Comments to the Proposed Regulations on Gross Proceeds and Basis Reporting by Brokers and the Determination of Amount Realized and Basis for Digital Asset Transactions (REG-122793-19)
To Whom It May Concern:
NODE40 would like to thank the U.S. Department of Treasury (the “Treasury”) and the Internal Revenue Service (the “IRS”) for the opportunity to comment on the proposed regulations on gross proceeds and basis reporting by brokers and the determination of amount realized and basis for digital asset transactions.
I. Background on NODE40
NODE40 Inc. is a company based in Albany, NY that specializes in the economic analysis and financial reporting for digital asset activity. We provide multiple perspectives of this activity without taking positions on the appropriateness of the accounting treatment, taxation and regulatory compliance. NODE40’s data solutions are used primarily by public accounting firms, auditors, investment funds and fund administrators, high-frequency traders, digital asset native companies, and other financial entities. We also partner with tax information reporting companies to provide various economic and financial data that could be used to prepare Forms 1099 and other information reports. We prioritize raw data analytics that are converted into valuable, actionable information. Our solution aggregates off-chain data (e.g., from a centralized exchange (“CEX”)) and on-chain data from available sources to trace the entire lifecycle of digital assets, from cost basis to disposition to other profit and loss events. We also contextualize (i.e., provide a financial story for) transactions by processing critical data and metadata for decentralized finance and non-fungible token transactions. This includes normalizing account categories for deposits, yield-farming, lending, collateralization, minting, swapping, dispositions and other categories of transactions.
Given our specialization in preparing digital asset financial data for multiple purposes including tax compliance, our comment letter focuses on certain data gathering issues that may arise as a result of the Proposed Regulations.
II. Summary of NODE40’s Comments
Issues arising with digital asset naming conventions
- The proposed reporting rules under section 6045 require a broker to report the “name” of the digital asset sold.1 Many digital assets share the same name or even the same ticker symbol. We therefore recommend that the Treasury and IRS allow the broker flexibility to provide enough information to reasonably identify the digital asset at issue, which we outline in more detail below.
Question 44 posed in the Proposed Regulations – applying the section 1012 ordering rules on a wallet-by-wallet basis versus a digital asset address-by-digital asset address basis
- We first provide a general summary on the different blockchain accounting models that could impact the approach to the ordering rules under section 1012.
- NODE40 believes that specific identification on a wallet-by-wallet basis is the most appropriate way to apply basis ordering rules for UTXO blockchains (as defined below).
- NODE40 believes that a FIFO methodology on a digital asset-by-digital asset address basis is the most appropriate way to apply basis ordering rules for account-based blockchains (as defined below).
- In the alternative, if the Treasury and IRS desire to have one approach for all digital assets regardless of the blockchain accounting model, we would recommend a digital asset address-by-digital asset address ordering rule along with an option for the taxpayer to include related digital asset addresses in the ordering rule, with the taxpayer having the burden of proof to show digital asset addresses are related. This approach would meet several goals including reducing discrepancies in the data reflected in the ordering rule adopted by the taxpayer under section 1012 versus the data reported by a broker under section 6045.
III. Background on the Proposed Regulations
On August 29, 2023, the Treasury and the IRS published in the Federal Register proposed regulations (the “Proposed Regulations”) that would require brokers to report a sale and exchange of a digital asset by customers. The proposed regulations cover a range of issues, including (without limitation) defining brokers, requiring brokers to report proceeds to the IRS under section 6045, and providing guidance on various aspects of income tax calculations under sections 1001 and 1012 (including gross proceeds, tax basis and other elements of the net income calculations).2
IV. Summary of Certain Ordering Rules Under Section 1012 and Reporting Rules Under Section 6045
Treas. Reg. §1.1012-1(j) provides ordering rules for identifying which units of a particular digital asset held in a single wallet or account are sold, disposed of, or transferred when less than all units of that digital asset are sold, disposed of, or transferred.3 The proposed ordering rules are subdivided into rules for units of digital assets held in an unhosted wallet as compared to units of digital assets held in the custody of a broker through a hosted wallet. The Proposed Regulations that provide reporting rules under section 6045 are subdivided in the same manner and, in some respects, the reporting rules are designed to reflect the ordering rules.
