A Deep Dive Into Crypto Staking
Berdon Digital Asset Advisory Team
7.20.22 | Tax Notes® Federal and Tax Notes® State [June 20, 2022]
On March 10 the Labor Department issued a statement, warning that cryptoassets are highly speculative, extremely volatile, and difficult to accurately value in the market.1 Even stablecoins — designed to be stable and tied to an external reference like the U.S. dollar — have recently crashed and fallen below their pegged value. While some stablecoins are backed by real-world assets, another variety is algorithmically coded to maintain a target value with a burning-and-minting or demand-and-supply mechanism. But these algorithms have failed to perform as expected. Given the lack of governmental oversight and the volatility in the unregulated crypto market, it is not uncommon for the volume of the staked crypto to increase but for the overall value to decline. Therefore, taxing staking rewards upon receipt and based on the increase of units rather than at disposition has punitively affected crypto stakeholders.
This article examines staking transactions within the framework of blockchain technology and the administrative tax guidance provided by the IRS. While one interpretation of the administrative guidance has been to tax staking rewards upon receipt, this article presents the alternative view of taxing staking rewards at disposition, which is consistent with the taxation of property derived from a capital investment under general tax principles.
What Is Staking?
From a technological perspective, crypto exists on the blockchain, which is a form of software, and crypto staking is a way to validate transactions on a proof-of-stake (PoS) blockchain network. Proof of work (PoW) and PoS are the two major consensus mechanisms used by crypto blockchains to verify transactions and to generate new coins on the distributed ledger. Crypto such as bitcoin that uses blockchain technology on a PoW system requires large amounts of processing power and hardware. Using computers, the virtual miner who first solves a mathematical puzzle is rewarded by the blockchain network with the next block of new crypto.
Staking, on the other hand, is a process that involves the users committing their crypto to support the blockchain network and to confirm transactions. Users may then be rewarded on their staked holdings with new units of crypto added to the distributed ledger based on their relative proportional ownership amounts on the staking protocol. Some staking protocols require a lock-in period during which the rewards are not available for redemption. In other instances, a transactional fee may be required to unstake a reward. For small transactions, it is not uncommon for the fee to outweigh the reward.
Staking rewards can resemble interest income in an interest-bearing savings account or dividend income on stocks owned. However, for federal income tax purposes, the IRS does not treat crypto as cash or stock. Crypto is not legal tender or money in the United States, and it is also not a stock for tax purposes under the IRC. Stock is applicable to shares of a corporation, and most of the cryptos available on exchanges do not represent an ownership interest in a corporation. Unless the crypto is tied to equity shares of a company or a debt instrument, it is also not likely to be a security, which is more broadly defined as “any share of stock in any corporation, certificate of stock or interest in any corporation, note, bond, debenture, or evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing.”2
IRS Administrative Guidance
In Notice 2014-21, 2014-16 IRB 938, the IRS refers to crypto as virtual currency instead of cash or stock. Under that notice, “virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” In FAQ A-1, Notice 2014-21 provides that “virtual currency is treated as property” for federal tax purposes. Thus, the IRS’s position is that general tax principles governing property transactions apply to crypto transactions. Despite the IRS’s position, there is no case law, statute, or regulation that defines crypto as property.
While there is no specific mention of staking, FAQ A-8 provides that a taxpayer who mines virtual currency is subject to tax on the new virtual currency received from those activities as ordinary income based on the fair market value of the virtual currency at the date of receipt. In the absence of specific guidance on staking, there has been a tendency among some tax professionals to view staking rewards like those of mining. But as noted, there is a technological distinction between staking and mining that warrants a different tax treatment.
