The Biden Administration FY 2023 Budget and Treasury Green Book, released on March 28, 2022, includes various proposals to modernize the United States’ current compliance and reporting structure surrounding digital assets. Individuals and businesses could welcome clearer guidance, with the understanding that additional reporting and compliance are likely to go hand in hand.
Expansion of FACTA Reporting To Include Foreign Digital Asset Accounts
The Foreign Account Tax Compliance Act (FACTA) provision of the Internal Revenue Code generally requires foreign financial institutions to report a variety of information to the IRS, including the account balance or value, amounts such as dividends, interest and gross proceeds paid or credited to the account, and information on any substantial U.S. owners of certain passive foreign entities.
Under current law, an individual that directly holds an interest in one or more specified foreign financial assets, or indirectly through a domestic entity, with an aggregate value of at least $50,000 during a tax year must attach Form 8938, Statement of Specific Foreign Financial Assets, to the individuals’ tax return.
Under the Biden proposal, any account that holds digital assets maintained by a foreign digital asset exchange must be included when assessing the $50,000 threshold. A foreign digital asset account would be defined based on where the exchange or service provider is organized or established.
The proposal would be effective for returns required to be filed after December 31, 2022.
Taxpayers should be mindful of potential filing requirements when engaging with a digital asset service provider. Failure to not provide the required information for a taxable year can create penalties between $10,000 and $60,000 for each failure. In addition, the accuracy-related penalty is increased to 40% for an underpayment that is attributable to a transaction involving undisclosed foreign financial assets.
Application of Securities Lending Rules to Actively Traded Digital Assets
As major cryptocurrencies have reached all-time highs in the past 12 months, investors are exploring more passive income strategies as opposed to active trading. The ability for individuals and businesses to earn impressive yields while loaning their cryptocurrency has provided a space to avoid selling digital currencies that could have extreme appreciation.
The most common way investors receive such yields is through staking. Staking allows investors to provide their digital currency to validators who are active in the blockchain verification process and in return, receive passive income.
Under current tax law, the securities loan nonrecognition rules under Section 1058 do not apply to loans of digital assets. Without clear guidance, a conservative approach to staking could require investors to recognize a capital gain when staking (transferring) their cryptocurrency.
The Biden proposal would expand the Section 1058 loan nonrecognition rules to apply to loans of actively traded digital assets, provided that the loan has terms similar to those currently required under 1058. Such terms include:
- The return to the investor of digital assets identical to the digital assets transferred
- The requirement that payments are made to the investor, such as hard forks and airdrops, which the investor would be entitled to receive if the investor was still holding the digital assets that were lent
- That there is no reduction to the risk of loss or opportunity for gain of the investors in the digital assets transferred
Such a proposal is a welcome relief for taxpayers in this space, as the existing law is unclear. The proposal would be effective for the tax year beginning after December 31, 2022.
Amend Mark-to-Market Rules for Actively Traded Digital Assets
Currently, IRC Section 475 requires dealers in securities to use the mark-to-market method of accounting for inventory and non-inventory securities held at year-end. This requirement forces dealers to recognize gain or loss on the securities as if they were sold on the last day of the taxable year. Dealers in commodities and trades in securities or commodities may elect to use the mark-to-market method.
Under the proposal, dealers or traders could also elect the mark-to-market method for actively traded digital assets and derivatives on, or hedges of, those digital assets. Whether a digital asset is actively traded would be based on relevant facts and circumstances, including whether they are regularly bought and sold for a fiat currency, their trading volume on exchanges that have reliable valuations, and reliable price quotations. It is the belief of the administration that allowing taxpayers to mark actively traded digital assets to market would clearly reflect income and could reduce tax compliance burdens.
The need for more guidance surrounding the increasingly growing digital assets market is greatly needed. Taxpayers active in the digital asset market should continue to carefully monitor the proposals to ensure enough time for proper tax planning and compliance.