Units of digital assets in an unhosted wallet
- Default to FIFO if no specific identification
If a taxpayer sells, disposes of, or transfers less than all units of the same digital asset held in a single wallet or account and the taxpayer does not make a specific identification (as described below), units in the wallet or account are disposed of in order of time from the earliest acquired (i.e., what is colloquially known as “first-in, first out” or “FIFO”).4 Importantly, for this purpose, the Proposed Regulations state that the date the units were transferred into the taxpayer’s wallet or account is disregarded which means the original purchase date supersedes the transfer date.5 For example, if (i) a taxpayer acquired, in Year 1, units of a digital asset in a wallet or account, such as an account at a CEX (lot 1), (ii) the taxpayer acquired, in Year 2, units of the same digital asset in a separate unhosted wallet or account (lot 2), (iii) the taxpayer subsequently transferred the units associated with lot 1 to the unhosted wallet in Year 3, and (iv) the taxpayer sells some of the units of the digital asset in the unhosted wallet in Year 4, the proposed regulations appear to apply FIFO by disregarding the Year 3 transfer and treating lot 1 as the earliest acquired units in the unhosted wallet or account.6
- Specific Identification
Conversely, if a taxpayer sells, disposes of, or transfers less than all units of the same digital asset held in a single wallet or account and the taxpayer makes a specific identification on the taxpayer’s books and records, on or before such sale, disposition or transfer, the basis and holding period of the disposed units are determined by that specific identification.7
- Proposed Reporting Rules Under Section 6045
For each digital asset sale subject to information reporting, the broker must report on the form required by the IRS the following information:
- the name, address, and taxpayer identification number of the customer;
- the name and number of units of the digital asset sold;
- the sale date and time;
- the gross proceeds amount (taking into account transaction costs allocated under the Proposed Regulations);
- any other information required by the form in the manner and number of copies required by the form or instructions;
- the transaction ID (or transaction hash) in connection with the sale, if any;
- the digital asset address (or digital asset addresses if multiple) from which the digital asset was transferred in connection with the sale, if any; and8
- whether the sale was for cash stored-value cards, or in exchange for services, or other property.9
V. NODE40’s General Comment Outside of the Questions Posed in the Proposed Regulations
Before addressing the specific questions posed in the Proposed Regulations, we address an issue regarding digital asset naming conventions. The proposed reporting rules under section 6045 require the broker to report “the name … of the digital asset sold.”10 Many digital assets share the same name or even the same ticker symbol as there is no universal convention or standard naming convention. We therefore recommend that the Treasury and IRS allow the broker flexibility to provide enough information to reasonably identify the digital asset at issue. We advise that the report should allow a broker to use two additional data points to prepare the form: 1) an optional contract address (for when the digital asset is defined as a protocol smart contract) and 2) a required source of the transaction (e.g., the name of a centralized exchange or the name of a blockchain or protocol).
VI. NODE40’s Response to Question Posed for Comments in the Proposed Regulations (Question 44)
Question Posed for Comments in the Proposed Regulations (Question 44)
Question 44 of the Explanation of Provisions in the Proposed Regulation provides: “Should the ordering rules for unhosted wallets be applied on a wallet-by-wallet basis as proposed, or should these rules be applied on a digital asset address-by-digital asset address basis or some other basis? See Part II.C of this Explanation of Provisions.”
Blockchain Accounting Models
Before proceeding specifically addressing Question 44, we would like to first provide a very general background on the different types of blockchain accounting models as the proposed ordering rules under section 1012 and the answer to Question 44 may have different ramifications depending on the blockchain accounting model applicable to the particular digital asset at issue.
UTXO-Based Blockchain Models
Certain blockchains, such as Bitcoin and others, but not Ethereum, use an Unspent Transaction Output (“UTXO”) accounting model. Very generally using Bitcoin as an example, a transaction consists of one or more inputs and one or more outputs11. When a transaction is executed, all of its inputs are marked as spent and all of its outputs are generated as “unspent.” Any outputs that remain under the control of the wallet from which the transaction was issued represent the unspent outputs; ergo UTXO.
A user’s wallet can hold many UTXOs. The wallet calculates the user’s balance by scanning the blockchain and aggregating all UTXOs under the user’s control (i.e., for which the user controls the private key of a UTXO).12 In such a model, a user’s “balance” of Bitcoin is the sum of all UTXOs that the user’s wallet can spend and which may be scattered over hundreds or thousands of addresses, transactions, and blocks. Where a user has units of Bitcoin in its UTXOs that are less than the amount needed for a transaction, the model uses multiple UTXOs in the user’s wallet. If the sum of all UTXOs included in a transaction exceeds the amount needed for a transaction, the sender will receive back the excess amount as “change” (a new UTXO) in the user’s wallet.13 To further illustrate using Bitcoin, assume a wallet has three UTXOs that total 300.01854520 Bitcoin.14 Assume a user desires to send exactly 300 BTC to a third-party. In this scenario, the wallet creates two outputs: one of 300 BTC is sent to the recipient, and one for the remainder (i.e., “change”), less transaction fees, is sent back to the sender in a new address controlled to the sender’s wallet.15 As described, the change is a new UTXO. The Bitcoin blockchain contains all the data required to audit transactions like the example outlined above.
