IRS Broker Rule Proposal Puts DeFi in Tough Spot

Background

In August 2021, when Congress was weighing President Biden’s Infrastructure Bill, later named the “Infrastructure Investment & Jobs Act,” language was included that broadened the IRS’ tax reporting rules to include a wide swath of entities in the digital assets ecosystem. At that time, I wrote that this language was ‘bad and needs to change,’ arguing that the language was highly problematic because it could require IRS reporting from several types of previously un-covered entities, including several that functionally will be unable to comply. Some such entities identified in our Aug. 2021 report included:

• Network participants like nodes, validators, or miners

• Non-custodial services like software wallets, hardware wallets, or multisig collaborative custody providers

• Software developers who build applications that facilitate blockchain access used by third parties

• Decentralized exchanges, DeFi applications, or NFT marketplaces

Applying a “broker” designation to these entities in law could make them illegal in practice given their functional inability to comply. There was a great back-and-forth, with many senators speaking on the industry’s behalf, but ultimately the language was included in the bill, which passed and became law. Two years later, on Aug. 25 the U.S. Department of the Treasury’s Internal Revenue Service (IRS) released a 282-page document detailing their proposed interpretation of their new authority to designate digital asset entities as brokers.

Rule Proposal

On Friday Aug. 25, the Treasury issued its proposed regulations emanating from the authority granted in the Infrastructure Investment & Jobs Act. The proposed language is quite expansive and would require IRS tax reporting from a wide swath of entities, even including many non-custodial services.

What Do “Brokers” Need to Do?

Entities that are designated brokers under the rules would be required to:

• Collect KYC information for all US users

• Furnish individual users and the IRS with transaction information (including gross proceeds) for digital asset sales/conversions on Form 1099-DA

Redefining “Broker”

Specifically, persons or entities that will be considered “brokers” and must comply with these new reporting requirements under the proposal include:

Any person (individual, legal entity, or unincorporated group or organization) that

• is “in the position to know the identity of the party” (i.e., user) AND

• provides “facilitative services that effectuate the sales of digital assets by customers.”

Notably, this interpretation expands the meaning of “effect” (under existing Treasury Regulation § 1.6045-1(a)(10)(i) and (ii)) to include any person that is in a position to know customer identity information is a broker and would need to comply—not simply a person who ordinarily would know such information (the prior language).

The IRS spends significant time explaining and clarifying the meaning of the first prong. The agency explains, for example, that the reason that “ordinarily would know such information” is insufficient for digital assets is that:

“Some digital asset trading platforms… have a policy of not requesting customer information or requesting only limited information… [but] have the ability to obtain information about their customers by updating their protocols as they do with other upgrades to their platforms. The ability to modify the operation of a platform to obtain customer information is treated as being in a position to know that information.” (p. 36, emphasis added)

Essentially, the IRS says, if you can upgrade your platform to request user identifying information, you must do so.

The IRS defines a facilitative service as:

“Any service that directly or indirectly effectuates a sale of digital assets, such as providing: a party in the sale with access to an automatically executing contract or protocol; access to digital asset trading platforms; order matching services; market making functions to offer buy and sell prices; or escrow or escrow-like services to ensure both parties to an exchange act in accordance with their obligations.” (p. 38)

The combined effect of these two changes – in a position to knowand facilitative service– are such that any digital asset trading platform, dApp, wallet (non-custodial or otherwise), or dApp that is a facilitative service and could perform KYC, whether or not they do today, must perform KYC and provide IRS reporting both to the agency and to users who transact in digital assets through the service.

Affected Crypto Entities

Based on our analysis (and the detailed explanations the IRS provides in its proposal), the following crypto ecosystem entities are likely “brokers” under the proposed regulation, ordered from most obvious/likely to least:

Centralized exchanges & custodians

This category is straightforward. Exchanges, which are certainly aware when a transaction they facilitate is a buy or sell and which already perform KYC, are undoubtedly digital asset trading platforms and will be required to provide tax reporting to both individuals and the IRS.

