KYC and IRS tax reporting are coming to DeFi platforms Emergency USA

Today, the IRS released the highly-anticipated & controversial Decentralized Finance (DeFi) broker tax regulations. If you are involved in the DeFi space, big changes are on the horizon.

Note: these new regulations primarily apply to DeFi trading platforms. So, individual taxpayers don’t have much to worry about at the moment. However, there are some indirect consequences for DeFi users such as exposing personally identifiable information (PII) to platforms and receiving incomplete tax forms.

Quick Background Broker Regulations

Under the original §6045 of the tax code, stock brokers were required to obtain customers’ Know Your Customer (KYC) information, compute gains and losses, and report that information to the IRS. This is why you receive Form 1099-B from stock brokers like Robinhood, Charles Schwab, etc. at the end of the year showing your annual gains and losses.

Last year, the IRS extended these rules to custodial crypto brokers, in simple terms, centralized finance (CeFi) exchanges. Today, the IRS clarified how these broker rules will apply to DeFi.

The Three Layers of the DeFi Stack

The IRS has identified three distinct layers within the DeFi ecosystem.

1. Interface Layer: This includes the user-facing components, such as screens, buttons, forms, and other visual elements within websites, mobile apps, and browser extensions. It’s the layer that facilitates communication between users and DeFi participants.
2. Application Layer: The layer that executes a user’s trade orders as part of the transaction validation process.
3. Settlement Layer: Responsible for recording financial transactions on the distributed ledger, including trades conducted using DeFi protocols.

Interface Layer to be Classified as a Broker

The IRS has determined that only the Interface Layer, more specifically, “Front-end trading services”, will be treated as “brokers” going forward. The general rationale is simple: front-end trading services have the closest relationship with customers and therefore in a position to obtain KYC info and report relevant data to the IRS.

Impact on DeFi Platforms

The IRS has indicated that Front-end trading services include websites, unhosted wallets, and browser extensions that allow users to swap digital assets through their interface.

If you operate such a service, you must KYC your customers (similar to CeFi exchanges), track transactions, and report proceeds to the IRS and customers using Form 1099-DAs for transactions occurring after January 1, 2027. There’s no requirement to capture or report cost basis.

Note: Unhosted wallets which only allow you to manage private keys (basic wallets) are not brokers.

Impact on DeFi users

As a customer of Front-end trading services, you can expect the following changes in the coming years. First, you will need to share your KYC information with the front-end service platforms during the onboarding process. Second, you will receive tax forms only showing proceeds generated by digital asset sales.

Note: these tax forms will not show your cost basis information. You will still need to use crypto tax software or rely on your book & records to track your cost basis and report accurate gains and losses on your taxes.

Potential Paths Forward for DeFi Players

Given these new regulations, DeFi platforms likely have three primary options:

1. Comply with the new rules.
2. Litigate and/or hope the DeFi regulations are repealed by the incoming administration—a significant possibility considering the incoming pro-crypto administration.
3. Relocate operations outside the US. However, this approach comes with its own challenges, as platforms may still fall under other international tax regimes, such as the crypto assets reporting framework (CARF) and Markets in Crypto-Assets Regulation (MiCA).

These new DeFi regulations mark a significant shift for the DeFi industry. While they aim to bring more accountability and transparency, they also pose challenges for both platforms and users. Staying informed and prepared is key as the DeFi ecosystem navigates these changes.

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Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.