Editor: Mo Bell-Jacobs, J.D.
Cryptoassets have increasingly proved to be a significant disruptive force across several industries, from financial services to energy and the arts. In this innovative and rapidly changing landscape, legislators and tax professionals are left trying to decipher how to tax and report this new asset class. Very limited guidance has been provided by the IRS and Treasury regarding the tax consequences of digital assets, and no guidance has been provided regarding the tax treatment of "staking" rewards earned through a proof-of-stake protocol, which is a consensus mechanism to validate transactions on a blockchain (more about the proof-of-stake protocol later).
In light of the lack of guidance from the IRS and Treasury, the case for deferred recognition of income for staking rewards has recently gained traction. This discussion considers both sides of this deferred recognition argument so that taxpayers who receive cryptoasset staking rewards can understand the possible risks and merits of each income tax position.
The Jarrett case and the argument for deferred recognition of gain
A good place to begin to explore the taxation of staking rewards is with the Jarrett case (Jarrett, No. 3:21-cv-00419 (M.D. Tenn. 5/26/21) (complaint filed)). In May 2021, Joshua and Jessica Jarrett brought forward an argument in court for the deferred recognition of gain from staking rewards. In their complaint submitted in a federal district court in Tennessee, the Jarretts assert that they should be refunded taxes paid on Tezos tokens, the value of which was mistakenly included in their tax return. Tezos tokens are a type of digital token that relies on a proof-of-stake protocol to validate transactions. The taxpayers claimed that the tokens at issue should be considered created property. They argued that the tokens did not exist prior to Mr. Jarrett's participation in the staking process (called "baking" on the Tezos blockchain) and, similar to a traditional baker who has baked a loaf of bread or an artist who has written a novel, he should not have to recognize the staking rewards as income until they are disposed of and a realization event takes place.
The complaint went on to state that the staking rewards were created by Mr. Jarrett through the proof-of-stake protocol on the Tezos blockchain and were not paid to him by any person as defined under Sec. 7701(a)(1). Fundamentally, the Jarretts argued that there is currently nothing under U.S. law that allows the U.S. government to treat created property as income. Therefore, staking rewards should not be taxed as income until the taxpayer sells or disposes of them in some other manner. In early February, the U.S. Department of Justice instructed the IRS to issue a refund to the taxpayer and moved to dismiss the case. The Jarretts declined the refund and are seeking a declaratory judgment to cover future tax years. The case is still pending.
In order to fully understand this argument, it is essential to understand a few fundamental elements of how staking rewards work and the law as it relates to created property.
Proof of stake and staking rewards
The proof-of-stake consensus algorithm is a blockchain consensus mechanism developed to facilitate and validate transactions in digital assets on a blockchain, such as the Tezos blockchain at issue in the Jarrett case.
As a reminder, a blockchain is a cryptographically secured digital ledger for publicly recording transactions in digital assets. Numerous individual nodes maintain this electronic ledger by connecting to one another over a network and by running the same protocol software. Transactions on a blockchain can include the transfer of digital assets, such as tokens, and users generally interact with the blockchain through user-level software or hardware-based tools called wallets. Digital tokens typically serve as a representation of value for online transactions, such as an online money transfer or subscribing to a service.
Rules governing a blockchain network, referred to as a consensus mechanism, are built into the protocol software, and a blockchain is only updated when there is consensus among the nodes that transactions and data being submitted comply with the built-in consensus rules and are validated accordingly. The appeal of blockchain is that it is a decentralized trustless verification system based on cryptography, which allows it to maintain all transactions publicly and transparently with a full audit log, eliminating the need for a middleman to facilitate transactions or value exchange (i.e., banks and other financial institutions), thus reducing costs, increasing efficiency, and improving transparency for transfers of value.
A cryptoasset transaction can be validated through numerous different consensus mechanisms, the most popular of which are proof-of-work and proof-of-stake consensus mechanisms. The proof-of-work validation process involves "miners" who compete in the task of solving a cryptographic puzzle in order to earn the right to propose a new block in the blockchain and receive the transaction fees and newly minted cryptoasset (collectively "mining rewards") in exchange for their efforts. Proof-of-work mining generally requires specialized computer equipment and significant energy consumption.
In a proof-of-stake consensus blockchain there is no energy-intensive cryptographic puzzle to solve. Rather, "validators" are chosen based on their proportional ownership amounts, in a random number lottery process, to propose a new block of transactions. For every block on a proof-of-stake blockchain, one validator is chosen to create the block, which is then proposed to the other validators for their approval. If there is a consensus among the validators that the transactions in the newly proposed block do not violate any of the protocol's rules, then the block is appended to the blockchain and the process starts over.
Under the proof-of-stake consensus mechanism, validators must have an economic stake in the blockchain's underlying digital asset to participate in the process. Validators are required to place their own tokens (which generally need to meet a certain staking threshold to qualify) into a smart contract where they are held for a period of time (otherwise referred to as a lockup period) during and after the time it takes for a person to validate the block (the lockup period is subjective and variable based on the blockchain). This process is enforced to ensure the validator is not acting maliciously. Proof-of-stake consensus mechanisms also can have built-in "slashing" rules, where staked tokens can be permanently taken away if the validator is violating any of the protocol's rules governing consensus.
Through the actions of the validators, the blockchain creates staking rewards, an allotment of newly minted tokens as part of the blockchain's built-in inflation. This staking reward comes from the blockchain protocol itself and not from any third party. Validators retain these rewards for their participation in the validation process.
