The meteoric rise of Proof-of-Stake (PoS) systems in 2021 have put a spotlight on “staking,” a process where users “stake” their crypto assets to become a validator of blocks within a PoS network. Stakers, however, face an uncertain tax regulatory landscape with respect to the taxation of their activities on PoS systems. Should tokens that stakers receive as rewards for validating blocks be treated as ordinary income? When should the rewards taxed, upon receipt or when the tokens are ultimately sold? Unfortunately, the IRS has offered limited guidance to answer these and other fundamental questions. Drawing on Notice 2014-21, the only significant IRS guidance on cryptocurrencies issued to date, this blog posting will offer a roadmap for stakers on how their activities should be taxed.
Background
PoS networks are decentralized, meaning there is no central authority or intermediary to referee financial transactions conducted through their systems. In the absence of a trusted third party, decentralized platforms must rely on a consensus mechanism to ensure that transactions recorded across the blockchain (i.e., blocks) are both current and accurate. PoS systems achieve this consensus through a group of participants, known as validators, to create and attest to blocks of transactions. To become a validator, users must “stake” their crypto assets to the network. When a transaction is submitted to the network, a validator will be chosen randomly, based on their percentage of staked crypto assets, to create a new block of transactions to the blockchain. Users that are not chosen will attest to the validity of the transactions within the selected validator’s proposed block. Validators are rewarded with tokens from the PoS platform for creating new blocks and for attesting to proposed blocks. Conversely, validators can lose their staked crypto assets if they fail to validate or attest blocks or otherwise act maliciously on the network. This carrot and stick approach encourages validators to add new blocks to the blockchain and act in good faith, which ultimately protects the integrity of the network.
Notice 2014-21 and Staking
Taxpayers have taken a wide range of positions on how and when the receipt of tokens should be taxed. On one hand, some practitioners take the view that stakers are essentially performing services – that is, validating and attesting blocks – in exchange for tokens. As such, the receipt of tokens should be treated as ordinary income and taxed at fair market value upon receipt. Still, other taxpayers have characterized staking as a return of investment on the staked crypto assets, similar to stocks or other investments. Thus, the staker would only recognize income (or loss) upon his or her sale of the reward tokens, with such gain or loss subject to capital tax rates.
As mentioned above, the IRS has not provided specific guidance to answer these questions. Nevertheless, tax practitioners can draw certain inferences from the Service’s treatment of mining activities and receipt of cryptocurrencies in exchange for services in Notice 2014-21. For context, mining differs from staking in that the former is used in Proof-of-Work networks and involves solving complex mathematical puzzles to validate blocks in exchange for reward tokens. The Notice treats miners as recognizing gross ordinary income upon the receipt of reward tokens, with such income equal to the fair market value of the tokens at the time of receipt. The miner also recognizes a capital gain or loss when the tokens are ultimately sold. The Notice also extends this treatment to any service performed in exchange for virtual currency.
Given the Service’s positions in the Notice, the more conservative position would be to characterize stakers as recognizing gross ordinary income upon the receipt of the reward tokens. Although staking differs in a few material respects from mining, both activities involve the creation and validation of blocks in a network. In this regard, the “staking” of crypto assets should be treated as a price of admission to become a validator rather than an investment asset that can generate a capital return.
Another related consideration is the deductibility of expenses related to staking operations. In the absence of clear IRS guidance, the answer seems to lie in whether a taxpayer’s staking activities rise to a trade or business. Standard considerations such as the time and effort spent, the continuity and regularity of the activities, and a profit motive would presumably come into play in making this determination. If a taxpayer’s staking activities do constitute a trade or business, any ordinary and necessary expenses related to staking operations are deductible. On the other hand, if the activities are viewed by the IRS as a hobby, any staking-related expenses are disallowed under tax reform legislation passed by Congress in 2017. Similarly, taxpayers engaging in staking for investment purposes are limited to certain investment-related expenses (within limits) and cannot deduct ordinary business expenses.
Ultimately, the lack of definitive IRS guidance has created uncertainty on how staking activities should be treated for federal tax purposes. Nevertheless, existing IRS guidance, most notably Notice 2014-21, and traditional tax principles provide some clarity into the taxation of staking activities. That being said, given the uniqueness and growing sophistication of staking transactions, more detailed direction from both the Service and Congress should be forthcoming.
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