Wallets, whether custodial or non-custodial, that facilitate any kind of trading

The operators of a custodial wallet, in which users register accounts with the software applications, likely already know their users’ identities, and if the application provides the ability for users to buy/sell, regardless of mechanism, then it would be a facilitative service. If it has both of those prongs, then it is reasonable to expect the wallet operators to be able to know whether gains or losses have occurred, requiring the operators to report.

The rule’s interpretation is a bit tricker for non-custodial wallets, but it appears that even those wallets, if they provide facilitative services, such as in-app swap functionality, would be required to add KYC and conduct tax reporting.

Take Metamask, for example. Metamask is a non-custodial wallet that provides users with the ability to trade tokens directly from its interface. While it does not actually conduct the trades itself as a principal or agent, it does “provide access to digital asset trading platforms” and thus “indirectly effectuates a sale of digital assets.” While Metamask-initiated swaps actually route through third-party DeFi applications, Metamask does collect a fee (consideration), and it certainly helps “effectuate” and “facilitate” sales of digital assets. Furthermore, Metamask is in a position to know because it easily could require KYC from all its users. Other non-custodial wallets offer much clearer facilitative services because their liquidity is sourced directly from centralized services (like exchanges, market makers, or other liquidity providers). These types of wallets that offer in-app trading, although non-custodial in nature, are likely to be “brokers” under the proposed rule. The IRS confirms that the following is a “broker” under the new rule:

“A person who sells or licenses software to unhosted wallet users if that person as part of its trade or business also offers services to such wallet users that effect sales of digital assets, provided the person would ordinarily know or be in a position to know the identity of the wallet users that effect the sales and the nature of the transactions potentially giving rise to gross proceeds from the sales.” (p. 211)

Website front-ends for DeFi, NFT platforms, even block explorers

In a section at the end of the proposed rule document regarding unhosted wallets, the IRS suggests that the broker designation should also be applied to:

“A person who in the ordinary course of a trade or business operates a non-custodial trading platform or website that stands ready to effect sales of digital assets for others by allowing persons to exchange digital assets directly with other persons for cash stored-value cards, or different digital assets, including by providing access to automatically executing contracts, protocols, or other software programs that effect such sales.” (p. 212)

It flows logically from the IRS’ prior construction, as discussed above, that a front-end website for a DeFi app (such as http://app.uniswap.org) is in a position to know its users and their gains and is also a facilitative service, but this footnote makes the government’s view on this matter plain. Front-ends created by DeFi teams are capable of being upgraded to require account creation and subsequent KYC procedures, and under the in a position to know standard, they would be required to do so. NFT marketplaces, even though they too are non-custodial, similarly could require account creation and KYC, and under the rule they are likely facilitative services.

However, the inclusion of the term “website,” along with the “providing access to automatically executing contracts” could also ensnare less obvious websites, such as block explorers themselves, which may assist in constructing transaction code that users can then execute themselves to access “automatically executing contracts.” As Delphi Digital’s Gabriel Shapiro points out, the proposal “could even sweep in Etherscan since it can be used with smart contracts.”

Decentralized applications themselves

Smart contract applications, such as many in DeFi, could be required to comply with the proposed rules, specifically if the contracts that comprise the application are upgradeable. The IRS writes that “a person is in a position to know the nature of the transaction… if that person maintains sufficient control or influence over the facilitative services provided… [and] as a result, a person will be considered to be in a position to know the nature of the transaction potentially giving rise to gross proceeds from a sale if the person has the ability to modify an automatically executing contract or protocol… the fact that a digital asset trading platform operator has modified an automatically executing contract or protocol in the past, or has replaced such a contract with another contract in its protocol, strongly suggests that the operator has sufficient control or influence over the facilitative services.”

