On December 30, 2024, the Department of the Treasury (the Treasury) and the Internal Revenue Service (the IRS) published the final regulations (Final DeFi Regulations) relating primarily to persons who are front-end service providers that operate decentralized finance (DeFi) platforms, The DeFi industry participants (such as InstaSwap or Uniswap) offer services to facilitate digital asset transactions that utilize self-executing software without any participant in the DeFi industry exercising custody over the private keys used for accessing the digital asset customer’s asset on a distributed ledger.
The Treasury and the IRS had previously published final regulations on July 9, 2024 (Final Regulations), which address information reporting by certain brokers (such as digital asset brokers that act as agents for a party in the transaction, operators of custodial digital asset trading platforms, certain digital asset hosted wallet providers, and certain processors of digital asset payments) and the determination of amount realized and basis for certain specified digital asset sales and exchanges. The Final Regulations, however, reserved on the proposed definition of “digital asset middlemen.” Under the proposed regulations that were published on August 29, 2023 (Proposed Regulations), such non-custodial industry participants and DeFi participants were treated as brokers.
Our alert on the Final Regulations can be accessed here and our discussion on the Proposed Regulations can be accessed here.
The Final DeFi Regulations are expected to take effect on February 28, 2025, but the IRS has provided transitional relief (as discussed below). A brief overview of the Final DeFi Regulations is set forth below.
Scope of Digital Asset Middlemen Limited to Front-End Service Providers
The Final DeFi Regulations attempt to identify operators who would be in the best position to know their customer. To that end, the Treasury and the IRS relied on the three-layer DeFi stack model (consisting of interface, application, and settlement layers), to conclude that only front-end service providers operating in the interface layer would be included within the definition of digital asset middlemen under the Final DeFi Regulations. Therefore, persons who provide front-end services that would facilitate customer interaction with DeFi trading applications, i.e., user interface services that would enable 1) users to input their order details and 2) the transmission of order details to the distributed ledger network or cause interaction with the digital asset trading protocols for the execution of the order, would be considered as digital asset middlemen.
Further, as indicated in the Proposed Regulations, persons solely providing certain unhosted wallet services and validation services involving sale of hardware or licensing of software that permit persons to control private keys used to access distributed ledger have been excluded from the reporting requirements. The Final DeFi Regulations further clarified that if such service operators provide trading front-end services in addition to unhosted wallet or validation services, they will only be required to undertake reporting to the extent of the front-end services furnished by them.
In addition, a modified “position to know” standard has been included to determine if service providers would be treated as delivering trading front-end services. Under this standard, a front-end service provider would be in a position to know the nature of the transaction potentially giving rise to gross proceeds from a digital asset sale if such person maintains control or sufficient influence over the services to have the ability to determine the extent to which the transaction gives rise to gross proceeds. The illustrative example provided to clarify the standard state that if a person has the ability to 1) amend, update, or substantively affect the terms of service, 2) charge fees for the trading front-end services, and 3) add to the order a sequence of instructions to query the distributed ledger to determine if the processed order is executed or to use another method to confirm execution. Any contractual limitations on the service provider’s ability to perform any of the above actions, which are not required by law, or any limitations on their coding ability, will be disregarded for purposes of the determination.
Exceptions for Certain DeFi Transactions
Notice 2024-57 that was issued contemporaneously with the Final Regulations would also apply to front-end service providers. This notice provides that no reporting is required in respect of specific digital asset transactions such as staking, wrapping and unwrapping, short sales of digital assets, lending of digital asset and notional principal contract transactions, etc., until further notice.
Effective Dates for Reporting and Backup Withholding
Notice 2025-3, that was issued contemporaneously with the Final DeFi Regulations, provides transitional relief by deferring the application of information reporting by front-end service providers to digital asset sales occurring on or after January 1, 2027, and backup withholding required by DeFi brokers under Section 3406[1] to digital asset sales occurring on or after January 1, 2028.
Challenge to Final Regulations
Several digital asset organizations have challenged the Final Regulations by way of a complaint filed in Northern District of Texas on December 27, 2024 (the same day on which the Final DeFi Regulations were released electronically).[2] The primary grounds of challenge are that the Final Regulations exceed the IRS’s statutory authority because the definition of “brokers” under Section 6045 was expanded beyond what was intended by the U.S. Congress, and that the regulations violate the Fourth Amendment because reporting would result in warrantless searches when the transaction participants have not voluntarily provided such information. Complaints also allege these regulations violate the Fifth Amendment because the requirements are overly broad and unclear and therefore violate due process requirements. The outcome of this litigation could affect the scope of these regulations.
If you have any questions about any tax issues involved in the application of the final regulations to digital assets, please contact Greg Broome or any member of the tax practice at Wilson Sonsini.
Anjali Krishnan contributed to the preparation of this Alert.
[1] Unless otherwise specified, all Section references are to the Internal Revenue Code of 1986, as amended.
[2] Blockchain Association et al. v. IRS, No. 3:24-cv-03259-X, (N.D. Tex. filed Dec. 27, 2024).
