Following the deluge of pandemic-related tax announcements in April, we have a bit of a respite in May in respect of tax information reporting developments. One news items of note though is that the IRS has reached out to certain tax technology vendors for help in crypto currency-related examinations. There are also several tax updates relating to default withholding on periodic payments with respect to pensions and annuities, certification obligations of Qualified Derivatives Dealers and specifications for qualified intermediaries utilizing the IRS QI/WFP/WFT electronic portal.

1. IRS Crypto SOW

As discussed in industry news reports, the IRS reached out to certain crypto tax vendors in May soliciting assistance in tax calculations and analysis related to taxpayer virtual currency transactions. The solicitation was accompanied by a statement of work (SOW) that detailed the specific areas of assistance that the IRS was interested in.

The assistance requested appears related to taxpayer examinations. The contractor would need the capacity to ingest virtual currency transaction data from the IRS and possibly third-party data feeds. Of specific interest is the ability to handle “decimal place precision” and varying field and file formats. The SOW lists as potential information sources:

i. Publicly available on-chain data and private off-chain data;

ii. API keys obtained through exchanges, wallets, etc.;

iii. CSV, Excel, or PDF files from various sources;

iv. Paper documentation submitted by taxpayers;

v. Data obtained through merchant electronic systems;

vi. Related data obtained by the contractor for valuation purposes;

The goal is then for the contractor to utilize the ingested information to create a report that calculates gains/losses for the virtual currency transactions in question, together with a summary of the methodology utilized.

According to the SOW, the report computing gains or losses must reflect the contractor’s ability to:

i. Track cost basis (in USD) for each unit (or fractional unit) of virtual currency by specific identification. In doing so, the following information must be included:

a. Type of virtual currency;

b. Quantity (in fractional units); and

c. Identifying information for the unit (or fractional unit).

ii. Provide cost basis computations for virtual currency lacking a USD analog or trading pair.

iii. Provide information on the acquisition of virtual currency. In doing so, the following information must be included:

a. Type of virtual currency;

b. Quantity (in fractional units);

c. Date and time of the acquisition;

d. Value at the moment of acquisition; and

e. Identifying information for the unit (or fraction) of asset.

iv. Provide tracking information for all sales or other disposition transactions, including but not limited to buy, sell, send, and receives, across multiple platforms, wallets, and exchanges. In the case of digital assets, this may include both on-chain and off-chain transactions to the extent feasible. In doing so, the following information must be included:

a. Type of virtual currency;

b. Quantity (in fractional units);

c. Date and time of the disposition;

d. Value at the moment of disposition; and

e. Identifying information for the unit (or fractional unit) of virtual currency.

v. Permit manual adjustments to the tax character and/or basis of the asset (classifying an asset as inventory versus non-inventory).

vi. Identify asset holding periods.

vii. Identify assumptions made by the contractor or its systems in creating the report, if any.

The SOW indicates that the IRS remains serious about crypto tax enforcement, but the specifications in the document also raise questions as to whether the IRS may try to mandate more detailed reporting elements when it issues regulations on tax information reporting for crypto. That is, instead of going through the laborious exercise of ingesting vast amounts of data and determining cost basis and gains or losses at the examination stage, would the IRS attempt to have brokers and other financial institutions facilitating crypto trades or transfers provide more detailed tax information to both the IRS and recipients in the form of tax information reporting?

Would Form 1099-B for virtual currencies involve more than gross proceeds reporting and involve some sort of cost basis element? How would cost basis reporting be accounted for where an account holder could transfer digital assets to and from private wallets? Would the specification of date and time in the SOW requirements mean that there might be a default valuation of an asset at acquisition or sale that would utilize the date and time data elements based on some default valuation methodology? The SOW mentions specific identification for tax lots but presumably based on previously issued FAQs, there would also be a need to handle FIFO methodology? At this point, we can only speculate, but the SOW provides an interesting window into IRS thinking on information and processes that may be necessary to calculate and corroborate virtual currency taxable income and loss.

2. Withholding on Periodic Payments from Pensions and Annuities

The IRS issued in late May proposed regulations that set the framework for potential changes in the default withholding that would occur on periodic payments made from pensions and annuities where a recipient has not provided a withholding certificate on Form W-4P. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), the statutory provision under section 3405(a)(4) had provided that absent a withholding certificate a taxpayer receiving periodic payments from pensions and annuities would be withheld as if the recipient were a married individual claiming 3 withholding exemptions. The TCJA changed section 3405(a)(4) to read that the default withholding shall instead be determined by rules issued by the Secretary of the Treasury (rather than a fixed default rule).

For 2018, 2019 and 2020, the IRS has issued guidance that default withholding in this case should continue as under the prior statutory rule. The proposed regulations, intended to be effective beginning for payments in 2021, would conform the regulations to the statute and tie default withholding on periodic payments from pensions and annuities to other guidance that the IRS may issue (e.g., pursuant to tax forms). Thus, future changes to such default withholding will likely be found in instructions to Form W-4P and related guidance.

3. Qualified Derivatives Dealers

Broker-Dealers and other financial institutions that act as qualified derivatives dealers (QDD) for purposes of section 871(m) derivative transactions should be aware that the IRS has clarified certification guidance for QDDs. In one updated FAQ and a new FAQ for qualified intermediaries, the IRS is now requiring that qualified intermediaries that are QDDs provide periodic certification even if their only activity is that of a QDD. QIs that are QDDs, however, may potentially request a waiver from periodic review for certification periods that end in calendar years prior to 2023. See the Certifications and Periodic Reviews section of the QI FAQs, FAQ 1 and FAQ 19 (updated April 30, 2020).

4. Publication 5262 Updated

The IRS has released an updated version of Publication 5262: Qualified Intermediary, Withholding Foreign Partnership, and Withholding Foreign Trust Application & Account Management User Guide. The user guide provides instructions and information for users utilizing the IRS electronic system for such tasks as applying for qualified intermediary (QI), withholding foreign partnership (WP) and withholding foreign trust (WT) statuses, renewing QI/WF/FT agreements, certifications, and managing information changes and status terminations. The publication has an updated May 2020 version date.