Unlike PoS, which is a passive process for the stakeholder and only entails a transfer of the crypto to a staking platform, PoW is an active process. A PoW miner must purchase computers and keep them running, incurring energy costs. Mining operations require powerful computers and continuing effort. While it is debatable that mining constitutes property received for services, crypto miners do need to be active participants by powering their machines, occupying physical space, and monitoring progress to ensure that the mining application is running. Stakeholders, on the other hand, are passive crypto holders, and there is no personal effort involved. No property is received for services rendered in staking. For this reason, the administrative guidance for mining should not apply to staking.
Applying IRS administrative guidance about crypto airdrops is also questionable in the case of staking. In Rev. Rul. 2019-24, 2019-44 IRB 1004, and IRM 202114020, the IRS provides that an airdrop of new crypto following a hard fork results in income if the taxpayer has dominion and control at the time of the airdrop. A hard fork is unique to blockchain technology and occurs when crypto on the distributed ledger undergoes a protocol change or software update resulting in a permanent diversion from the legacy distributed ledger. The airdrop is a means of distributing units of a crypto to the distributed ledger of multiple addresses after a hard fork. The basis for the conclusion in the revenue ruling that an airdrop of a new crypto following a hard fork is taxable is premised on section 61(a)(3), which provides that, except as otherwise provided by law, gross income means all income from whatever source derived, including gains from dealings in property. Under section 61, all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion, are included in gross income.3
In staking, there is no hard fork or protocol change. So arguably the administrative rulings are inapplicable, but one interpretation of these airdrop rulings has been to view staking rewards as income if the taxpayer can dispose of the new crypto at the time of receipt like an airdrop over which the taxpayer has dominion and control. However, the rulings, which are based on section 61’s “accessions to wealth, clearly realized” are problematic in the staking context and under general tax principles of income realization as explained below.
General Tax Principles
Historically, under federal tax case law, the Supreme Court has held that “income” for purposes of the tax law meant income “derived from capital, from labor, or from both combined.”4 In other words, income could arise by way of a taxpayer’s personal efforts via labor, or without personal participation by way of the use of the taxpayer’s capital. However, income defined as the gain derived from capital is generally understood to include profit gained through a sale or conversion of capital assets, to which it was applied in.5 Under general tax law principles, a taxpayer “realizes” income or gain not just by holding property that increases in value, but by disposing of the property and realizing the inherent gain.6 In their tax treatise, Boris I. Bittker and Lawrence Lokken explain realization:
Whatever may be said for or against taxing unrealized appreciation, the federal income tax has never applied to gains until they have been realized in some way. The realization principle is found in the Code only by implication [referring to section 1001(a)], but, despite occasional judicial statements that all gains embraced by section 61(a) unless specifically excluded by statute, realization is so basic to the structure of the law that the principle is not challenged. Like other fundamental concepts, however, it is a bit vague around the edges, giving rise to some troublesome peripheral issues.
Under section 1001, gain or loss on the sale or other disposition of property is measured by the difference between the amount realized on the sale (the sale price or consideration received in the exchange) and the taxpayer’s adjusted basis in the property given up, and this gain or loss must then be recognized for tax purposes. But in the case of crypto staking, in which crypto is property, there is no application of section 1001 when the taxpayer does not realize income, and there is generally no realization when there is no sale or exchange of property. In the seminal case Eisner v. Macomber, the Supreme Court held that a stock dividend in kind, consisting of new stock issued to stockholders in proportion to their previous holdings, without any distribution of profits, could not be taxed as income under the 16th Amendment.7 The Court said, “We are clear that not only does a stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder, but . . . [the shareholder] has not realized or received any income in the transaction.”8 This is because a stock dividend shows that the company’s accumulated profits have been capitalized instead of distributed to the stockholders or retained as surplus for distribution.9 The Court explained that “enrichment through increase in value of capital investment is not income” and further clarified that it is when the stockholder sells the new shares that any profit on the sale is then income.10
Like a stock dividend accrued in kind, a staking reward is crypto (property) accrued in kind from a capital investment. Under Eisner, the stakeholder has not realized any income on the transaction by an increase in the value of the capital investment via a staking reward until the reward is sold and generates a profit. Therefore, just as unrealized appreciation is not taxed until there is sale or exchange in the case of other capital assets like real estate and publicly traded securities, staking rewards should not be taxed until disposition. Otherwise, the taxpayer could end up paying taxes on ordinary income upon receipt of the rewards. Subsequently, if the reward value declines, the tax loss upon disposition could be limited by capital loss rules. Thus, taxing upon receipt has the potential to create a whipsaw effect resulting in a harsh tax outcome.
