IRS Enforcement of Digital Assets is on the Rise
Tax Guidance and Expectations
While regulatory guidance for digital assets is still unclear, enforcement actions are on the rise. What should you be thinking about to be better prepared and avoid non-compliance risks?
Good afternoon everyone. Thank you for joining us today. Greatly appreciate your time and energy devoted to this webinar. I wanted to introduce you to my partners who are joining me on this call. Miri Forster, who's the leader of our tax controversy practices group. Nate Shubert, who's a member of our private client services group, and blockchain and digital assets group as well. And I'll be joining you on this webcast today. We have an exciting outline and agenda of topics to discuss with you today, and hopefully it will be relevant and timely. We're going to provide you with an overview of the current state of affairs.
We're going to discuss briefly non-fungible tokens, and we're going to talk about an item near and dear to my heart, staking and the Jarrett case. We're also going to discuss the proposed regulations that have been issued and the impact on broker reporting requirements. That's a broad topic that will interest most of the listeners today. We're going to talk about future expectations, and then most importantly, tax reporting and IRS enforcement as we go forward. With that, I'm going to turn it over to my colleague, Miri, to discuss the overview. Miri.
Thanks so much, Jon. So, it's been a long time since Bitcoin was launched back in 2009 as the first cryptocurrency. Since then cryptocurrencies have exploded in popularity. There are more than 25,000 different types in the marketplace today. And while the popularity and the market swings that have occurred over the years are well known, the guidance on the tax treatment of cryptocurrency transactions has been quite a bit light. As some of you on the webinar probably know, the first guidance was issued by the IRS in notice 2014-21. That early notice explained that virtual currency was to be treated as property for federal income taxes rather than as a security. And that notice gave examples of how tax principles for property transactions would apply to virtual currency. And then there was a little bit of a lull, and about five years later the IRS released a revenue ruling, revenue ruling 2019-24, and that addressed the tax implications of a hard fork.
And in the absence of real formal guidance, the IRS also began issuing FAQs to help taxpayers who wanted to try to do the right thing with regard to the reporting of crypto transactions. And while the FAQs were certainly helpful, FAQs are not law. And so, intentionally or unintentionally, abuses started to take place and the IRS realized it needed to step up its game. So, about a year or so ago the IRS created a digital assets office. It has a dedicated project director and somewhere between half a dozen and a dozen people dedicated to identifying strategy and priorities related to the tax treatment of digital assets. And since that office was formed, there's been a lot of activity actually. The IRS has continued to add to its FAQs. There's about 46 now. The last update on the IRS website was I think August of '23. And the FAQ development has been the result of the office's own internal work, but they've also gathered a lot of feedback from industry groups, tax practitioners and other stakeholders.
And the most significant amount of guidance, like I said, was '23, the non-fungible token guidance that we're going to talk about, the tax treatment of staking and the proposed regulations. Now, while many unanswered questions remain, it's certainly clear that the current state is much different from the limited guidance that we had back in 2014. And the message also clear is that the IRS is focused, very focused, on the proper reporting of cryptocurrency transactions and that taxpayers who don't comply really should expect increased scrutiny. So, to start us off, I'm going to pass it off to Nate. Let's talk about some of that NFT guidance that came out this year.
Miri, I think we got polling question next, actually.
Polling Question #2
I lost track-
And while the poll...
Sorry, Nate. While we're waiting for the polling question, I just want to talk about FAQ number 46. Number 46 asks, what records do I need to maintain regarding my transactions in virtual currency? So, that FAQ does talk about the RSC and regulations that require taxpayer to maintain records that are sufficient to establish the positions taken on their tax returns. Records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of virtual currency. So, the expectation is that people are maintaining documents already.
There's a significant number of transactions that can definitely get involved with digital assets. So, the volume can greatly muddy the waters, if you will.
Okay. Looks like we're done with the polling question. So, Nate, go ahead on NFTs.
Sure. Thanks, Miri. Good afternoon everyone. As she mentioned, 2023 was a pretty active year. To start things off, in March the IRS issued notice 2023-27 regarding NFTs, non-fungible tokens, and basically determining whether or not they may be considered a collectible. Before getting into that, I'm first just going to give a little background on NFTs to make sure we're all on the same level playing field. So, NFT is non-fungible tokens. I actually like to start with the word fungible. You can replace an identical item with another one, they're mutually interchangeable. So, think of your $5 bill, it can exchange with any other $5 bill. Or that $5 bill can interchange with five $1 bills. That's perfectly fine. NFTs though are unique. And so, they cannot be copied, substituted or subdivided. They're recorded on blockchain and it's used to certify the authenticity and ownership. And so, really that's where that value argument comes into play with NFTs, regarding that ownership and then the scarcity component.