Along the same lines, the IRS addresses the fact that many DeFi applications are controlled by DAOs, suggesting that the upgradeability of contracts, and thus the possibility that those applications could be in a position to know, is not necessarily mitigated by widely distributed governance token structures:

“Some decentralized autonomous organizations (DAOs) are an example of this organizational structure. Even in structures where governance tokens may be widely distributed, individuals or groups of token holders can have the ability to maintain practical control. In addition, in some cases, so-called “administration keys” exist to allow developers or founders to modify or replace the automatically executing contracts or protocols underpinning digital asset trading platforms without requiring the vote of governance token holders.” (p. 41)

Thus, popular DeFi applications that can be upgraded on the direction of votes by token holders could be required to collect KYC information and track and report user PnL. Unlike some other determinations made in the proposal, the IRS is not certain on the extent to which these types of entities qualify as brokers. Instead, they seek comment specifically on this point. However, the government appears to be leaning more firmly in the direction of designating as brokers any such apps that can be controlled or upgraded unilaterally via admin keys (such as a multisig arrangement, with or without the votes of token holders). The bottom line, though, is that smart contract upgradeability—regardless of method—is likely to be a significant determinant of broker status in the eyes of the IRS.

Exempted Crypto Entities

Some entities are specifically exempted from brokers as defined in the proposed rules.

Miners & Validators

Miners or validators who simply append transactions to the blockchain, although they may collect a small network transaction fee, do not provide facilitative services, do not act as “a digital asset middleman” or a “broker” and thus are not covered by the proposed rule. This is a crucial exemption that prevents the broker designation from extending to layer 1 blockchain infrastructure. Specifically, because these parties are not in a position to know the parties making a sale, they cannot be brokers, even if they may indirectly function as facilitative services.

Hardware & Software Wallets

Entities that are “solely in the business of selling hardware or licensing software for which the sole function is to permit persons to control private keys” are excluded from the facilitative services definition. However, as mentioned above, if wallets also provide “users with direct access to trading platforms from the wallet platform” then they would be included. Similarly, collaborative custody services (such as Casa or Unchained Capital), would not be deemed to be brokers if they do not also provide the ability to buy and sell bitcoin.

Key Dates

• The proposal was published in the Federal Register on Friday, Aug. 29, and the public now has 60 days (Oct. 30) to submit comments on the proposed regulation.

• The IRS will hold a public hearing on Nov. 7 at 10am ET. Those who wish to speak at the public hearing must also submit their written comments and an outline of topics to be discussed (and the time requested for each topic) before the 60-day comment window closes (Oct. 24). If too many people want to speak at the Nov. 7 hearing, the IRS will hold a second hearing on Nov. 8.

• If adopted, the rules will require entities classified as brokers to furnish both to customers and the IRS Forms 1099-DA in 2026 covering transactions in the 2025 tax year, meaning that platforms and users must comply for the entirety of 2025.

Discussion & Analysis

The expansion of the “broker” definition for the proposed rules has major implications for the cryptocurrency ecosystem. Formalizing the industry’s tax compliance can help tether the industry to the national wellbeing by codifying the fact that the ecosystem contributes to the broader economy.

However, the proposed rules may be a major setback for the more decentralized segments of the ecosystem, particularly for otherwise non-custodial onchain applications. DeFi applications are the most directly affected, as most front-end websites will need to comply or block U.S. users. Although DeFi applications can be accessed without the use of a front-end, or with an open-source front-end run locally by the user, the smart contracts themselves may be brokers if they are controlled by persons directly (through admin keys) or collectively (through DAOs).

It’s very possible that the pragmatic effect of these rules, if they come into force (and we believe there is a strong likelihood that they are enacted with minimal changes), is the wholesale relocation of DeFi outside the U.S., which is a precarious suggestion given that these applications live on global, permissionless ledgers whose jurisdictional nexus is still an uncertain question of law. Rather than undertake the burden of complying (which may have the practical effect of neutering core features), some applications and developer teams may decide instead to try to ban U.S. users, effectively creating a “Great American Firewall” around what many consider to be the future of finance.

