IRS Cranks Up Pressure: Crypto Compliance Becomes Mission Impossible

"Proposed 6045 Digital Asset Broker Regulations Face Criticism for Impractical Taxpayer Compliance Requirements"

New Regulations Pose Challenges for Crypto Tax Compliance

Crypto once again finds itself at odds with regulatory requirements. The proposed 6045 digital asset broker regulations, currently in a comment period, have raised concerns due to problematic requirements that may make taxpayer compliance impossible. This article is part of CoinDesk’s Tax Week 2023. Kirk Phillips, founder of cryptobullseye.zone, an education site offering crypto crash courses and mastermind coaching, discusses the challenges faced by digital asset brokers and taxpayers in complying with the proposed regulations.

One of the main issues is the reporting of proceeds and cost-basis on a proposed Form 1099-DA information return, which is similar to a 1099-B but for digital assets. The complexity of cost-basis reporting creates multiple challenges for brokers and taxpayers, adding to the already daunting task of calculating crypto taxes.

The proposed regulations clarify that taxpayers have two cost basis choices: FIFO (First-In, First-Out) and Specific Identification. FIFO is the default method, which considers the oldest purchases as sold first. Specific Identification allows taxpayers to choose which digital assets to sell. Many people in the crypto space are already familiar with FIFO and have been using it for tax calculations. However, if taxpayers do not choose FIFO, they are required to use specific identification, which presents numerous challenges for digital assets.

Taxpayers are responsible for specifically identifying the units of digital assets sold before the trade takes place. This means that taxpayers must mark the specific digital assets they intend to sell in their “crypto inventory” before making a trade. This process is time-consuming and requires taxpayers to dig through their records. If a broker is used, taxpayers must instruct the broker on which digital assets they intend to sell before the trade.

Failure to meet the specific identification requirements results in the default use of FIFO, potentially leading to a significant tax liability. These rules are already applicable to securities sales, but they do not align with the unique characteristics of the crypto market and the proposed reporting regime.

One of the challenges lies in the broker notification requirement. Centralized exchanges like Coinbase and Kraken do not provide a mechanism to support specific identification, leaving taxpayers with no way to instruct the exchange to sell a specific lot of digital assets. As a result, these exchanges default to FIFO reporting for all their customers. This creates a perpetual cost-basis mismatch for taxpayers who previously used different cost-basis methods.

Even if taxpayers could notify brokers, they would still need a system to track and report 1099-DAs on a specific identification basis. This raises questions about how taxpayers can reconcile the differences between the 1099-DA issued by the broker and their own calculations, as well as how they can report these differences on their tax returns.

Crypto tax software providers typically include FIFO and other cost-basis methods in their software settings. Taxpayers have used these non-FIFO methods as a proxy for specific identification, as the software is not designed for taxpayers to identify digital assets before the trade. However, it is practically impossible to calculate crypto taxes without the aid of software. Even if taxpayers mark their records to indicate specific digital assets they intend to sell, the software cannot incorporate those assets into gain and loss calculations. Taxpayers are left with logical cost-basis methods and have to manually mark records outside of the software.

The inability to meet the specific identification requirements can result in a recalculation of gains and losses using FIFO as the default method. This could lead to a significant tax liability, including interest and penalties. The difference between FIFO and other methods can be substantial, which is why taxpayers chose alternative methods in the first place to minimize gains.

The proposed regulations also place a burden on taxpayers who have multiple exchange accounts and wallets. Before the proposed regulations, these taxpayers were responsible for calculating their own crypto taxes. They would gather all transactions from various exchanges and wallets and input them into crypto tax software to produce Form 8949.

In conclusion, the proposed 6045 digital asset broker regulations present significant challenges for both digital asset brokers and taxpayers. The specific identification requirements and the lack of support from centralized exchanges make it difficult for taxpayers to comply with these regulations. The reliance on FIFO as the default method may result in substantial tax liabilities for taxpayers. The unique characteristics of the crypto market should be taken into account when formulating regulations to ensure fair and accurate tax compliance.

Martin Reid

Martin Reid

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