They can come in a lot of different forms. It could be providing ownership related to various digital files, images, which seem to be the most popular, maybe videos. Perhaps it relates to a physical item, gems or maybe down the road vehicle titles. But also maybe other rights, maybe that NFT provides the owner of it the right to attend an event, for example. And with NFTs, there's also, from a technology component, different types. And so, Ethereum, which is the most popular, you have ERC-721, which means each NFT is unique. There's no one other one like it. And then there's also ERC-1155. I give the example it's like baseball cards, if there's only one card of Michael Jordan dunking, then it's ERC-721. There's only one person that has it. But perhaps there could be 1,000 of Michael Jordan shooting a three-pointer. That would be ERC-1155. There could be many of the same items, but it still certifies that this person, that this wallet address owns it.
The tax treatment on NFTs, because it's on the blockchain to acquire that NFT generally you're using cryptocurrency. And as Miri mentioned regarding property, every transaction then becomes taxable. Just purchasing an NFT actually triggers a taxable event based on the crypto you use to acquire it. And so, again, you got to look at that fair market value of the currency at the time of purchase compared to your respective basis in that cryptocurrency. The treatment of buying and selling really depends on your intent. So, an individual that just buys it to hold as an investment, for example, they're going to have a capital asset and look at a capital gain or loss depending on their whole... But say, what if that person was buying it for the intent to sell it? And they do this continuously like it is their trader business to buy some NFTs and sell them. They are known as flippers in the space.
In that case maybe that NFT actually is ordinary income, it's maybe treated almost like inventory, intangible inventory but inventory. On the flip side of it, what if you're the creator? You're maybe the artist or on the technical team on a project, you are actually creating the NFTs and minting and then selling them, or minting to others. In that case that same theory there, it is your trader business essentially. What you're doing here, you're creating that self create property and upon that sale you've got ordinary income on that transaction.
Flipping a little bit, what if a business purchases an NFT and the NFT has a right to attend a conference and that conference is in line with your actual business? Then perhaps is it a business expense that you're buying that NFT solely for the purpose that you can attend this conference, which the only way to get the ticket is to buy the NFT. So, there's lots of different things that you need to be discussing with your tax advisor on the treatment of these, why you're doing it and what the underlying rights are. So, let me jump down into notice 2023-27. So, again, this discusses how the IRS intends to determine whether an NFT actually constitutes a collectible under section 408(m), which is actually under the retirement account section. And so, in that section they define collectible as any work of art, rug or antique, metal or gem, stamp or coin, any alcoholic beverage or any other tangible property specified for purpose of the subsection.
So, there's a number of things there. Some of them seem pretty straightforward. And what the IRS is using is a look through method is what they call it. And so, is the underlying right or property of that NFT one of these items? And so, one of the examples they provided was a gem. If you own this NFT, this points to the fact that you own this specific gem, tangible gem. In that case, selling that NFT would be considered a collectible in this case. That seems pretty straightforward. At the end of the day, why is IRS issuing a notice on these collectibles? Why does it even matter? Well, collectibles do have a special tax rate. The long-term rate there, instead of 20% for the highest rate, it's actually 28%. So, you got a good amount higher rate there. Also, depending on your intent on the reasoning of why you bought the NFT, if it's deemed to be collectible and you sell it for a loss, there's a chance that, that loss is not deductible. And so, again, it goes back to your intent on why you purchased it.
They did provide another example in the notice regarding an NFT that, say, has a right to use or develop a plot of land in a virtual environment. So, we would call that the metaverse in Web3. In this case, they're saying it doesn't meet one of those criteria, therefore it's not a collectible. So, again, a lot of those are pretty straightforward, but the one that they're really focused on here is the work of art and what really is defined as a work of art. Well, it's actually not defined. So, that's part of the challenge here. It is interesting, there's a couple comments that were submitted, one by a16z, which is if you're not familiar with, that's a large venture capital firm. And in their analysis in the response to the IRS there, they're really focused on whether or not actually there's a tangible requirement under Section 408(m).
Particularly, it's really focused on the language that at the very end it says any other tangible property. And so, while they agree with the look through analysis, their question back to the IRS was, does it have to be tangible? New York State Bar Association also had a much longer response actually. They agreed with a16z whether or not there's that tangible property requirement. But they actually go on to add more about if a work of art can be an intangible, we need some specific guidance on that. So, lots of stuff going on with this. It will be interesting to see what the IRS comes out with now after. Hopefully they've already gone through those comments and we see some feedback from them on that. Next we're going to shift over to polling question three.