If these rules are the ‘stick,’ then the Tornado Cash court ruling may be the “bludgeon.” While these proposed rules concern tax compliance and the Tornado Cash ruling and arrests involve claims of money laundering, the requirement for DeFi applications to perform KYC on users is a common thread. While it appears the government’s aggressive stance to Tornado Cash is driven primarily by national security concerns, tax compliance is also high on the government’s list of priorities. While the Tornado Cash developers were not in a position to know at the smart-contract level, they were in a position to know on their website front-end, and they apparently expressly chose not to enact any KYC or anti-money laundering mitigations. It is not difficult to imagine the IRS utilizing the same tactics against developers of non-upgradeable smart contracts who do not update their web front-ends to comply with the tax reporting rules. (It is important to note that the Tornado Cash cases and the broker rule involve different matters of law—money laundering vs. tax compliance—and also that there are some bad facts in the Tornado Cash allegations, such as the fact that developers are alleged to have known that Lazarus Group hackers were utilizing their web front end but still chose not to block their access, as well as the fact that Tornado Cash fees accrued to a team treasury (so the developer profited off Tornado Cash usage). However, Tornado Cash developers possessed no admin keys and the contracts themselves cannot be upgraded.)

Another big question is whether an entity in a position to know that provides a facilitative service would need to also do so for a consideration, which is a contingent clause in the currently statutory language (and which is not modified by the new language). The proposed rules appear to be inconclusive on this point, suggesting perhaps that entities seeking to avoid a broker designation could do so by not accepting any fees for their facilitative services. That being said, the thrust of the document suggests that the IRS is not inclined to allow digital asset facilitative services to avoid a broker designation simply by removing fees (or by not charging them in the first place). This question will certainly be raised in comments by industry participants.

It does appear, though, that DeFi applications with no front-end website, non-upgradeable contracts, and that receive no “consideration” from the disposition of digital assets (i.e., collect no fees), could be exempt from being designated “brokers” under the proposal. Said another way, extremely decentralized applications are not in a position to know and thus could not comply with broker reporting requirements, and they wouldn’t have to. Most of DeFi does not meet this standard today, as the majority of applications have contracts that are upgradeable (either by admin keys, governance, or both) and developers who also operate a front-end website to facilitate access to the services.

Three Options for DeFi

Thus, it appears there are essentially three options for DeFi to consider with respect to the proposed reporting rules:

1. Accept a broker designation and comply. To accomplish this, web front-ends will require account registration (not just “connect wallet”) so they can properly create Forms 1099-DA to be furnished to both the users and the IRS. If the underlying smart contracts are not upgradeable in any way, it appears that only the front-ends would be deemed brokers. If the smart contracts are upgradeable, it appears that developers may be required to create address-based whitelisting at the contract level, effectively creating “permissioned DeFi.” There will likely be many comments to IRS on this point.

2. Attempt to block U.S. users. As these rules only apply to U.S. taxpayers, DeFi applications could attempt to block U.S. users from accessing the facilitative services. For website front-ends, this can be somewhat accomplished by banning U.S. IP addresses from website front-ends, but it is most likely impossible at the smart contract level without enacting full address whitelisting.

3. Abandon upgradeability, front-ends, and fees entirely. Smart contract code that is 1) deployed to Ethereum or another blockchain that cannot be upgraded (by governance or admin keys or otherwise), 2) has no accompanying publicly website front-end maintained by project developers to assist users in accessing the facilitative services, and 3) pays no fees to project teams or developers, may be able to avoid a broker designation entirely. It may be possible for developers to publicly release code for a web front-end that can be run locally by users. This approach harkens back to the most cypherpunk visions of the cryptocurrency movement. But while it could remain effective for users, it makes it difficult if not impossible for developers to profit off their inventions and applications.

There are plenty of questions about the proposed rule and how it will affect various segments of the cryptocurrency ecosystem. IRS is accepting public comments until October 30, and it’s very likely we will see many comments made by industry participants and stakeholders to seek clarity or push back on various of the points raised in the report.