Digital asset broker tax reporting rules for DeFi participants finalized

On December 27, 2024, the US Department of the Treasury and the Internal Revenue Service (IRS) announced the release of a second set of final regulations implementing a new reporting regime for digital asset “brokers,” which focuses primarily on decentralized finance (DeFi) transactions that utilize automatically executing software (the DeFi Regulations). (For information on the first set of final regulations, see our earlier alert). The DeFi Regulations expand upon final regulations published on July 9, 2024 applicable to custodial digital asset trading platforms (the Custodial Regulations), which we discussed in an earlier alert. The DeFi Regulations require DeFi service providers that interface with users (so-called “front-end trading services”) to collect certain information from users, and report digital asset transactions to the IRS on new IRS Form 1099-DA. Importantly, while reporting obligations for brokers subject to the Custodial Regulations begin for sales occurring on or after January 1, 2025, reporting obligations for DeFi service providers will begin for sales of digital assets occurring on or after January 1, 2027.

Background

The Custodial Regulations generally apply to digital asset brokers that act as agents for a party in the transaction, such as operators of custodial digital asset trading platforms, certain digital asset hosted wallet providers, and certain processors of digital asset payments (PDAPs), as well as persons that interact with their customers as counterparties to transactions, such as owners of digital asset kiosks, brokers who accept digital assets as payment for commissions and certain other property, brokers that transact as dealers in digital assets, and certain issuers of digital assets who regularly offer to redeem those digital assets. In the Custodial Regulations, Treasury and the IRS punted on finalizing the definition of “digital asset middleman” from the proposed regulations as applied to DeFi service providers (referred to in the preamble to Custodial Regulations as “noncustodial industry participants”), because they determined that additional consideration of the issues and comments received with respect to these participants was warranted. After six months of additional study and review, the DeFi Regulations have been finalized.

In the preamble to the DeFi Regulations, Treasury and the IRS dedicated significant time discussing the “decentralized digital asset ecosystem” and explaining how, in their view, DeFi service providers use distributed ledger technologies to offer investment and other financial services, similar to those provided in the securities industry by securities brokers and exchanges, that enable customers to carry out trades of digital assets using applications (sometimes referred to as DeFi applications or dApps) without relying on a traditional centralized financial intermediary. Treasury and the IRS described the decentralized digital asset ecosystem as being a technology stack with (at least) three distinct layers:

• Interface layer: The layer that enables digital asset users to communicate with DeFi service providers operating on the other layers for ultimate execution and settlement of the transaction, which is achieved by providing software (sometimes referred to as front-end services) that provides the digital asset user with tools – including screens, buttons, forms, and other visual elements incorporated in websites, mobile device apps, and browser extensions – that users may use to trade digital assets in their unhosted wallets using DeFi protocols or DeFi aggregators operating on the application layer.
  
  
• Application layer: The layer that executes the user’s trade order as part of the validation process. It is comprised of DeFi protocols that consist of automatically executing software programs or smart contracts that, when called upon, perform a predetermined series of actions. For example, exchanging digital asset A for digital asset B, when certain conditions are met.
  
  
• Settlement layer: The layer generally responsible for recording financial transactions on the distributed ledger, including transactions conducted by users that trade digital assets using DeFi protocols.

Who is a broker under the DeFi Regulations?

Under the DeFi Regulations, only those service providers at the interface layer (ie, trading front-end services) are treated as brokers. Treasury and the IRS determined that the only DeFi service providers that should be treated as brokers are trading front-end service providers, because (i) such providers are the DeFi participants that have the closest relationship to customers and therefore are in the best position to obtain customer identification information, and (ii) they provide services that are most analogous to the functions performed by brokers in the securities industry.

The DeFi Regulations implement this decision by defining the term “digital asset middleman” as,

“any person who is responsible for providing an effectuating service ... with respect to a sale of digital assets. An “effectuating service” in turn means any service, with respect to a sale of digital assets, that is a trading front-end service and where the type of arrangement means the provider would know or is in a position to know whether the nature of the transaction involved gives rise to reportable gross proceeds from the sale of digital assets.”

A trading front-end service means a user interface that enables a user to input order details and transmit those order details to an automated protocol that is part of a distributed ledger network. This seems to focus on persons who operate websites that enable users to connect to digital asset trading protocols.

Being in a “position to know” depends on whether a person has control or sufficient influence over the trading front end-service, which means having the ability to (i) amend, update, or otherwise affect the terms under which the services are provided, (ii) collect fees from the transaction flow, whether or not such fees are being collected, and (iii) track or receive confirmation back from the distributed ledger that the order was executed and posted to the ledger.

Who is not a broker under the DeFi Regulations?

The DeFi Regulations exclude from the definition of “effectuating services” (and therefore from the definition of broker) the following market participants:

• Distributed ledger validation services, which includes all services necessary to complete the validation of transactions on a blockchain, regardless of the consensus mechanism involved.
  
  
• Persons that license or sell unhosted wallet services that are used to manage private keys, except (i) where the unhosted wallet service provider also provides effectuating services, including trading front-end services, in which case the wallet service provider will be subject to reporting, but only with respect to the effectuating services it provides, or (ii) where the wallet provider creates the coded trade order instructions that includes the specifics of the customer’s trade order.

When do the DeFi Regulations take effect?

Reporting by DeFi brokers is required on transactions that they effectuate on or after January 1, 2027, with reporting beginning in 2028. Since the DeFi Regulations address non-custodial participants, Form 1099-DA reporting by DeFi brokers is expected to include only reporting of gross proceeds. Backup withholding applies to DeFi broker transactions, as with other reportable broker payments, but Treasury and the IRS intend to release proposed regulations under section 3406 to “provide trading front-end service providers with greater flexibility to satisfy their backup withholding obligations with respect to these transactions.”

However, to permit DeFi participants, who are unaccustomed to collecting information from their users, more time to prepare for these rules, the IRS issued Notice 2025-03, which provides that a DeFi broker will not incur penalties for failure to comply with its reporting requirements vis-à-vis transactions effectuated on or after January 1, 2027, but only where the DeFi broker makes a good-faith effort to file and furnish required Forms 1099-DA accurately and timely. Notice 2025-3 provides that a broker will not be considered to have made a good-faith effort if it files or furnishes “after the later of the date that the IRS first contacts the broker concerning an examination of such broker or one year after the original due date for filing such returns.” Backup withholding also is phased in under Notice 2025-3.

Lawsuit against the DeFi Regulations

On the same day the DeFi Regulations were published, the DeFi Education Fund, the Blockchain Association, and the Texas Blockchain Council filed a lawsuit in the US District Court for the Northern District of Texas, challenging the rule on the basis that it exceeds the agencies’ statutory authority, violates the Administrative Procedure Act, and is unconstitutional.