There we go. What is the largest challenge you face in the digital asset space? Accounting for digital asset activity, B is industry confidence, C, maintaining compliance, D, market performance, E, transaction monitoring, or F, other. I almost feel like there should be a all of the above option as well. While we're waiting here for people, I think there was a question regarding purchasing NFTs. So, let me just give an easy example. So, if you bought one ETH when it's worth, say $2,000 and a month goes by and you go to purchase an NFT for one ETH, one ETH is worth $1,000. In that situation, you'd actually have a realized loss short term, because I said it was a month, a realized loss of $1,000 on your ETH. Now, that also assumes that's the only ETH you own, because if you have purchased a lot over time, you have to look at what method of transaction, your cost basis there, FIFO, LIFO, there's lots of different options and that's where the complexity really comes into play with the volume.
All right. Well, we got most responses. I'll give it a few more seconds here. All right. Switch over here. So, next we're going to talk about staking. Miri is going to get into the Jarrett case. Before we get into there, just a little background on that. So, staking is with the proof of stake blockchains. And so, it's a process by which a person that holds crypto participates in their consensus process and essentially they're agreeing to temporarily give up the right to sell, exchange, transfer a part of their token for a set period of time. And so, by doing this, they're helping the network, they're helping validate transactions on the ledger, and in exchange for doing that they receive rewards if the validation is successful.
A lot of people are familiar with the proof of work, which is for Bitcoin. That one is much more about your horsepower, if you will, of your computing power on whether or not you can, actually it's like a lottery, win the block essentially to get rewards. I feel like staking is a little more egalitarian in that regard in that, yes, to run your own node you need a lot, for example, for ETH32, but you have a more equal chance, if you will, to receive rewards. Miri, do you do you want to jump into the Jarrett case?
Sure. Jarrett is an interesting case. In 2019, Mr. Jarrett, with a home computer and some existing Tezos tokens used a staking process to create new ones. And he maintained them in his digital wallet throughout the year. And he reported initially on his original 1040 individual income tax return, the newly created tokens as income based on their fair market value. Later he decided to amend his return. He claimed a small refund, about $3,800. And he took the position that the tokens were newly created, there was no sale or exchange, so they weren't subject to tax. And then six months later the IRS didn't respond to the amended return and he was permitted to file a suit, a refund suit in district court, which is what he did. And so, I guess the hope there was, okay, let's get the IRS to make some decision about the treatment of staking. But instead of addressing the issue, the substance of issue on whether staking rewards were or were not considered income, the IRS simply approved the small refund and issued the Jarretts the check for the full amount.
I don't think the Jarretts were that happy with that response. So, they said, okay, we're not going to cash the check, we're just going to appeal the decision to the Sixth Circuit and try to push the IRS to clarify its position on the substance of issue. Now, at that time really the guidance, as I said earlier, was limited. In 2014 that notice and some FAQs stated that if a taxpayer mined virtual currency, the fair market value of the virtual currency was included in income as of the date of receipt. But there was really nothing explicit on staking. Unfortunately for the Jarretts, when the refund was issued, the suit was moot because the subject of the suit was the outstanding refund and that had been resolved when the IRS sent out the check, whether they cashed it or not. So, the lack of clarity on staking remained once that decision came out. But interestingly, just three days later the IRS then issued Rev. Rul. 2023-14 talking about staking. So, Nate, I'm going to pass back on to you to talk about the new guidance.
Sure, thank you. So, right at the end of July, IRS issued 2023-14. In that they take a position that a cash basis taxpayer who stakes cryptocurrency directly or actually through delegating, they must report those rewards as gross income in the year which they gained dominion and control. And so, going back and looking at how is gross income defined under Section 61, there it states instances of undeniable ascensions to wealth clearly realized and over which the taxpayers have complete dominion, require inclusion in gross income. And so, if you have control, if you have dominion, it is taxable. That's the IRS's position. The gross income on that is equal to the fair market value. While the ruling does not really get into the determination of fair market value other than it's at the date and time that you gained dominion control, back in notice 2014-21 they did state it's based on converting your cryptocurrency to the U.S. dollar at the exchange rate. As we already mentioned, the Jarrett position, self-created property, not taxable until disposed.