Account-Based Blockchain Models
The account-based model is used on certain blockchains such as Ethereum and others, but not Bitcoin. Unlike the UTXO model, the account-based model is analogous to a bank account. The model keeps track of a digital asset as a balance within that account. Users can deposit or withdraw amounts of the digital asset from the account and the digital asset units are divisible, whereas UTXO models are not divisible and use “change.”
For example, assume a user (Jane) has 3.0 Ether. Jane can send John 2.5 Ether as part of a transaction in exchange for services. The remaining account balance would be 0.5 Ether. Unlike a UTXO model, it is not necessary for Jane to send the entire 3.0 Ether balance to then receive 0.5 Ether as change. Now suppose Jane had a balance of 2.0 Ether associated with one digital asset address 0x123 and 1.0 ETH associated with a different digital asset address 0x456. To send John the amount of 2.5 Ether, Jane would have to create two transactions; one from each address because when using account based blockchains, a transaction can pull a digital asset from only a single address at a time.
NODE40’s Comments to Question 44
As a data company that specializes in economic analysis and financial reporting for digital asset activity, NODE40 has approached digital asset processing by balancing the following goals:
- We believe that the blockchain ecosystem, especially in the case of on-chain data, provides a unique opportunity for various parties to access publicly available, open source data that can be used to verify transactional data. We therefore analyze data with the goal of providing reports to create an independent, verifiable audit trail that enables the taxpayer, Government, accountant, auditor or any other party to confirm exactly how and why a report produced a particular finding.
- We also seek to provide a user, such as a taxpayer, flexibility to apply different methodologies that may be allowed under a tax, accounting or other financial system.
The following comments are provided with these goals in mind.
UTXO Blockchain Accounting Models
The differences in technical design across the many blockchains that exist today pose material administrative difficulties related to the proposed ordering rules under section 1012.
NODE40 believes that specific identification on a wallet-by-wallet16 basis is the most appropriate way to apply basis ordering rules for UTXO blockchains for the following reasons:
- A user’s balance of a digital asset is the sum of all UTXOs in that user’s wallet. Through automated UTXO analysis on blockchains, it is possible to configure reports that meet the goals of the specific identification requirements in the Proposed Regulations.
- UTXO analysis allows for the generation of a provably correct audit trail representing precisely what actions the wallet owner participated in, the date and time of the action, and which specific tax lots were involved.
- Specific identification of UTXO tax lots is simple to administer and may be objectively audited independently from a wallet owner.
That said, we want to make the Treasury and IRS aware that it is technically possible to apply other methodologies such as FIFO to UTXO blockchains but is administratively complex and cannot be objectively audited independently from a wallet owner, leading to competing interpretations of the digital asset actions that took place.
Account-Based Blockchain Models – Discrepancy between the ordering rules under section 1012 versus section 6045 reporting rules
In contrast to UTXOs, NODE40 believes that a FIFO methodology on a digital asset-by-digital asset address basis is the most appropriate way to apply basis ordering rules for account-based blockchains. Specific identification of individual tax lots is not administratively straightforward like it is with UTXO blockchains and may not be possible in all cases. Applying FIFO rules to account-based activity is simple to administer and may be objectively audited independently from a wallet owner.
Through automated data analysis of blockchains, it is possible to configure reports that meet the goals of the Proposed Regulations using FIFO for any units of digital assets held within a digital asset address. Further, applying FIFO on a digital asset address-by-digital asset address basis accurately reflects blockchain data for account-based blockchains thereby providing an objective audit trail including the digital asset purchase date and fair and consistent ordering of tax basis for a unit of any digital asset.
