Important Effective Date Item in Preamble to Digital Asset Broker Reporting Prop. Regs.

The proposed regulations on broker reporting of digital assets released August 29, 2023 (REG-122793-19) included more than guidance under IRC section 6045. They also included related proposed regulations under section 1001 on amount realized and section 1012 on basis. I think that generally, the 1001 and 1012 proposed regulations are fairly straightforward and tie to the general rules at these provisions.  

One clarification they offer is that in a transaction where a taxpayer exchanges, for example, X coin for Y coin and pays a transaction fee, 50% of the transaction fee is treated as a reduction to the amount realized for the disposition of X coin and 50% is added to the basis of the Y coin acquired.

Unlike the virtual currency FAQs #39 - #41, Prop. Reg. 1.1012-1(j) provides that in applying the specific identification method to know which digital asset was disposed of (when the taxpayer has more than one unit or code representing their digital assets), the taxpayer must apply specific identification on a wallet by wallet or exchange by exchange system. In contrast, the FAQs allow (or at least do not disallow) use of a universal tracking approach where the taxpayer transferring, for example, 2 Xcoin out of wallet 1 to buy goods, could specifically identify to say they used the basis of 2 Xcoin in T's wallet 2. This would not be allowed under the proposed regulations. The long list of questions in the proposed regulations include though, whether there are alternatives to this approach (questions 44 & 45 at page 59616 in the Fed. Register).

Prop. Reg. 1.1001-7(c) and 1.1012-1(j)(6) provide that these proposed regulations are effective on the January 1 following when final regulations are published. However, page 59616 in the Fed. Register states that the 1001/1012 proposed regulations are reliance regulations. That is, per the preamble, taxpayers "may rely on these proposed regulations under sections 1001 and 1012 for dispositions in taxable years ending on or after August 29, 2023, provided the taxpayer consistently follows the proposed regulations under sections 1001 and 1012 in their entirety and in a consistent manner for all taxable years through the applicability date of the final regulations."

Since the broker reporting regs under section 6045 won't be effective for reporting of gross proceeds until sales on or after January 1, 2025 (basis reporting for sales on or after January 1, 2026), if a taxpayer follows the date of the proposed 1001/1012 regulations starting for 2023, they would also do so for 2024.

But, I don't think most taxpayers can follow the 1001/1012 proposed regulations until the 6045 regulations are effective because taxpayers might not be able to get the exchanges they use to help them with the specific identification called for in the proposed regulations.

But, practitioners need to present the effective date choice to clients because the decision is theirs to make. But before making it they should check if any exchange they use will allow them to specifically identify the digital asset they are transferring at the time of the transfer and document that for them (and apply FIFO if they do not give the exchange specific identification information at the time of a transfer). For unhosted wallets, the taxpayer handles that specific identification on their own, likely by sending themselves an email to document what they are doing and have the date verification from the email.

Also, would be a good idea to let your client know that the final regulations might have a different approach then tracking basis wallet by wallet and exchange by exchange. 

Not sure why the 1001/1012 proposed regulations were offered as reliance regs when there are reasons it is either impossible or unwise for taxpayers to start applying them for 2023 and 2024. Also, given the latitude in the virtual currency FAQs, if a taxpayer were tracking on a universal approach, they should be able to change going forward to wallet by wallet and exchange by exchange (with no need to get help from the exchange for that until the regs are finalized). The IRS notes in the preamble to the regs (page 59611 of the Federal Register) and at Prop. Reg. 1.1012-1(j)(4) that such a change is not a method of accounting as the method is still specific identification.

So, something to think about and find a way to present to your clients with digital assets so they can make the decision the IRS offers all taxpayers regarding the effective date of the 1001 and 1012 proposed regulations.

What do you think?

Challenges of Defining Virtual Currency - Recent Observations from FASB

At its August 31, 2022 meeting, the FASB discussed the scope of its digital asset project (see meeting handout here). This FASB project was adopted in May 2022 with the objective "to improve the accounting for and disclosure of certain digital assets." Well a good question is - what are digital assets and which should be addressed in the FASB project.

One part of the handout aims to identify characteristics that can help distinguish among various digital assets. It notes that specifying that the assets are "created or reside on blockchains and are secured through cryptography" will distinguish cryptocurrencies or crypto assets form other digital intangible assets such as software and data.

FASB also notes that terms such as "store of value" and "medium of exchange" are often used but "may not be helpful in defining" the scope of the FASB digital assets project because:

"(a) Other assets share these characteristics (real estate may be viewed as a store of value and money is a medium of exchange).

(b) A medium of exchange may depend on the perspective of the holder.

(c) A digital asset may not be considered a medium of exchange by some in practice because of limitations of networks.

(d) Evaluating whether an asset is a medium of exchange or store of value is subjective. For example, relative volatility may lead some stakeholders to conclude that a digital asset is a poor store of value."