And so, that's when they actually exchange that for, say, another cryptocurrency or fiat. The revenue link does not discuss self-created property. I feel like the IRS does know that, that argument is out there, that they just wanted to get something out there with obviously what had occurred with the Jarrett case. They wanted to draw a line in the sand on their position. And I do feel like at some point in time there's probably someone that's going to have large enough dollars at stake here, if you will, that's going to challenge this in court. And in which case the IRS will have to make that decision of whether or not they take on that case or whatnot and adjust the issue. And I just want to remind everyone too, that with this notice coming out, or sorry Rev. Rul., if you take a position contrary to it, you do need to disclose that on the 8275. So, just be aware of that on your filing compliance. So, the next big one here, most recent one that came out, Jon is going to get into here on the proposed regs of 6045 here.
Thanks, Nate. Really appreciate that. And that was a good overview of the staking issue, which I'm sure we'll touch upon in the Q&A. I think it's informative for us to go back to 2021 for a minute. If we can go back in time. The perceived pseudo anonymous nature of cryptocurrency presents a number of issues to the IRS, particularly with respect to tax compliance risks, lack of overall compliance. So, if we go back to 2021, we realized that the IRS in early 2021, in May, launched operation Hidden Treasure, I can't make these names up. The goal of Hidden Treasure was to root out tax abuses among cryptocurrency users. We saw a plethora of John Doe and Jane Doe notices go out as part and parcel of that. The overall concern was the lack of information, because of its pseudo anonymous nature cryptocurrency presents a number of problematic issues from a reporting perspective.
So, what happens, on November 15th, 2021, president Biden signs the Infrastructure Investment and Jobs Act of 2021 into law. Under the act Congress enacted new broker reporting requirements with respect to digital assets. And so, what we'll see is public law 117-58 comes into being and it creates a new section, 6045(c)(1)(D), that provides that brokers include any person who for consideration is responsible for regularly providing any services effectuating transfers of digital assets on behalf of another person. Broad definition. Starting in 2024, brokers of digital assets under the Act will be subject to the same information reporting requirements that currently apply to brokers of securities, if you trade Alphabet and you are a broker in that, the reporting requirements are very similar, or will be very similar. For this purpose however, and this is to distinguish the discussion that Miri had on Notice 2014-21 and Rev. Rul. 2019-24, a digital asset initially under the Act is defined as any digital representation of value, which is recorded on a cryptographically secured distributed ledger, or any similar technology.
This definition expands the definition of digital assets. So, now we roll the clock forward 21 months, and here we are sitting in August of this year and we finally get the proposed regulations from the Treasury under the Act. The proposed regulations, once again, were issued on August 25th, 2023. Those proposed regulations will apply the tax years ending after the proposed regulations were published in the Federal Register. And just so everyone's aware, they were published on August 29th, 2023. So, what happens? The goal of the proposed regs is to provide greater reporting and information to the service. That's been the perceived concern about the pseudo anonymous nature of cryptocurrency. There's a lack of information reporting. So, the IRS can't determine whether gain or loss is represented.
Broker reporting on gross proceeds is delayed under the proposed regulations until 2025 while reporting on basis is delayed until 2026. But there are five major categories that were addressed in the proposed regulations that we're going to go into right now. That will then make its way onto a new 1099 digital asset form that everyone will be required to comply with, particularly brokers with respect to digital asset transactions. So, let's step back and process what the proposed regs are doing on our behalf. The first area of consideration is how do they define a digital asset? I think what you're going to see now and what I'm going to talk to you about in the next 30 seconds is a broad expansion of what digital assets are. By definition, a digital asset under the proposed regs is defined as any digital representation of value that is recorded on a cryptographically secured distributed ledger, nothing's changed, or any similar technology without regard to whether each individual transaction involving a digital asset is actually recorded on that ledger.
The definition of digital asset includes digital assets that may be recorded using technology that uses cryptography to secure transactions, and it is clearly intended to include non-fungible tokens that Nate had addressed, as well as stable coins. What doesn't the definition of digital assets include? Well, it clearly doesn't include cash. We know that. But the proposed regulations also do not apply to virtual assets in a closed system. So, for example, if Jon Zefi created an online football video game that provided that tokens related to the game could be purchased with fiat currency, but only used in the football game itself to either bet or play with your game players, that would not be a digital asset per the proposed regs.
So, now we see the gradual expansion of the definition of digital assets, and I think you're going to see continuous, as guidance rolls out in the future, I think one would expect that the definition will expand further and we'll touch on those areas. So. If we're going to have to report, we have to report gains and losses associated with those digital assets. So, for reporting purposes, how do we define a gain? So, there are a couple of key words here that we're going to disaggregate and dig a little bit more deeply in so that everyone's fully aware of what the intent here is. So, first I'm going to bore you with some tax lingo, but gain is defined as the amount realized over the basis of the digital asset. So, let's step back. What's amount realized? Well, the amount realized according to the proposed regs is equal to cash plus the fair market value of any property, including digital assets, or any services received to which we subtract from that amount realized any digital asset costs.
