Committee echo the concerns of industry participants regarding the overly broad range of reportable transactions. They claim that this broad definition prioritizes transparency but could hinder the growth of the digital asset industry and compromise taxpayer privacy. Moreover, they argue that when traditional financial brokerages were first required to report financial securities information, they were given five years to comply with the rules. As such, they believe that digital asset brokers should be granted a longer transition period. 

Conclusion 

The Treasury has indicated that the final regulations and Form 1099-DA will be forthcoming, despite facing significant opposition from industry participants. While this will lead to greater transparency for the industry and reduced opportunities to conceal taxable income in digital assets, there are several concerns that need to be addressed or carefully managed. These include the regulations’ broad scope, the possibility of duplicative reporting, the potential for an overwhelming number of filings to the IRS, and the associated compliance costs. 

It is important to recognize that these issues are interconnected. A broad scope may lead to duplicative reporting, resulting in a large number of information returns and higher compliance costs. Conversely, overly narrow definitions may reduce the number of filings and associated costs, but they may also fail to deter illicit financial activities and undermine efforts to improve taxpayer compliance. 

This material may be quoted or reproduced without prior permission, provided appropriate credit is given to the author and Rice University’s Baker Institute for Public Policy. The views expressed herein are those of the individual author(s), and do not necessarily represent the views of Rice University’s Baker Institute for Public Policy.