Last week, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) released final regulations that significantly impact the reporting requirements for brokers involved in digital asset transactions. The stated aim of the new rules, which are part of the Biden-Harris Administration’s implementation of the bipartisan Infrastructure Investment and Jobs Act, is to streamline tax reporting and ensure compliance within the decentralized finance (DeFi) sector. The regulations will become effective 60 days after their publication in the Federal Register.

However, on the same day the regulations were announced, a complaint was filed by the Blockchain Association, Texas Blockchain Council, and DeFi Education Fund against the IRS challenging the new regulations for allegedly violating the Administrative Procedure Act (APA). The plaintiffs also raise constitutional issues, arguing that the final regulations violate the Fourth Amendment by invading the privacy rights of transaction participants and amount to an unconstitutional search. Additionally, the regulations are claimed to be unconstitutionally vague under the Fifth Amendment, as they do not provide clear notice to regulated parties.

Authority and Background:

The regulations clarify that the definition of a broker under § 6045(c)(1)(D) of the Internal Revenue Code includes any person who regularly provides services effectuating transfers of digital assets on behalf of another person. This broad definition ensures that various DeFi participants, including those providing front-end services, are covered under the reporting requirements.

The regulations draw a comparison between the functions carried out by brokers in the securities industry and those in the DeFi ecosystem. In the securities industry, brokers facilitate transactions by receiving trade orders, routing them to trading centers, and ensuring the settlement of trades. Similarly, DeFi brokers provide services that enable digital asset transactions through decentralized platforms.

Impact on Taxpayers and Brokers:

The new regulations do not impose any additional tax obligations on digital asset holders. Taxpayers have always been required to report gains from digital asset transactions. The regulations aim to make the filing process easier by ensuring that taxpayers receive Form 1099 from brokers, reminding them of their tax obligations and reducing errors or noncompliance.

DeFi brokers are now subject to the same information reporting rules as traditional securities brokers and custodial digital asset trading platforms. This includes reporting gross proceeds from digital asset transactions and furnishing payee statements to customers.

Complaint Filed

On the same day the rule was announced, a trio of nonprofit organizations filed a complaint in the Northern District of Texas arguing that the new regulations represent an unlawful and unconstitutional overreach by the Treasury and the IRS.

Specifically, the complaint asserts that the Treasury has unlawfully redefined the statutory term “broker” to include entities that provide “trading front-end services” or “other effectuating services,” even if they do so for free and do not themselves effectuate transfers. This redefinition, according to the plaintiffs, goes beyond the authority granted by Congress.

The plaintiffs also argue that the regulations impose onerous reporting requirements on DeFi industry participants, which are not brokers in the traditional sense. Complying with these requirements would be technologically impossible for many DeFi entities and would require them to collect and store vast amounts of sensitive personal information. The complaint highlights the significant economic burden the final rule would impose on the DeFi industry. The IRS estimates that compliance would require more than four billion hours annually and cost over $260 billion. According to the complaint, this burden could drive many DeFi companies to move overseas or shut down entirely.

The plaintiffs are seeking several forms of relief, including a declaratory judgment that the regulations are arbitrary, capricious, or otherwise contrary to law within the meaning of the APA, an order vacating and setting aside the regulations in their entirety pursuant to the APA, and an injunction preventing the Treasury from enforcing the regulations against the plaintiffs and other blockchain industry participants.

We will continue monitoring this litigation and reporting any significant updates.