So, we're going to break down each of those component parts. The first question is, the key term is cash plus fair market value. How is fair market value determined? Well, we have to look at the date and time of the exchange or disposition of the digital asset to determine fair market value. If the fair market value of such property or services that we receive in that exchange can't be determined with reasonable accuracy, once again, the facts and circumstances test. So, I think that's a difficult process to determine what reasonable accuracy is. The fair market value of the property or services received must be determined by reference to the fair market value of the digital assets that were transferred in the transaction.
What if debt is issued as part of the consideration that you're receiving in the transaction? If a debt instrument is issued as consideration, the amount attributable to the debt instrument is the issue price on the debt instrument. So, if you receive a debt instrument whose issue price is $1 million, that's the deemed amount of consideration received. But in order to report gain or loss, we need to understand what the definition of basis is right now. And that's important. And I see some questions coming up about validating and staking. We're going to address that shortly. So, bear with us. So, basis under Section 1012 of the Internal Revenue Code, is equal to the basis of the digital asset received in a purchase or exchange, is equal to the cost at the date and time of the purchase or exchange, plus any digital asset related transaction costs. The rules under Section 61 and 83 of the code are referenced for digital assets received with the performance of services and rules under Section 1012-2 are a reference for digital assets received in a transaction that is part sale and part gift.
So, the next step when we're trying to figure out what our gain or loss realized on the transaction is, we need to look at the basis of the underlying assets and the holding period itself of those assets to determine whether gain is long-term, short-term, and what the aggregate amount of gain or loss is on any exchange. So, what we oftentimes do in the securities world is we see specific identification of lots and basis of equity transacted. So, if I was a holder of Alphabet and I own various interests in Alphabet at $100 or at $183, I could designate by specific identification which lot I'm transacting. If specific identification isn't available, they take a FIFO methodology approach in the proposed regs and first in is first out.
So, how do we go about, in the digital asset world, going about the process of specifically identifying holding periods and items to be sold? So, specific identification is made if the taxpayer identifies on its books and records, and that's been a problem for many of the clients that we've seen walk through our doors, their books and records haven't been all that well documented or maintained. So, specific identification is made if the taxpayer identifies on its books and records, particularly units to be sold, disposed of or transferred no later than the date and time of the sale or disposition of the underlying asset. Specific identification can only be made if adequate records are maintained for all units of a specific digital asset held in a single wallet or account to establish that a disposed unit is actually removed from that wallet or account.
One of the biggest hurdles when we're dealing with a lot of folks that operate in the cryptocurrency space is this lack of adequate books and records and maintenance, which calls into question whether they can make the claim that they could specifically identify the lots of digital assets transacted in or sold. That's been a problematic area from a practice perspective that we've been dealing with. If they can, obviously they revert to the FIFO method. But for brokers, the taxpayer has to specify to the broker the particular units of additional assets that will be sold or exchanged in a transaction. That's a critical component. And they have to reference the purchase date and time of the purchase of the specific digital asset. Now, for the tax geeks out there, identifying units of a digital asset is not a method of accounting under 446 or 481. So, just make note of that.
So, remember, we reduce the amount of gain by structural transaction costs related to the sale of digital assets. Let's talk about what they are. So, digital asset transaction costs include fees, transfer taxes and commissions paid associated with the exchange of digital assets. In an exchange of digital assets, one for one, half of the digital asset transaction costs paid by the taxpayer to effectuate the exchange are allocatable to the disposition of the transferred assets and the other half of the transaction costs are allocatable to the basis of the digital assets received as part of the transaction that was entered into.
So, now the big gorilla in the room is, what are the reporting requirements associated with digital assets? They're going to be robust obviously, because of the pseudo anonymity associated with cryptocurrency and the desire by the service to pierce that anonymity and identify players who are transacting amongst the digital assets and the information that's required to determine whether we have a taxable event or not. So, let's get into that category. It's reporting requirements. Section 6045(g), which applies to digital assets under the IIJA, requires the information reported by a broker related to the digital assets to include the customer's adjusted basis. Brokers under 6045, the definition of broker is expanded but includes digital asset trading platforms, digital asset payment processors, certain digital asset wallet providers, and persons who regularly redeemed digital assets that were created by that very same person.