Discrepancy between the ordering rules under section 1012 versus section 6045 reporting rules
Adopting an ordering rule under section 1012 that uses a wallet-by-wallet approach could lead to discrepancies between (i) the the application of FIFO or specific identification on a wallet-by-wallet basis as compared to (ii) the wallet address data provided by brokers under the section 6045 reporting rules. Under the Proposed Regulations, when a taxpayer sells, disposes of, or transfers less than all units of the same digital asset held in a single wallet, the units of the digital asset are treated as disposed by applying FIFO or a specific identification to the units held in that single wallet (or account).17 Conversely, upon a sale of a digital asset, the unhosted wallet broker must provide information on, among others, the transaction ID (or transaction hash) in connection with the sale and the digital asset address(es) from which the digital asset was transferred.18
Consider the following scenario.19 Suppose Taxpayer holds two lots of digital asset DE in a single unhosted digital asset wallet.20 The first lot is held at digital asset address AAA123 and consists of 10 units of digital asset DE, with a purchase date of January 1, Year 1, and a basis of $2 per unit. The second lot is held at digital asset address BBB456 and consists of 20 units of digital asset DE, with a purchase date of January 1, Year 2, and a basis of $5 per unit. On September 2, Year 2, when the DE units have a fair market value of $10 per unit, Taxpayer exchanges 10 units of digital asset DE held at digital asset address BBB456 for 10 units of digital asset ST using the services of P2X.21 Prior to the exchange, Taxpayer did not keep a record of the specific 10 units of digital asset DE that Taxpayer intended to sell. Pursuant to the ordering rule, the units disposed of are the earliest acquired in the wallet (or account). Accordingly, the Taxpayer must treat the 10 units sold as the 10 units with a purchase date of January 1, Year 1, held in digital asset address AAA123.
However, the proposed reporting rules under section 6045 appear to require P2X to report the transaction ID of the exchange transaction and the digital asset address (10 units from digital asset address BBB456) from which the digital assets were transferred, resulting in a material information reporting discrepancy between the taxpayer’s obligations and the broker’s obligation.
Under a wallet-by-wallet approach, the ordering rule treats as a disposition the units held in digital asset address AAA123 which is different from the digital asset address of BBB456 reported by the broker. The discrepancy can be prevented if the ordering rules were applied on a digital asset address-by-digital asset address basis. In such a case, FIFO would apply only to those units held in digital asset address BBB456 which is the same digital asset address from which the transfer is made as reported by the broker, resulting in consistent data reported by broker and taxpayer.
As the above example illustrates, adopting an ordering rule under section 1012 that uses a wallet-by-wallet approach will result in administrative issues because of discrepancies between the taxpayers records and the wallet address data provided by brokers. These discrepancies could cause confusion on the part of the Government and the taxpayer especially in situations where the IRS is conducting an audit of the taxpayer and the taxpayer must explain the reason the broker has reported a digital asset address that is different from the taxpayer’s internal records. Adopting an ordering rule under section 1012 that uses a digital asset address-by-digital asset address approach will reduce the discrepancies. More importantly, a digital asset address-by-digital asset address approach would provide an objective “audit trail” that more closely aligns with the purported benefits of blockchain technology, i.e., providing consensus-driven and tamper-proof trail of system events that are viewable and verifiable by various parties.
Recommendation if one unified approach is desired
Finally, in the alternative, if the Treasury and IRS desire to have one approach for all digital assets regardless of the blockchain accounting model, we would recommend a digital asset address-by-digital asset address ordering rule along with an option for the taxpayer to include related digital asset addresses in the ordering rule with the taxpayer having the burden of proof to show digital asset addresses are related. We propose such an approach because it:
- may be more easy to administer while at the same time providing a correct audit trail for verification by parties independent from the wallet owner;
- would allow for some flexibility for taxpayers to how digital asset addresses are related for UTXO blockchain accounting models;22 and
- may give rise to fewer discrepancies between the position a taxpayer has taken under the proposed ordering rules versus the data provided by unhosted wallet brokers on a Form 1099.
We would like to thank the U.S. Treasury and the IRS for the significant effort made to publish proposed regulations to provide more tax clarity for the U.S. digital asset ecosystem. We also appreciate your consideration of our comments and we welcome the opportunity to discuss our comments and any other tax policy issues or technical considerations related to digital assets with you and your staff.
CEO and Co-Founder
Head of Tax & Accounting Solutions
1 Unless otherwise indicated, all section references in this comment letter are to the Internal Revenue Code of 1986, as amended (hereinafter the “Code”), all “Treas. Reg. §” references are to the U.S. Treasury’s regulations under the Code, and all “Prop. Reg. §” references are to the U.S. Treasury’s proposed regulations under the Code.
