Understanding the IRS Broker Rule: Current Insights and Implications

Bitcoin Magazine

The Current State Of The IRS Broker Rule

In the final days before the New Year, the IRS took decisive action, finalizing the much-dreaded Broker Rule during the last stretch of the Biden administration. This regulation mandates that all cryptocurrency exchanges – whether custodial or non-custodial, as well as those dealing in fiat to crypto or crypto to crypto transactions – implement Know-Your-Customer (KYC) protocols for their users.

The new rule clarifies that it is not a requirement for an entity to have custody of funds to be classified as a broker by the IRS. Instead, it compels “DeFi front-end services” to report trading activities to the IRS using the 1099 tax form. This encompasses any developer responsible for creating interfaces, buttons, forms, and other visual elements within websites, mobile applications, and browser extensions that allow users to trade digital assets residing in their unhosted wallets.

Under this broker rule, the IRS claims that developers exert a certain degree of “control” over the services provided, regardless of whether they have custody over coins or the ability to modify the underlying protocols. This aligns with the guidance from the Financial Action Task Force (FATF), which categorizes developers of user interfaces as Virtual Asset Service Providers (VASPs) that must comply with anti-money laundering (AML) and counter-terrorism financing (CTF) requirements.

In parallel to FATF’s stance, the broker rule interprets control as the “ability to change, update, or otherwise significantly influence the terms under which services are rendered.” Additionally, it includes the “ability to gather fees associated with these services from transaction flows […], regardless of whether fees are actually collected this way” and/or the ability “to modify an order by adding a sequence of commands to access the cryptographically secured distributed ledger to verify if the order has been executed or to utilize alternative confirmation methods based on information accessible to that individual by providing trading front-end services.”

Given the substantial overreach implied by this rule – where control over funds has been commonly interpreted as a necessary criterion for being regulated as a financial service, according to FinCEN guidelines – the industry acted swiftly. Just one day after the rule’s announcement, the Blockchain Association sued the IRS and the Treasury Department, asking federal judges to invalidate the rule before it goes into effect, claiming that it is unconstitutional and contradicts established federal statutes.

Alongside the lawsuit, Senator Ted Cruz proposed a joint resolution to disapprove of the IRS’s rule through Congressional authority, with sponsorship from Senators Cynthia Lummis, Bill Hagerty, Mike Lee, and Tim Scott, among others.

“This regulation undermines the fundamental purpose of DeFi technology: to empower individuals to freely buy, sell, and trade digital assets,” Cruz stated in a press release regarding the resolution. Representative Corey, who co-introduced the resolution with Cruz, characterized the rule as “a blatant overreach.”

In a recent vote in the Senate, the resolution garnered significant backing, passing by a commanding 70 to 27 margin, and is set to proceed for consideration in the House.

This broker rule represents yet another attempt by the Biden administration to extend its regulatory reach over non-custodial services. The U.S. Department of Justice has been asserting, in cases against the developers of tools like Samourai and Tornado Cash, that actual custody of funds is unnecessary to incur liability as a money service business in accordance with U.S. law. They argue that simply creating user interfaces and associated features conveys sufficient control over a service to be subjected to sanctions and AML/CTF compliance requirements.

While a repeal of the broker rule would undoubtedly be a significant achievement, the sentencing of the Samourai and Tornado Cash developers could lead to similarly impactful outcomes pertaining to reporting duties for non-custodial service providers.

To affirm that non-custodial service providers are not classified as money service businesses, Representative Tom Emmer has introduced the Blockchain Regulatory Certainty Act in Congress, which aims to provide extensive protections for developers.

This article is a guest contribution by L0la L33tz. The views expressed are solely those of the author and do not necessarily represent the views of BTC Inc or Bitcoin Magazine.

This content originally appeared in The Current State Of The IRS Broker Rule on Bitcoin Magazine, authored by L0La L33Tz.