The proposed regs also include as a broker, the definition of broker, a person that provides facilitative services that effectuate sales of digital assets by customers, provided the person ordinarily would know, once again facts and circumstances, or be in a position to know the identity of the party that makes the sale and the nature of the transaction giving rise to the gross proceeds. The definition of broker includes persons who sell or license software to unhosted wallet uses if they facilitate or offer services to facilitate the purchase or sale of digital asset. So, we have a broad spectrum of people who would be deemed to be brokers. Who's not a broker, first and foremost? Persons who are solely engaged in the business of validating transactions through either proof of work or proof of stake, are not brokers. Merchants that sell goods and services in return for digital assets are brokers. Persons engaged in selling hardware or licensing software without such persons providing other functions or services.
A couple of folks in the tax world have been arguing and thinking that the IRS would expect to see the definition to require decentralized exchanges to collect information on customers and report that information. So, if we're going to report something, what are we reporting? Well, we have to report sales, so we need to take a minute, and we only have a few minutes left, but we need to take a minute to talk about what sales are and how we determine whether we have a sale. First, sales are defined to include any disposition of a digital asset in exchange for cash or stored value cards. I've yet to see a transaction happen with stored value cards. But love to hear commentary from the folks online if they've seen anything. Any disposition of a digital asset in exchange for a digital asset. The delivery of a digital asset pursuant to the settlement of a forwards contract and options contract, a regulated futures contract or a similar executory contract.
A sale also includes transactions involving digital assets and a broker that is a real estate reporting person, or in the business of effectuating sales of property. Obviously one of the areas that are ripe is the tokenization of real world assets that are out there. And I think the IRS anticipates that, that will be happening. It's actually happening as we speak right now amongst various parties, and I think they want to address that head on. They've indicated that intent can be read from the proposed regs as issued. Also, transactions related to digital assets entered into by a digital asset payment processor as defined in the proposed regs, and you'll see the regs there.
So, what don't sales include? Well, a transaction in which a customer receives a new digital asset without disposing of something else in exchange. So, two, the receipt by a customer of a digital asset from an airdrop. And three, a transaction in which a broker's customer receives a digital asset in return for the performance of services. We were all hoping that the proposed regs would address liquidity pools and liquidity pool service providers. The treasury did not address whether a loan of a digital asset is required to be reported or transactions involving a transfer of a digital asset to and from a liquidity pool by a liquidity pool provider would be considered a sale. So, how does this all get reflected? As I mentioned to you moments ago, there's going to be a new reporting form 1099-DA.
Each sale of a digital asset on or after January 1st, 2025 will have to report that information on a 1099-DA. The broker will need to take the following information. It's critical. There's no longer going to be anonymity in the world. The name and address and the taxpayer identification number of the customer. The name and the number of units of the digital assets sold. The sale date and time associated with the transaction. The gross proceeds less allocatable digital asset transaction costs. The transaction ID associated with any sale, if any. The digital address from which the digital asset was transferred in connection with the sale transaction. Finally, whether the sale was for cash, stored value cards, or an exchange for services or other property. Sales on or after January 1st, 2026 brokers also need to report the adjusted basis of the underlying assets, the date and time of the purchase, and whether any gain or loss is long or short-term associated with those transactions. For each sale of a digital asset... Sorry, go ahead Nate.
Yeah. Just one comment on that. For the 2026 reporting. For that basis, it's actually basis back to 2023. So, January 2023. So, they look back three years.
So, that's applicable now. We all need to understand that these proposed regs are applicable to transactions that we're undertaking in 2023. And that may be something that has been overlooked by a number of people involved in the space. And finally, to close this out, and one thing I just wanted to make sure you were aware of, for each sale of a digital asset that was held by a broker in a hosted wallet on behalf of a customer, and was previously transferred into an account at the broker, what we'll call a transfer in of a digital asset, the broker must also report the date and time of the transfer into the wallet, the transaction ID, if any, the digital address from which the digital asset was transferred, and the number of units transferred in.
All encouraging greater disclosure of information, greater transparency, terminating the ability to be completely anonymous when you're involved in a transaction. So, these are all considerations that are being addressed by the proposed regs. We could have gone on for another hour with respect to the 123 pages of proposed regs that have been issued, but I think this gives you an overview of the reporting requirements here. With that, I'll turn it back over to Miri, I believe, to continue on with the conversation. Miri.
I'm going to transfer it to Nate to talk about future expectations.
