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Cryptocurrency

Tax Implications of Staking Cryptocurrency

By February 2, 2022September 7th, 2022No Comments

Because cryptocurrencies have no central authority, they need a way to ensure that their ledgers are accurate and that nobody spends the same token twice. To accomplish this, cryptocurrencies use different consensus mechanisms to reach an agreement as to which transactions are legitimate. A consensus mechanism is a crypto-economic system of computers that helps secure the blockchain and regulate newly issued tokens. The two most widely used consensus mechanisms are Proof of stake (PoS) and proof of work (PoW). In a PoS, participants – known as validators – lock up their cryptocurrency as collateral to help secure a particular blockchain network or smart contract protocol.1 As a reward for verifying transactions, validators are paid in newly created tokens.2 Staking is therefore seen as a great way to generate passive income on your crypto holdings. Per Internal Revenue Service Notice (“IRS”) 2014-21, staking rewards are taxed as ordinary income at its fair market value on the date that you receive the rewards.3 This has been a point of contention in the cryptocurrency industry for many years. However, a change may be on the horizon as the IRS is facing an uphill battle in an ongoing case that deals with this exact issue.

How Should Staking Rewards be Taxed?

Staking rewards should be treated as created property and should only be taxed when they’re sold or exchanged for new tokens.4 This is the argument that one taxpayer who is suing the United States for clarity on his staking rewards is going with. In a closely followed case in the US District Court for the Middle District of Tennessee, taxpayers are suing the United States for taxes they paid when they created new property through staking on the Tezos blockchain.5 In 2019, taxpayers reported $9,407 from the creation of new Tezos tokens. Taxpayers paid $3,239 in taxes as a result, and subsequently filed a claim for refund. After the IRS denied a refund, taxpayers pursued the matter in federal court by suing the United States for misinterpreting the law.  In the complaint, taxpayers argue that staking rewards are their created property and “[l]ike a baker who  bakes a case using ingredients and an oven, or a writer who writes a book using Microsoft Word and a computer[,]” they should realize taxable income only when they sell or exchange the new property they created.6 They go on to argue that “new property – property not received as payment or compensation from another person but created by the taxpayer – is not and has never been income under U.S. federal tax law.”7 The question before the court is whether staking rewards generate taxable income at the date the rewards are received.

The United States, in its Answer, denies that virtual currency is in all instances property for the purpose of U.S. tax law. This has confused some taxpayers as the 2014 IRS notice reads, “[F]or federal tax purposes, virtual currency is treated as property.” After filing its Answer, however, the IRS offered the taxpayers a refund of $3,379, plus interest, without admitting the merits of the taxpayers’ argument. The taxpayers rejected the settlement offer citing that they want clear guidance from the IRS, not a mere monetary victory. It’s worth noting that a settlement would not stop the IRS from challenging the taxpayers again if they were to take a different position on any future tax returns. Although not a victory for the taxpayers at this point, the fact that the IRS has offered to settle the case suggests that the IRS may be willing to change its position on taxing staking rewards. It’s important to note that the settlement offer doesn’t create any legal precedent. While a judicial opinion could provide guidance, the case might take years to litigate, and if a formal judgment comes to fruition, it will only serve as binding precedent for taxpayers in the Middle District of Tennessee. For the decision to have any effect on taxpayers outside of the Middle District of Tennessee and serve as legal precedent, the IRS or the taxpayers would have to appeal the decision to the 6th circuit. A bench trial on this matter is set to start 2023.

If the taxpayers receive a favorable decision by the court, the IRS may be compelled to clarify its position on the taxation of cryptocurrencies, and, specifically, the taxation of staking rewards. The effects of such a decision should not be interpreted as merely a victory for PoS validators, it would also be good news for PoW miners and Bitcoin. With a favorable decision, an argument can be made that any block reward from a decentralized cryptocurrency network constitutes a creation of value through one’s own capital and labor, and, therefore, should be taxed when sold and not when the newly issued coins are created. 

A favorable decision may also add some much-needed clarity to some of the more complex areas of staking. Staking is also commonly used in reference to cryptocurrency deposits when providing DeFi liquidity and accessing yielding rewards. As such, most investors consider staking to be a part of yield farming and liquidity mining, another area of DeFi that has seen massive growth. When yield farming or liquidity mining users deposit cryptocurrency into various liquidity pools, and in return get payouts in the form of transaction fees or interest. Yield farming works much like your savings account; however, rather than earning interest on the money in your savings account, you earn interest by staking your crypto in various liquidity pools – a lot more interest. Because the whole purpose of yield farming is to make a profit – and not to secure the blockchain – it’s likely that the court would view it as ordinary income at the time the user receives the rewards.

Let Gordon Delic & Associates Help!

There is hope that this case will bring about industry-wide clarity to crypto investors, and a definitive ruling that tokens earned from staking rewards [and mining rewards] are not taxable until sold or exchanged. For the sake of innovation and artistic creativity, the IRS should come to its senses and realize that their current policy on cryptocurrencies is outdated and unjustified. The last time the IRS provided any guidance on crypto was in 2014.

Since then, the crypto economy has grown into a multi-trillion-dollar industry, and we’ve seen innovation that has surpassed anything that we’ve ever seen before – the fourth industrial revolution. One thing is certain, although the IRS devotes tremendous efforts and resources to cryptocurrency enforcement actions, minimal efforts have been spent in developing a clear policy that would make it easy for cryptocurrency users and investors to comply with. As we’ve seen in the past, when regulatory bodies fail to keep up with technological innovation, litigation most often precedes regulation. 

Because there is still no clear guidance on the tax treatment of staking rewards, taxpayers must proceed with caution. Our team at Gordon Delic and Associates is ready to help you navigate the legal landscape to make sure your cryptocurrency assets are protected and properly reported. Contact us or call us at (208) 900-9509. 

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References:

  1. https://blog.chain.link/what-is-staking/
  2. https://ethereum.org/en/developers/docs/consensus-mechanisms/pos/
  3. https://www.irs.gov/pub/irs-drop/n-14-21.pdf
  4. Jarett v. United States, NO. 3:21-cv-00419 (M.D. Tenn.)
  5. Id.
  6. https://www.proofofstakealliance.org/wp-content/uploads/2021/05/IRS-Tax-Litigation.pdf
  7. Id.