BCOTAX
August 2022
*Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice.
Proof-of-stake (PoS or staking) is considered to be the next big business as it’s the greener alternative to proof-of-work (PoW or mining). Although PoW and PoS are often linked as similar processes, there are distinct differences between the two that may affect how they are taxed. Through PoW, miners create new coins through completing complex puzzles that validate transactions. In PoS, users contribute (or stake) their own coins to validate transactions. A larger staking of coins will increase the probability of the user being chosen to validate the transactions on the network, which in turn creates a block reward. [1] [4] [7]
We already have received guidance on the taxation of mining, as the IRS published in Notice 2014-21. Users who successfully mine cryptocurrency must include the fair market value of the cryptocurrency upon receipt as a part of their gross income. [5] The question remains whether the IRS will take a similar stance with staking, or if they will treat it differently. With the additional consideration of the recent Tezos case, this article will explore both potential stances on the taxation of staking.
There are two main schools of thought regarding how staking ought to be taxed as an individual. Although the IRS has not published any official guidance regarding the taxation of staking – yet – we can make an educated guess as to whether staking will be subject to taxation upon sale, or taxation upon receipt.
Income Deferred Until Sold or Transferred
Many consider staking rewards as newly created property. Were an author to write a book, that book wouldn’t be subject to tax until the author chose to sell it. Similarly, in the case of staking, the individual is creating the block rewards with the use of the software protocol – thus the individual creates their own new property. The taxable income event would be deferred until the reward is sold or transferred.
Ordinary Income Upon Receipt
The second stance that the IRS may choose to take is to consider staking rewards as a part of the individual’s gross income upon receipt. The argument for taking this stance is that the individual receives the block reward as a result of participating in the protocol’s consensus mechanism.
Were the IRS to decide to take this stance, then the sale of the block rewards would be subject to capital gains tax. Upon receipt of the block rewards through staking, the user would record the fair market value of the rewards. Then any increase in value will be subject to capital gains tax, with the fine details depending on when the user chooses to sell the rewards (short-term: <1 year ; long-term: >1 year).
The New York State Bar Association argues that staking should be taxed as ordinary income. An important note to make is that they do recognize the staking rewards as property, however the distinction is who created that property – the individual or the protocol. [6]
The IRS did publish in Notice 2014-21 guidance that mining is to be taxed as ordinary income. As mining and staking are commonly compared, it is possible the IRS could categorize the two similarly from a tax perspective. [5] There is the additional consideration of the jargon typically used to explain staking. Often it is described as a method for participants to earn block rewards as a result of staking. This wording may lead one to believe that the participant receives a payment through property (ie. block rewards) from the act of staking, thus resulting in a tax event of ordinary income.
It has additionally been suggested that the fair market value of the receipt of block rewards through staking is taxed as ordinary income, and any future sale of those block rewards will also be subject to capital gains tax as it is considered property. [8]
The Argument for Deferral
Despite the NY State Bar Association’s argument for block rewards through staking to be taxed upon receipt as ordinary income, there is an argument that block rewards received ought to be subject to tax upon sale. Fenwick & West LLP provide a clear and concise rationale for this stance, stating that it is the staker who builds the new blocks, for the software protocol has no agency and is simply a tool that the staker uses. In opposition to the NY State Bar Association’s assertion that it is the software’s consensus mechanism that creates the property, Fenwick & West LLP argue that it is the taxpayer that creates the block reward. This distinction is important, for essentially how the IRS views who is the creator of the block rewards will determine when those rewards will be subject to tax. [2]
The Tezos Case
In the recent Tezos Case, taxpayer Jarrett disclosed Tezos tokens (tez) as ordinary income that were acquired through staking on his 2019 Federal Tax Return. After not receiving a response from the IRS when he submitted a request for a refund, Jarret filed suit. His stance was that his staking rewards are property that he created, thus should not be taxed as ordinary income. In response to this suit the IRS offered to grant the refund, but Jarrett has rejected the offer to pursue a definitive court ruling. For although the IRS has offered to grant the refund, they still haven’t explicitly stated their views on the taxation of staking rewards. A definitive court ruling would confirm the official stance of the IRS. [3]
In Summary
Although we have yet to receive guidance from the IRS regarding the taxation of staking, and the Tezos case merely sheds a small glimmering light as to the direction that they will officially take, it is safe to say that enough pressure is being placed on the IRS to take a stance. As we filter through the educated guesses as to how staking should be taxed, nothing will be certain until the IRS officially provides guidance.
References
[1] Coinbase: What is staking? https://www.coinbase.com/ja/learn/crypto-basics/what-is-staking
[2] Fenwick & West LLP: The creation of property through staking https://drive.google.com/file/d/11mvNq0gEB749blGZlHVVGdhtcb0sbD_7/view
[3] Forbes: Tezos Case https://www.forbes.com/sites/kamranrosen/2022/02/02/in-huge-precedent-irs-says-it-will-not-tax-unsold-staked-crypto/?sh=2eece9de464c
[4] Fortune: Staking as the next big business https://fortune.com/2022/03/24/what-is-staking-crypto-bitcoin-ether-passive-income-yield/
[5] IRS Notice 2014-21: https://www.irs.gov/pub/irs-drop/n-14-21.pdf
[6] New York State Bar Association: https://nysba.org/app/uploads/2022/04/1461-Report-on-Cryptocurrency-and-Other-Fungible-Digital-Assets.pdf
[7] Proof of Stake Alliance: https://www.proofofstakealliance.org/
[8] Taxbit: What is crypto staking and how does it work? https://taxbit.com/blog/what-is-crypto-staking-and-how-does-it-work#how-do-you-start-crypto-staking