Yeah. Let me just address a couple of the questions really briefly here. Want to make sure we've got enough time. There's a question on what constitutes gaining control over a reward regarding staking? If you have the ability to withdraw that asset, sell or exchange it, that's control. If you think of ETH, in end of 2022, September 2022, when ETH did their upgrade to allow for staking, switching from proof of work to proof of stake, that allowed for staking. At that moment you were not allowed to withdraw any of those stake rewards. It wasn't until April of this year that the Shanghai upgrade went into place that you were allowed to withdraw. So, I think that's a pretty good example of you didn't have any dominion control prior to that Shanghai upgrade. You were not able to access that.
Only question on transaction costs regarding the efforts for validating staking. And again, it goes back into, are you doing this for a trader business or is this just an investment? If it's an investment, it's an investment expense, which under the tax of jobs act, those expenses are not deductible as a 2% deduction. So, looking ahead here, future expectations. So, IRS end of 2022 had this priority guidance plan. On that plan about five items on there for digital assets. Obviously they've been pretty active this year with issuing a number of things. Additionally, in June they came out with an RFI, request for information, in that they're specifically, it again touches on exactly they're going after enforcement here. They're looking for support on improved data, digital asset pricing data, assistance with processing larger bulk transactions, large scale gain or loss complications. And then also, again, just speaks to what they feel about this area, digital asset custody and management solutions that provide secure, seamless and automated processes to support assets, seizure or recovery.
So, I think it's pretty clear here that they're looking at enforcement. Anecdotally, one of our colleagues attended the IRS Nationwide Tax Forum this year. And in that, over multiple sessions, non-compliance of digital assets was brought up multiple times and really spoke in the same breath as ERC refund claims and listed transactions as items of concern for the service. And then lastly here just one thing, wash sales. So, as Miri started out, digital assets or property, not considered a security. The wash sale rules specifically refer to securities. And so, as of now wash sale rules do not apply. There was a proposal in July by a couple of senators under the Responsible Financial Innovation Act. In this proposal it does include where cryptocurrency would be subject to the wash sale rules. However, it would not be treated as a security for tax purposes. So, something to keep your eye on, especially as we close out towards the end of year here, on your own for the tax plan. Miri, would you like to jump into the reporting and enforcement?
Absolutely. Thank you. So, for 2023, there is going to be reporting required for cryptocurrency transactions, and you've seen it for a few years now on the individual income tax returns. But new for 2023, the cryptocurrency question is expanded to entity returns in the draft 1120 for C corp, 1120-S for S corp and 1065 for partnerships, are now specifically asking if at any time during the year did the entity receive a digital asset as a reward, award or payment for property or services, or did the entity sell, exchange or otherwise dispose of a digital asset, or a financial interest in a digital asset? In addition to that, cryptocurrency held in foreign accounts may also be subject to reporting. First off, the FBAR, U.S. taxpayers with foreign accounts with an aggregate value of greater than 10,000 during the year, are subject to reporting on FBAR.
The FBAR gets reported with FinCEN, which is the Financial Crimes Enforcement Network, not the IRS. As of now, FinCEN has excluded cryptocurrency held in foreign accounts from FBAR reporting, but only if cryptocurrency is the only asset in the foreign account. So, if you have a foreign account with a combination of crypto and other assets, some hybrid account, and the value is greater than 10,000, an FBAR filing is going to be required. Now, while a foreign account with just cryptocurrency might not be subject to reporting right now, FinCEN has stated that it intends to include those into the definition of a reportable account for FBAR purposes in the future. That's something we're monitoring and we'll share more once formal changes are announced. In addition to the FBAR, certain foreign financial accounts are subject to reporting on form 8938. That form is filed with the IRS and it's attached to your income tax return, whether it's an entity income tax return or an individual one.
There are various triggers that will result in form 8938 reporting. Generally, a single U.S. resident filer will have to file that form if the value of all financial foreign accounts is greater than 50,000 at the end of the year, or 75,000 at any point during the year. And those thresholds are higher for married filing jointly and non-U.S. residents. Now, currently the Internal Revenue Code, it doesn't provide clear guidance on whether virtual currency is a type of foreign financial asset subject to reporting on form 8938. But more importantly, there's nothing that clearly excludes it from the reporting requirement. Therefore, we're strongly recommending taxpayers that have cryptocurrency in a foreign account with a value that exceeds the applicable thresholds, to timely file the form 8938 with their tax return. Now, in terms of enforcement, individuals and businesses with potential non-compliance should be aware that IRS enforcement continues to increase in this area, and it has for many years.
