KYC and IRS tax reporting are coming to DeFi platforms

Today, the IRS released the highly anticipated and controversial tax regulations for Decentralized Finance (DeFi) brokers. If you’re 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 to worry much at the moment. However, there are some indirect consequences for DeFi users, such as: B. sharing personal information (PII) with platforms and receiving incomplete tax forms.

Brief background information on broker regulations

Under the original Section 6045 of the Tax Code, stockbrokers were required to obtain customers’ know-your-customer (KYC) information, calculate profits and losses, and report this information to the IRS. This is why at the end of the year, stock brokers like Robinhood, Charles Schwab, etc. will give you Form 1099-B detailing your annual gains and losses.

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

The three layers of the DeFi stack

The IRS has identified three different 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 is the layer that facilitates communication between users and DeFi participants.
2. Application layer: The layer that executes a user’s trading orders as part of the transaction validation process.
3. Settlement layer: Responsible for recording financial transactions on the distributed ledger, including trades conducted via DeFi protocols.

Interface layer to be classified as a broker

The IRS has determined that only the Interface layermore specifically, “front-end trading services,” will henceforth be treated as “brokers.” The general idea is simple: front-end trading services have the closest relationship with customers and are therefore able to obtain KYC information and report relevant data to the IRS.

Impact on DeFi platforms

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

If you operate such a service, you will be required to 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 1st take place in 2027. There is no obligation to record or report cost basis.

note: Non-hosted wallets that only enable the management of private keys (basic wallets) and 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 need to share your KYC information with the front-end service platforms during the onboarding process. Second, you will receive tax forms Only revenue is shown generated through the sale of digital assets.

note: Your cost basis information will not appear on these tax forms. You will still need to use crypto tax software or rely on your books and records to track your cost basis and report accurate gains and losses on your taxes.

Possible future paths for DeFi players

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

1. Follow the new rules.
2. Litigation and/or hope that DeFi regulations are repealed by the new government – ​​a significant possibility given the new crypto-friendly government.
3. Relocating operations outside the United States. However, this approach comes with its own challenges as platforms may still be subject to other international tax regimes, such as the Crypto Assets Reporting Framework (CARF) and the Markets in Crypto-Assets Regulation (MiCA).

These new DeFi regulations represent a significant shift for the DeFi industry. While they aim to provide greater accountability and transparency, they pose challenges for both platforms and users. As the DeFi ecosystem navigates these changes, it is important to stay informed and prepared.

Disclaimer: This post is for informational purposes only and is not intended as tax advice. For tax advice, please contact a tax advisor.