There is more analysis in the handout.

I think the observations are interesting because in Revenue Ruling 2019-24, the IRS defines virtual currency as "a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the United states dollar or a foreign currency."

It does not define the terms "medium of exchange," "unit of account" or "store of value."

The instructions to the 2021 Form 1040 virtual currency questions also used the three traits above only it used OR rather than AND as used in Rev. Rul. 2019-24 (for more on that, see this 8/29/22 letter submitted to the IRS by the AICPA with suggestions to improve the ability of taxpayers to understand the question).

So, if FASB wasn't able to reach a clear understanding of cryptocurrencies per the terms "medium of exchange" and "store of value", how are individual taxpayers to do so?

When the word "or" is used for the three terms, non-fungible tokens (NFTs) seems to be a virtual currency for the Form 1040 question in 2021, but since they are non-fungible, they likely are not a virtual currency (not a unit of account perhaps) for the definition in Rev. Rul. 2019-24.

And the IRS definition makes no reference to a blockchain or distributed ledger for tracking the currency.

So, how should virtual currency be defined?

What do you think?

Helpful Crypto Taxation Report From Kansas

This month, the Kansas Legislative Division of Post Audit, a "non-partisan audit arm of the Kansas Legislature, released a very good background report on cryptocurrency and tax issues - Reviewing Issues Related to State Cryptocurrency Tax Policies. The Division's website also has a link to a 16-mimnute audio file that is about the best I have heard on the basics of cryptocurrency tech and tax. I recommend it if you feel you are missing the basics on these topics.

Appendix B is a helpful glossary of terms such as airdrop, blockchain, hard fork and staking.

A few interesting items from the report:

• 16% of people in the US have invested in or used cryptocurrency (per Pew Research Center).
  
  
• When there is not third party reporting (such as a 1099), only 45% of taxpayers accurately report their income. I have heard this before. Per the IRS (page 14), for income subject to substantial information reporting and withholding, there is only about 1% underreporting. In contrast, for income subject to little or no information reporting and no withholding, compliance is only about 55% (45% non-compliance).
  
  So if you wonder why IRC §6045 on broker reporting was expanded by the Infrastructure Investment and Jobs Act (PL 117-58, 11/15/21) to include virtual currency sales by exchanges (and perhaps by others), that the underreporting of transactions without third party reporting, is the key reason.
  
  
• "State governments have yet to agree on a set of best practices regarding the taxation of cryptocurrencies." There are no uniform laws. There have been a good number of legislative proposals (tax and non-tax) including per the NCSL, 43 bills in 22 states since 2015.

Some of the open issues in most states regarding cryptocurrency include:

• For states that subject digital goods and electronic transmissions to sales tax, are cryptocurrency and non-fungible token (NFT) transactions subject to sales tax. Recently, Pennsylvania confirmed that NFTs are subject to sales tax.
• How does a business source income and gains from virtual currency?
• How do unclaimed property laws apply to cryptocurrency and other digital assets?

At the virtual currency and blockchain website I maintain, search for "state information" and you'll see a long list of various rulings and legislation in states regarding cryptocurrency.

What do you think?  Any particular guidance you are waiting for on cryptocurrency from a state?

Digital Asset Reporting in H.R. 3684 Infrastructure Legislation

Late on November 5, 2021, the House passed (228-206) H.R. 3684, INVEST in America - the infrastructure bill that has received a lot of attention this year. It already passed in the Senate on August 10 (69-30).

One of the few tax items here and added for tax gap concerns is to expand the definition of broker under §6045 to require additional reporting for certain digital asset transactions. A few observations:

1. There are much bigger tax gap concerns than misreporting or non-reporting of digital asset transactions such as underreporting and non-reporting by some cash businesses.

2. The text added to §6045 requires actions by the IRS and is confusing and potentially too broad to be administrable (unless the IRS addresses that broadness). The issue is that "broker" is expanded to include: "any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person." While the goal was likely to make virtual currency exchanges such as Coinbase and Kraken be brokers, the reach is potentially wider. For example, what about a company that provides various software for transfers or wallets? 

Digital asset is also broad and warrants input from IRS: "Except as otherwise provided by the Secretary, the term "digital asset" means any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary."

That last phrase reminds me of the cryptic item in the 2020 Form 1040 instructions on the broadness of "virtual currency." The instructions for the virtual currency questions included for 2020: "Regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as virtual currency for Federal income tax purposes." [page 17 of 2020 Form 1040 instructions] What does that mean?

I have a track changes version of §6045 and related provisions that were modified by H.R. 3684 (Sec. 80603), which can help see the set of changes to broker reporting that were made.

These changes are effective for statements required by be furnished after 12/31/23 so there is time for the IRS to issue proposed regulations and get public comment.

What do you think?