Navigating the IRS Web3 maze: A comprehensive guide to new digital asset regulations

Unveiling the complexities of the IRS’s newly proposed regulations on digital assets, this guide aims to be your compass in the ever-changing landscape of digital finance.

The IRS takes a step forward

The Internal Revenue Service (IRS) has recently put forth a set of proposed regulations concerning the reporting requirements for digital assets. These proposals, released on August 25, 2023, are open for public comments until October 30, 2023. This guide aims to dissect these intricate regulations, offering insights into their potential impact on various industry players.

The Morgan, Lewis & Bockius LLP team wrote an article on Lexology trying to emphasize the main measures and provisions of the IRS proposal. Below, you’ll find our guide to them.

The evolution of the ‘broker’ definition

The term “broker” has undergone significant changes, especially with the passage of the Infrastructure Investment and Jobs Act (IIJA) in 2021. The IRS’s proposed regulations further expand this definition to include anyone who facilitates digital asset transactions and is privy to customer information.

Operators of decentralized exchanges (DEXs) and issuers of initial coin offerings (ICOs) may find themselves under this broadened definition. They would be required to collect and report customer information, a move that could clash with the ethos of anonymity in the digital asset space.

What constitutes a ‘digital asset’?

The IRS’s proposed regulations offer a nuanced definition of “digital assets,” which includes not just cryptocurrencies but also non-fungible tokens (NFTs). The definition is expansive, covering any digital representation of value recorded on a cryptographically secured ledger.

Interestingly, the IRS has chosen to include digital assets that are also securities under federal laws in this category. This means that the reporting requirements would apply to a wide range of digital assets, potentially complicating compliance for market participants.

The intricacies of ‘sales’ in digital assets

The proposed regulations extend the concept of a “sale” to include not just cash transactions but also exchanges for services, property, or stored-value cards. This broad definition aims to capture the movement of digital assets from a broker-held account to a private wallet.

Specific rules have been outlined for calculating the fair market value of received property or services, adding another layer of complexity to the reporting requirements.

Determining the basis for digital assets

The IRS has also provided guidelines for calculating the cost basis of digital assets. Brokers offering custodial services will be required to provide adjusted basis information for sales taking place on or after January 1, 2026.

This requirement could pose challenges for brokers, especially given the IRS’s request for comments on whether reporting should be done on a wallet-by-wallet or asset-by-asset basis.

Backup withholding: A new challenge

The proposed regulations extend backup withholding requirements to digital asset transactions. This means brokers will need to collect taxpayer identification numbers, a move that could deter potential investors who value anonymity.

While most of the proposed regulations are expected to take effect in 2025, industry players should start preparing now. The timeline for compliance is tight, and the regulations could undergo further changes.

Emerging regulatory challenges

As the landscape of digital assets, including Non-Fungible Tokens (NFTs), continues to evolve, so does the regulatory framework governing them. Recent developments in both the United States and the European Union have introduced new complexities that stakeholders must navigate. This chapter aims to explore these new regulatory challenges and relate them to the guidelines discussed in the preceding chapters of this guide.

The U.S. Securities and Exchange Commission’s (SEC) recent action against LA-based media giant, Impact Theory, serves as a cautionary tale for entities operating in the NFT space. The SEC’s charge, which claims that the company conducted an unregistered offering of “crypto asset securities,” has far-reaching implications. It suggests that NFTs could be classified as securities under certain conditions, a classification that comes with stringent regulatory requirements. 

The European Commission and the European Union member states have been working on the Markets in Crypto Assets (MiCA) regulations, which were recently accepted by the European Parliament. Set to take effect in January 2025, MiCA will introduce a new set of rules for crypto assets. Entities operating in the EU will need to align their practices with these new regulations, which could impact the tokenization strategies discussed in Chapter 5. The Financial Markets Authority (FMA) in France has already indicated that this regulation will have a significant impact on financial markets.

A patchwork of legal regimes

The proposed regulations do not cover all transactions involving digital assets. They acknowledge other legal frameworks, such as federal securities laws and the Commodity Exchange Act, creating a complex patchwork that market participants will need to navigate carefully.

So, as you delve into the labyrinthine world of IRS regulations, may this guide serve as your Theseus’s thread. And remember, when it comes to digital assets and the IRS, it’s always better to be a-maze-d than to be a-missed.