KYC and IRS tax declarations are coming to DeFi platforms

Today, the IRS released the highly anticipated and controversial tax regulations for decentralized finance (DeFi) brokers. If you’re involved in the DeFi space, big changes are on the horizon.

Note: These new regulations mainly apply to DeFi trading platforms. Taxpayers therefore have little to fear at the moment. However, there are some indirect consequences for DeFi users, such as exposing personally identifiable information (PII) to platforms and receiving incomplete tax forms.

Fast settlements on background brokers

Under the original §6045 of the tax code, securities dealers were required to obtain Know Your Customer (KYC) information from customers, calculate gains and losses, and report that information to the IRS. This is why you receive Form 1099-B at the end of the year from stock brokers like Robinhood, Charles Schwab, etc. showing your annual gains and losses.

Last year, the IRS extended these rules to custodian cryptocurrency brokers, in simple terms, centralized finance (CeFi) exchanges. Today, the IRS clarified how these brokerage rules will apply to DeFi.

The three layers of the DeFi stack

The IRS has identified three distinct layers within the DeFi ecosystem.

1. Interface layer: This includes user-facing components, such as screens, buttons, forms and other visual elements of websites, mobile applications 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 trade orders as part of the trade validation process.
3. Settlement layer: Responsible for recording financial transactions on the distributed ledger, including transactions made using DeFi protocols.

Interface layer to classify as broker

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

Impact on DeFi platforms

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

If you operate such a service, you must KYC your customers (similar to CeFi exchanges), track transactions, and report proceeds to the IRS and customers using Form 1099-DA for transactions made after January 1 2027. There is no requirement to capture or report cost basis.

Note: Unhosted wallets that only allow you to manage private keys (core wallets) 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 will need to share your KYC information with the front-end service platforms during the onboarding process. Second, you will receive tax forms show only profits generated by sales of digital assets.

Note: These tax forms will not display your basic cost information. You’ll still need to use crypto tax software or rely on your books and records to track your cost basis and accurately report gains and losses on your taxes.

Potential paths forward for DeFi players

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

1. Respect the new rules.
2. File a lawsuit and/or hope that DeFi regulations will be repealed by the new administration – a significant possibility given the new pro-crypto administration.
3. Relocate operations outside the United States. However, this approach comes with its own challenges, as platforms may still fall under other international tax regimes, such as the Crypto Asset Reporting Framework (CARF) and the Markets in Crypto-Asset Regulation (MiCA).

These new DeFi regulations mark a significant change for the DeFi industry. Although they aim to bring more accountability and transparency, they also pose challenges for both platforms and users. Staying informed and prepared is essential as the DeFi ecosystem navigates these changes.

Disclaimer: This article is informational only and does not constitute tax advice. For tax advice, please consult a tax professional.