Final regulations on informational reporting obligations for custodial brokers were published in the Federal Register on July 9, 2024 with an ominous note that the information reporting requirements for non-custodial brokers (i.e. Decentralized Finance or DeFi) would be forthcoming. The first effective date for those final regulations would be January 1, 2025. On December 27, 2024 the Treasury Department published the final regulations applicable to DeFi specifically targeting participants in trading front-end services that help retail investors interact with DeFi protocols.
The final regulations outline the three traditional steps in the sale of a security involving a customer giving a trade order to a broker, the broker routing the order to a trading center, and then finding a counterparty and settling and recording the transaction. The IRS then outlines the DeFi model as also involving three “layers” it calls the interface layer, application layer, and settlement layer. Commenters to the proposed regulations objected to the use of traditional securities transactions as a model, but the IRS decided it was informative nonetheless for defining traditional steps. When discussing the definition of broker, however, the IRS decided on a broader definition “not limited to conventional securities brokers.” The IRS maintains a broad definition of “broker” is required by the statutory language and the Internal Revenue Code and includes those providing “services” that “effectuate transfers of digital assets.”
The IRS acknowledges, in the final regulations, that participants can execute transactions directly with the DeFi protocol but that most retail digital asset users use the services provided by other participants creating a more user-friendly way to provide details on a transaction to the DeFi protocol. The cost of providing these user-friendly services is that the IRS has singled them out as the first, and potentially only, wave of informational reporting requirements for digital asset transactions in the DeFi space. The IRS indicates that these trading front-end services permit a customer to select, confirm, and communicate the details of a trade transaction it wants to execute on a DeFi protocol so that it can be executed and settled by other DeFi participants. As such, the IRS has determined that those services are similar to those provided to a customer by a traditional securities broker that also does not hold custody to a customer’s assets but can be subject to informational reporting requirements.
The final regulations and the IRS itself recognize that the “broker” definition should not apply to “ancillary parties who cannot get access to information that is useful to the IRS.” However, the IRS does not believe that this includes the trading front-end service providers because they have the closest relationship to customers and information sought and are usually legal entities or individuals that can easily be identified by taxpayers and the IRS, and the software used for the services are outside of potentially immutable DeFi software. As such, the IRS has determined that these non-custodial brokers are capable of modifying their software and operations to comply with the reporting obligations. The final regulations defines “effectuating service” as any 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. The Treasury exercised its discretion in not treating other DeFi participants (e.g. those performing settlement of transactions) as brokers. However, a wallet provider may end up a “broker” under this definition if it offers services that creates the coded trade order or instructions communicated to a DeFi protocol in addition to other non-included services.
Although currently limited to one type of DeFi participant, that may not always be the case. The final regulations indicate that the IRS intends to evaluate the information reported by trading front-end service providers and “if the IRS learns that a significant amount of DeFi trading does not give rise to information reporting” the IRS may reconsider the scope of the definition of broker. Therefore, the DeFi community is again left wondering if the current limitations are just the first step in even broader definitions and more onerous reporting requirements.
Also notable in these final regulations on DeFi reporting requirements are protections that appear as a pre-emptive strike against expected litigation over government interpretations of statutes previously limited by the Supreme Court in the Loper Bright decision. There are references to specific authority to regulate in the Internal Revenue Code and commentary dealing with potential ambiguity and authority issues including an entire section addressing “Constitutional Concerns.” In response to concerns about timing for compliance, the effective date for reporting for covered transactions is on or after January 1, 2027 and IRS Notice 2025-3 provides transitional relief from broker reporting penalties and backup withholding. The DeFi industry and its advocates have a lot to consider before the effective date in their ability to comply and their ability to challenge the obligations imposed by these regulations.
This article was originally published on Forbes.com on December 27, 2024.