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November 14, 2023

Read Ledgible's Full Testimony to the IRS

Ledgible was honored to be the first to provide testimony to the IRS during their hearing on Monday, November 13th around REG-122793-19. Ledgible's VP of Tax Information Reporting, Jessalyn Dean, was first to speak. The written transcript of her verbal testimony can be found below. Please note, the transcript may have grammatical and textual errors due to the transcription process.

Speaker: Jessalyn Dean

Good morning, everyone. I'm Jessalyn Dean and I'm the Vice President of Tax Information Reporting at Legible. On behalf of the team at Legible and our CEO Calcanti (phonetic), we're thankful for the opportunity to participate in the legislative process of tax reporting over digital assets. Crypto and other digital assets are currently facing the unprecedented prospect of 1099 tax reporting over transactions where substantive tax law about those transactions is still unsettled. In contrast, the traditional financial services industry has had the benefit of decades of largely settled substantive tax law before being required to layer 1099 tax reporting on top of those transactions. The traditional financial services industry has also been given far more time to implement various components of tax reporting while the digital assets industry is being given a shockingly short window to stand up their entire operating models.

Indeed, gross proceeds reporting on Form 109 B was in place for 20 years before cost basis information was required to be reported by traditional securities brokers. Though native crypto tokens and NFTs are facing the brunt of the short implementation window offered by the IRS, a subset of digital assets called tokenized securities and tokenized real estate already have existing tax reporting obligations to comply with tokenizing of securities and real estate creates a digital receipt of ownership but does not necessarily create new financial products.

Because of this, some of the largest names in traditional financial services are embracing tokenization, even where they have shied away from native crypto tokens and related services. Longstanding, heavily regulated financial institutions are entering the tokenization market in order to leverage blockchain technology to innovate back-office infrastructure and shareholder record keeping.

Names you can find in the news offering tokenized financial products in the U.S. include Wisdom Tree and Franklin Templeton, and abroad include Deutsche Bank and HSBC, increasing speed of transactions, increasing efficiency, and reducing costs to investors. Tokenization is not just the future of blockchain technology; it is here today in the types of products that the IRS and taxpayers are already familiar with and are subject to existing tax reporting requirements. I will address the remainder of my remarks to two categories of tokenized financial products, 1940 Act Mutual Funds and real estate.

1940 Act Mutual Funds, particularly subchapter C-Corporations and subchapter M:RICs, today fall under existing 60/45 broker regulations. Sales or exchanges of these mutual funds are reportable on 1099B reporting the proceeds and basis information. Reporting of gross proceeds on sales or exchanges of mutual funds dates back to the 1980s, and in 2011, mutual funds began reporting cost basis information in addition to gross proceeds.

One very important exception to Form 1099B reporting is given to money market funds whose stable value means that it is bought and sold at the same price and therefore not reported at all on Form 1099B, though it may optionally be reported. This exception gives relief to the IRS and to the taxpayer having to process large volumes of unnecessary data for transactions resulting in zero gain or loss.

The proposed regulations for digital assets will require tokenized mutual funds by default to be reported on a Form 1099DA. Recognizing that this is double reporting on a Form 1099B, the IRS has proposed a coordinating regulation so that sales or exchanges of tokenized mutual funds would only be reportable on the Form 1099DA and reporting on the B would end.

We at Legible strongly disagree with this proposal and insist that 1940 Act Mutual Funds that are already reportable on a Form 1099B should remain so. The Tokenized Mutual fund industry is dominated today by traditional financial institutions. Though the proposed regulations for tax reporting on digital assets were largely written with a distrust of the digital assets industry, there is zero evidence to indicate that tokenized and highly regulated mutual funds offer any heightened risks of noncompliance with tax obligations when compared to their non-tokenized mutual fund counterparts. This is because today most of these tokenized mutual funds do not yet allow for transfers to self-hosted private wallets, peer-to-peer trading, indirect investment through omnibus accounts, or even broker-to-broker transfers.

Most alarmingly, the proposed regulations requiring Form 1099DA reporting instead of the B reporting would cause tokenized money market funds to lose their exception to reporting and would therefore create a real de-incentivization to the mutual fund industry to tokenize their mutual funds. For many decades, shareholder record keepers have invested significant amounts of their operating budget into software and infrastructure that is adapted to these existing 1099B tax form structures. The cost to these brokers would be enormous to overhaul their cost basis and 1099 reporting software and infrastructure for a specific subset of their mutual funds, even though they are economically identical to and regulated in the same way as their non-tokenized counterparts.

These costs would include shifting tokenized mutual funds from reporting on the B to the DA and to start reporting sales or exchanges of money market funds which were exempted under the B rules. In return for such enormous costs to these brokers, the IRS would receive no additional volume of transaction reporting compared to today, nor would they see an increased compliance rate by taxpayers that are already receiving Forms 1099B for these products. Next, I would like to address tokenized real estate.

In the proposed regulations, the IRS has spent considerable time addressing real estate transactions that involve digital assets. However, the explanation of provisions, the text of the proposed regulations, and the examples all fail to capture and address the reality of most real estate transactions that leverage blockchain technology. In the U.S., the tokenization of real estate is complex in that it could result in a number of different legal structure outcomes. Sales of single pieces of real estate are commonly sold as NFTs, but they still have an LLC interposed as the owner of the real estate, since in all cases we are aware of an NFT cannot hold legal title to real estate in the U.S.

Where real estate is being sold as fractional ownership, there is typically a partnership or LLC interposed as the owner of the real estate for the same reason that I just mentioned, but also to make partial ownership changes smoother. Even where a partnership or LLC agreement has not been legally drafted, most every tax accountant would agree that a group of unrelated parties agreeing to pool their money together to purchase and hold real estate is a default partnership for tax purposes under the Internal Revenue Code.

Another possible structure outcome is that a REIT is formed, a real estate investment trust, and shares of the REIT are then tokenized. This is the case with the most often quoted use case of real estate tokenization, the Aspen Coin, which tokenized fractional ownership of a ski resort in Colorado. However, in the structure outcome, there is no partnership or LLC, and instead, you have a tokenized security which falls under existing 1099B reporting that I discussed in my earlier remarks.

So, why does all of this matter? I mentioned that the IRS has failed to capture and address the reality of most real estate transactions that leverage blockchain technology. This is because investors in tokenized real estate are not buying and selling tokens representing ownership interests in real estate. They are buying and selling tokens representing ownership interests in LLCs or partnerships, and where an LLC or partnership exists for tax purposes, then Form 1065 and Schedule K1 reporting will follow the cost basis rules of interest in an LLC or partnership.

The cost basis rules of interest in an LLC partnership for tax purposes are complex and will never be information that is available to digital asset brokers. Not only is Form 1099DA reporting therefore completely inappropriate for these transactions, but it will lead to double reporting due to the absence of a 14 coordinating regulation with Schedule K1 reporting. This double reporting will create 16 meaningless cost basis information and reconciliation nightmares with Schedule K1 for the taxpayers. We, therefore, insist that transactions 19 involving tokenized real estate where Schedule K1 reporting applies should be exempted from the VA reporting in the proposed REGs. My comments are now complete, and I thank you for your time.

Read the full testimony from all participants in the document below.

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