Current guidance: Notice 2014-21
Currently, there is limited guidance from the IRS and Treasury specifically applicable to the taxation of digital assets. The IRS first addressed digital assets in 2014 with Notice 2014-21. The notice, which addresses virtual currency and convertible virtual currency, clarifies that digital assets are considered property and not currency for federal tax purposes. Additionally, Question 8 of the notice states that a taxpayer who mines virtual currency would need to include the fair market value of the mining rewards in gross income as of the date of receipt of such rewards.
Based on the notice, the mining rewards would likely be taxed at ordinary income rates and not at capital gains rates since miners are receiving compensation in exchange for providing a service and the rewards would likely not be seen as a capital asset in the hands of the miner. The notice does not include specific guidance relating to proof-of-stake transactions and staking rewards because proof of stake had barely begun to emerge at that time. Subsequent cryptoasset guidance has been quite limited and does not address mining or staking.
Should staking rewards be considered taxpayer-created property or income that should be recognized upon receipt?
The concept of "income" is defined by the Internal Revenue Code as well as in case law. Sec. 61 defines gross income as "all income from whatever source derived." Eisner v. Macomber, 252 U.S. 189 (1920), defines income as "the gain derived from capital, from labor, or from both combined," and Glenshaw Glass Co., 348 U.S. 426 (1955) defines income as "undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion."
While not specifically stated anywhere in the Code or related Treasury regulations, there is a fundamental concept in tax law that the creation of property is not a taxable event in itself (e.g., a baker who bakes a loaf of bread, an artist who creates a painting, or a writer who produces a novel) and that a taxpayer does not recognize income until a realization event takes place and income is actually earned from a sale or exchange of such property. For example, an artist does not need to include the value of a finished sculpture as soon as he puts down his chisel but, instead, will have to include any income from the sale of the sculpture after the sale has been completed and he receives payment for his sculpture. In the parlance of the case law, it is the sale from which the "gain [is] derived" that makes the income "clearly realized." (id. at 431).
The question here, then, is whether staking rewards should be considered taxpayer-created property or, on the other hand, income that should be recognized upon receipt.
Staking rewards as taxpayer-created property
There is an argument that staking rewards should be considered to be taxpayer-created property. As previously stated, in the proof-of-stake protocol, validators are chosen based on their economic investment in the blockchain. Once a validator is chosen to produce a new block for the blockchain, his or her staked tokens serve as collateral backing the veracity of the newly created block. As a part of this process, the validator engages in the creation or minting of new tokens that did not previously exist and would not exist unless that validator participated in the process. This validation process demonstrates that the validator creates the new tokens, similar to how a baker creates a loaf of bread. As the baker would not need to include the bread in his gross income until the bread has been sold, a validator could argue that he or she would not need to include the new tokens minted through the proof-of-stake validation process in his or her income until the tokens are sold or otherwise disposed of.
Additionally, unlike in a proof-of-work blockchain, the validators of a proof-of-stake blockchain have a vested interest in the blockchain, and staking is a means to protect and secure their existing token value. A proof-of-stake blockchain requires the participation from as many of its token holders as possible in order to ensure a distributed consensus mechanism that is resilient to an attack from a bad actor. This is much different than in proof of work, where anyone can participate in the mining process in order to verify a transaction.
In proof of stake, digital token owners in the token ecosystem need to validate transactions in order to protect digital assets that they already own. If they did not stake, they would be jeopardizing the investment that they already made in the blockchain. Thus, their participation in the validation process is not a service that they are providing as in a proof of work, but instead it is a necessary process for the token owners to actively participate in so that they protect their current investment in the blockchain.
Staking rewards as current income
There is another argument that the staking rewards, similar to mining rewards, are not created property and instead should be considered income from services performed. As services income, the argument goes, mining and staking rewards should be taxed when the taxpayer has dominion and control over the reward tokens. While not explicitly stated in Notice 2014-21, this is likely the position of the IRS and was the position taken by the Department of Justice in its answer filed with the court in the Jarrett case.
Under this line of logic, the taxpayer is receiving income in exchange for providing transaction and security services to the blockchain and other users of the digital asset. Instead of seeing this as a baker in the community creating bread, perhaps the validator's services would instead be likened to a police officer or civil servant providing a service to the community for a price paid for by the entire community (via staking rewards). The deposit of the staking reward into the validator's wallet address would be the realization event under the case law.
Pros and cons
Given the unique nature of each blockchain and each validator's unique situation, it is difficult to categorically say with a high degree of confidence whether or not staking income should ultimately be considered created property. Digital assets represent a new asset class, and ultimately every analogy used to evaluate the proper tax classification will break down at some point. However, the income tax issues around staking involve classic considerations of timing and character that tax practitioners have always had to consider.
Ultimately, at some point, taxpayers will have to recognize income from "self-created property," either upon creation or upon disposition; the key question therefore is timing. Taxpayers who treat their staking rewards as created property would likely recognize income upon disposition of the rewards. This income would likely not be considered capital gain under Sec. 1221 and therefore would be subject to the higher ordinary income tax rates. While a tax deferral is usually desirable, in this case the ultimate tax liability may be significantly higher because of it, especially in light of the astonishing price appreciation of some tokens over time.
Taxpayers should seek advice from a professional tax adviser when determining which position to take relating to staking rewards. Tax advisers will need to carefully review the facts and circumstances of each taxpayer before advising how to appropriately report staking rewards.
Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.