Blockchain validators may not be off the hook for all US tax reporting

Jan 18

Published: January 18, 2023

Overview

Are proof-of-stake blockchain validators excluded from US IRS Form 1099 reporting? Some news reporters seem to think so.

But I say: not so fast.

While validators are expected to be excluded from the definition of “broker” for sales and transfers of digital assets (e.g. crypto) on Form 1099-DA, they could still have existing obligations for Form 1099 reporting of staking income/rewards that they pay to other parties.

Broker tax reporting

The definition of “broker” has been debated over the last 2 years under the US Infrastructure Bill with regards to crypto, digital assets, and blockchain. This Bill, passed into law in 2021, imposes Form 1099-DA reporting requirements on digital asset “brokers”. After guidance is issued, this will lead to the annual reporting by “brokers” of digital asset sales and transfers by their customers.

The proposed rules on reporting requirements were recently sent to the White House for review which has renewed discussions about whether validators will be excluded from the definition of “broker”. Indeed, in February 2022 US Treasury sent a letter to US Senator Portman (which was posted to Twitter) indicating their view and intention to issue guidance that would generally exclude validators under certain conditions from the definition of “broker” under IRC Section 6045.

We all are watching intently for the release of the proposed rulemaking for IRC Section 6045 and Form 1099-DA.

Other tax reporting for non-brokers

In the meantime, with many other types of annual Forms 1099 filed by businesses coming due in January and February 2023, it is worth having a look at other possible Form 1099 obligations that could still be out there for validators. Let’s consider the following:

IRC Section 6045 reporting obligations exist for persons doing business as a broker.
IRC Section 6041 reporting obligations exist for persons in a trade or business that make a payment of income to another party.

IRC Section 6041 covers other payments that a business might make to another party, such as rent, services, royalties, and “other income”. We can see that 6041 is much more general than 6045. Which means that if a validator is operating a trade or business, and makes a payment of income to another party, then they must assess if they have a 6041 reporting obligation on Form 1099-MISC (or other applicable 1099). In other words, obligations under IRC Section 6041 can still exist for a validator even in the case that they are excluded from the definition of “broker” under IRC Section 6045.

Assessments by staking pool operators

Some staking protocols distribute blockchain validation staking rewards directly back to the original delegator without the asset ever passing into the wallet of the staking pool operator. Other staking protocols deliver staking rewards to the wallet of the staking pool operator first, who then turns around and distributes the allocable reward amounts to their delegators wallets. Staking pool operators that first take possession of the awards into their own wallet before paying them out to other parties are at a higher risk of being obligated to issue a Form 1099-MISC. This is because the payment flow is from one identifiable party (the staking pool operator) to a second identifiable party (the asset owner that delegated their crypto, etc to the staking pool operator). Further assessment of the circumstances and protocol involved is needed for each separate validator. Some considerations will include, amongst others, is the staking pool operator:

in a trade or business?
in possession of and making a payment to another party?
is the nature of the payment considered to be “income”? (most items are income unless explicitly excluded)
is there an identifiable third party in the chain of payment flows that otherwise has management or control of the payment, or more substantial knowledge of the identity of the recipient?
subject to any AML/KYC legislation?
are there any other circumstances of the flow of payments or the nature of the recipients that might cause an exclusion from Form 1099 reporting?

TLDR

The forthcoming IRS guidance may likely only address whether a validator is a “broker” for purposes of IRC 6045 and Form 1099-DA reporting for digital asset sales and transfers. If the forthcoming guidance does not address validators Form 1099 obligations under any other code sections (such as IRC 6041), then these validators will still need to assess if they have any other Forms 1099 to issue. Think twice when you see news headlines reporting that blockchain validators are excluded from US tax reporting obligations.