2 Unless otherwise indicated, all section references in this comment letter are to the Internal Revenue Code of 1986, as amended (hereinafter the “Code”), all “Treas. Reg. §” references are to the U.S. Treasury’s regulations under the Code, and all “Prop. Reg. §” references are to the U.S. Treasury’s proposed regulations under the Code.
3 A digital asset is considered “held in a wallet or account” if the wallet, whether hosted or unhosted, or account stores the private keys necessary to transfer control of the digital asset. Prop. Reg. §1.6045-1(a)(23). A digital asset associated with a digital asset address that is generated by a wallet, and a digital asset associated with a sub-ledger account of a wallet, are similarly considered held in a wallet. Id. References to variations of held in a wallet or account, such as held at a broker, held with a broker, held by the user of a wallet, held on behalf of another, acquired in a wallet or account, or transferred into a wallet or account, each have a similar meaning. Id.
4 See Prop. Reg. §1.1012-1(j)(1).
5 See id.
6 This example is based, in part, on Prop. Reg. §1.1012-1(j)(5)(ii), Example 2.
7 Prop. Reg. §1.1012-1(j)(1). A specific identification of the units of a digital asset sold, disposed of, or transferred is made if, no later than the date and time of the sale, disposition, or transfer, the taxpayer identifies on its books and records the particular units to be sold, disposed of, or transferred by reference to any identifier, such as purchase date and time or the purchase price for the unit, that is sufficient to identify the units sold, disposed of, or transferred in order to determine the basis and holding period of such units. Prop. Reg. § 1.1012-1(j)(2). A specific identification can be made only 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 removed from the wallet or account for purposes of subsequent transactions. Id.
8 A transaction ID or transaction hash and a digital asset address may be more applicable to a sale or other transaction that takes place through an unhosted wallet as compared to a hosted wallet account with a broker, such as a centralized exchange.
9 See Prop. Reg. §1.6045-1(d)(2)(i)(B).
10 See Prop. Reg. §1.6045-1(d)(2)(i)(B).
11 Some rare exceptions to this exist, such as newly created Bitcoin through mining. Such transactions do not have any input.
12 See Andreas M. Antonopoulos, Mastering Bitcoin: Unlocking Digital Currencies at ch. 6. O’Reilly Media, Inc. (2017).
13 See Id.
14 See Jim Calvin, Adequately Identifying Bitcoin Dispositions for Federal Income Tax Purposes, Tax Management Memorandum, Vol. 58, (September 4, 2017).
15 See Jim Calvin, Adequately Identifying Bitcoin Dispositions for Federal Income Tax Purposes, Tax Management Memorandum, Vol. 58 (September 4, 2017). To analogize to fiat paper currency, assume a person is buying a $1.50 beverage and the buyer pays with a $5 bill, the buyer will receive $3.50 of change, which is returned to the buyer’s wallet and available for future transactions. See Andreas M. Antonopoulos, Mastering Bitcoin: Unlocking Digital Currencies at ch. 6. O’Reilly Media, Inc. (2017).
16 The Treasury and IRS appear to treat references to “wallet” and “account” interchangeably based on the definition of “held in a wallet or account” in Prop. Reg. §1.6045-1(a)(23). See, supra, footnote 3. The definitions of wallet and account are generally blockchain specific and may represent a singular collection of multiple addresses or multiple collection of multiple addresses, depending on context. For clarity, our use of wallet refers to a singular collection of logically related addresses for which their container software (the wallet) may form transactions involving more than a single address. Our use of “account” refers to a single address for which its container software (the wallet) manages the address in isolation from any other address it manages and never forms a transaction involving more than a single address. We are happy to comment on these important points in a separate discussion or document.
17 See Prop. Reg. §1.1012-1(j)(1).
18 See Prop. Reg. §1.6045-1(d)(2)(i)(B).
19 This scenario is based, in part, on the facts in Prop. Reg. §1.1012-1(j)(5), Example 2 and Prop. Reg. § 1.6045-1(d)(2)(vii)(D), Example 4 with some changes to each example to illustrate the issue.
20 Here, this example refers to a digital asset wallet that is not in the custody of a broker, as defined in Prop. Reg. §1.6045- 1(a)(1).
21 For this example, assume that P2X is a digital asset broker that affects sales of digital assets directly between customers by providing customers with access to automatically executing contracts.
22 The approach could also reduce confusion as to what constitutes a “wallet” and “account” for federal tax purposes. See, supra, footnote 16.