While there is no specific IRS guidance about the taxation of crypto staking, there is tax case law support for deferring taxable income until the sale or exchange. There is also a crypto staking case of first impression pending in a Tennessee federal district court.11 In Jarrett, Joshua Jarrett staked crypto known as Tezos and received new Tezos during the 2019 tax year.12 He and his wife initially reported the value of the Tezos received in gross income but then filed an amended return for a refund. When they received no refund, the Jarretts filed suit against the government for the federal income tax paid on the staking rewards, arguing that they created property and should not be taxed until the new Tezos are sold.
Although the Jarretts’ initial refund request was denied, the government later reversed course and offered them a full refund, plus statutory interest, for the 2019 tax year. But the government did not explain or provide a written reason for the offer. While an offer generally indicates the government’s reluctance to litigate, it does not necessarily indicate a change in the government’s view about staking. In this case of first impression, Jarrett announced that he rejected the offer because accepting it does not prevent the government from challenging him or other taxpayers again on the same issue by attempting to tax his staking rewards at the time of receipt.
Without an explanation by the government or a rationale for the offer, the IRS’s silence means taxpayers are still at risk for staking. The government’s position remains unclear even though some members of Congress have also expressed support for taxing only the gain arising from staked crypto.13 Moreover, the offer made to the Jarretts is not binding to other taxpayers and cannot be relied on as authority.
If the IRS views crypto as property and not money, and staking is a capital investment and not a service, any incremental growth of staked crypto should not be income upon receipt. Thus, the staking rewards should not be taxed until there is a realization event or disposition. Further, from a policy perspective, taxing staking rewards before disposition fails to consider the associated technological risks. Crypto exists on the still-developing and unregulated blockchain. Stakeholders can lose much of their staked value in the volatile tech environment. While there is no clear resolution from Jarrett, the government can help promote proper tax compliance by providing specific guidance for staking consistent with general tax principles of income realization. Until then, the debate on the taxability issue will likely continue and taxpayers engaged in staking transactions may need to proceed with caution and consider adequate disclosure requirements on their tax returns.
For more information, please contact a member of the Berdon Digital Asset Advisory team.
This alert is for general information purposes only and is not intended, and should not be construed, as legal or tax advice.
Berdon New York Accountants
1 Department of Labor, “Compliance Assistance Release No. 2022-01” (Mar. 10, 2022).
2 See section 1236(c). Despite the above, some types of digital assets may be viewed as a security by the SEC or for purposes of some financial reporting, depending on the characteristics and use of that particular asset.
3 See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).
4 See Eisner v. Macomber, 252 U.S. 189, 193 (1920).
5 See Doyle v. Mitchell Brothers Co., 247 U.S. 179, 185 (1918).
6 Bittker and Lokken, Federal Taxation of Income, Estates, and Gifts, para. 5.02.
7 Eisner v. Macomber, 252 U.S. 189, 195. See also U.S. Constitution Amendment XVI, which provides: The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.
8 As a general rule, section 305(a) continues to exclude stock dividends from income, but there are several exceptions (such as distributions in lieu of money) under section 305(b).
9 Eisner, 252 U.S. at 192-193.
10 Id. at 194-196.
11 Jarrett v. United States, No. 3:21-cv-00419 (M.D. Tenn. May 26, 2021).
13 Congressional letter to IRS Commissioner Charles Rettig (July 29, 2020).