In 2018 the IRS announced a virtual currency compliance campaign where they sent notices to taxpayers to try to educate them on the tax treatment of cryptocurrency transactions. They tried to encourage taxpayers that they thought might be non-compliant to amend their returns and they started conducting examinations. And more recently, those examinations are increasing and they're starting to use sophisticated data analytics and AI to try to select better cases. As Jon mentioned earlier, the IRS is issuing John Doe summonses to banks and currency exchanges. They're trying to identify U.S. taxpayers that are engaging in these types of transactions. And in those John Doe summonses, they've been focusing it on transactions where at least the value is 20,000 or more over a six-year period. And not-
Miri, if I may for a moment interject there.
Just really briefly. On the John Doe, Jane Doe summonses, you've recently seen some negative impact to folks like Kraken, June of 2023, this year. California federal judge said that Kraken had to comply with the John Doe, Jane Doe summonses and provide customer information. You're seeing some current litigation going on with respect to Coinbase. If you recall, the case is Harper versus Rettig in November 2016, going way back now, over six years. The IRS issued a third party summons to Coinbase demanding that they turn over information and financial records of thousands upon hundreds of thousands of their clients. In August 2018, as a result of that, the IRS notified this gentleman, James Harper, in a form that it had possessed information about his virtual currency accounts and transactions warning him that he could face civil or criminal enforcement if he inaccurately reported those transactions on any returns.
There were over 10,000 virtual currency holders who received those letters from the IRS. In July 2020 Harper sued the IRS in the District Court of New Hampshire. The court dismissed the case, concluding that it had no subject matter jurisdiction. In August 2022, the U.S. Court of Appeals for the First Circuit, reversed the case indicating that they had jurisdiction over Harper's claim. You're seeing a ton of amicus briefs now being filed on behalf of Harper to protect his right to privacy in his account data and information. We'll see how that case plays out. But unfortunately, I think the IRS benefits from a lot of the Jane Doe and John Doe summonses that have been issued and will continue to utilize that as a method to get non-compliant folks compliant. Miri.
And not just that Jon, internationally for several years the Joint Chiefs of Global Tax Enforcement, or what they call the J5 because there are five countries involved, U.S., UK, Canada, Australia and the Netherlands. They've been coming together with investigators, with cryptocurrency experts, data scientists, to combat non-compliance, and they're sharing information. So, just another area where the information is coming from. So, why do we talk about all the reporting requirements? And we only have a few minutes left. The IRS is looking at non-compliance. Does it matter? It does, because the consequences from non-compliance are incredibly severe. So, failure to file an FBAR return can result in a $10,000 penalty if the failure is non-willful. And if the penalty is willful, it's $100,000 per violation. Failure to file an 8938 that I mentioned, is $10,000 per form for year. And if the IRS discovers the failure first, there are continuation penalties of up to $50,000 can be tacked on to the original $10,000 until the outstanding return is filed.
There could be late payment penalties of 0.5% per month up to 25%, and there could be accuracy related penalties related to negligence or substantial understatements. And they could be either at 20% or 40% of the underpayment. In addition to the penalties, there could be statute of limitations issues. So, the statute that IRS typically has three years to assess tax, but if there's a substantial omission of income of 25% or more, that expands to six years. In addition, if a taxpayer omits gross income of more than 5,000 attributable to one of these foreign financial accounts, regardless of whether they have to report on the 8938, the statute could be extended as well.
And so, these are all things to keep in mind. So, think strategically if you discover some non-compliance, what can you do. The IRS doesn't have a voluntary disclosure program specifically for digital assets right now, just for digital assets, but there are many voluntary disclosure programs that may apply for failures in the FBAR space, for failures in the 8938 space and the like. So, certainly something to explore to try to get into compliance and to minimize penalties along the way.
Miri, thanks for that. In order to wrap this up, we wanted to give everyone the opportunity to respond to polling question four. Would you like to discuss concerns regarding U.S. or foreign reporting compliance? Yes, I want to better understand my obligations. B, I do not hold any digital assets. No, thank you at all. We wanted to give everyone the opportunity to get CPE here. So, take a moment to chime in here and record your response to this polling question. This is our last poll before we wrap things up. And people are jumping in to get their CPE as we speak right now, Miri. So, let's give them a minute to respond and then we could close things out.
I'm going to switch over to the findings. We are about at time. It's three o'clock Eastern Standard Time. We wanted to thank you all for your participation and attendance here today. If there are any follow-up questions, please feel free. You have our bio and contact information associated with that. If you'd like to reach out to us, we'd be more than happy to entertain some general questions or comments from the crowd if we were not able to address those questions fully. Thank you again, and we want to thank everyone for participating in this. Miri and Nate, wanted to thank you all as well. Thank you so much.
Jon, thank you.
Thank you, Jon.
Transcribed by Rev.com
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