Crypto mining has been extremely profitable over the last few years, with Bitcoin miners making an estimated $15 billion of revenue and several mining companies going public in 2021. Miners are critical to preventing the “double-spend” problem in decentralized cryptocurrency networks such as Bitcoin. They validate and add blocks of transactions to the blockchain ledger by competing with other miners to solve complex mathematical problems and receive crypto tokens as a reward for their mining activities.
Unsurprisingly, crypto mining profits have caught the attention of the IRS, which has taken an increasingly aggressive approach over the last few years to auditing and taxing mining activities. Given this increased enforcement, tax practitioners and their clients alike have explored ways to minimize mining profits by performing mining activities through tax-advantageous vehicles such as IRAs and 401(k) accounts.
Drawing from existing law, this posting examines the potential tax implications and planning opportunities of conducting mining activities through tax-advantageous retirement accounts.
Existing Law on Retirement Accounts
Making investments through retirement accounts has become an increasingly popular and controversial practice because investment income is generally allowed to grow tax deferred. For these purposes, investment income includes rental real estate, interest, dividend, royalty, and capital gain income relating to the purchase or sale of a capital asset. Because the IRS has generally characterized cryptocurrencies as a capital asset under Notice 2014-21, any gain from the sale of crypto assets is generally tax deferred.
The specific tax implications, however, may differ depending on the type of retirement vehicle used. For 401(k) workplace plans, the enrollee typically makes pre-tax contributions to the account, and any investment income is taxed when it is withdrawn. If any portion of the funds is withdrawn after age 59 ½, any investment income attributable to the withdrawals (as the case may be). If withdrawals are made before age 59 ½ , any earnings attributable to the withdrawn funds are subject to a 10% penalty in addition to capital gains taxes.
Similarly, pre-tax funds are contributed to traditional IRAs and earnings attributable to withdrawals made after 59 ½ are taxable at the applicable gains rate (again, a 10% penalty is assessed on earnings from such withdrawals made before this age). By contrast, after-tax contributions are made to Roth IRAs, and any earnings from withdrawals are nontaxable, provided withdrawals are made after age 59 ½. A 10% penalty applies to earnings attributable to withdrawals made before age 59 ½.
Taxpayers, however, can be taxed currently on any retirement account earnings attributable to “Unrelated Business Taxable Income” (“UBTI”) at a top individual rate of 37% (the “UBIT”). In this case, UBTI broadly includes any gross income derived by any organization from an unrelated trade or business. Generally, income flowing to or earned by a retirement account from an active business would be treated as UBTI. As further described below, earnings derived from crypto mining flowing to a retirement account (e.g., IRA, 401(k)) will likely be characterized as UBTI.
Crypto Mining as UBTI
The IRS has not specifically opined on whether crypto mining earnings would be considered UBTI. With that being said, the IRS has indicated in Notice 2014-21 that reward tokens received from mining activities as a trade or business are includible in gross income and subject to self-employment taxes.
Given the Service’s position in Notice 2014-21, earnings flowing to or earned by a retirement account from an active crypto mining business/activity may be treated as unrelated to the account’s tax-exempt purpose of providing savings for the account holder’s retirement. In this regard, the tax treatment of crypto mining income as UBTI is similar to income generated from an account’s investment in a PTP or MLP, a common situation where accounts can inadvertently generate UBTI.
If the crypto mining earnings are treated as UBTI, the income will not be tax-deferred, but will instead be taxed currently at varying rates, with the maximum rate being 37%. One way that retirement account holders can potentially reduce their UBIT is contributing retirement funds to a newly created “blocker” C-corporation, which would then invest the same funds into the crypto mining business (either as an investor or an active participant in the business). In this way, the retirement account would hold 100% of the corporation and the blocker would be the direct investor/earner of the crypto mining operations.
Under this scenario, income generated by crypto mining activities would be taxed at the blocker at the lower 21% corporate rate (rather than the highest 37% individual rate). Once taxed, the blocker could distribute the crypto mining earnings up to the sole IRA or 401(k) shareholder. A distribution of crypto earnings to the account would be treated as a dividend, which, as mentioned above, is a permissible form of investment income that will not be subject to current taxation.
The Takeaway
In light of the crypto mining boom, crypto miners and investors in crypto operations have looked for ways to shield their earnings from federal taxes. Using retirement accounts to achieve this purpose, however, comes with pitfalls, as the IRS will likely treat crypto mining as UBTI subject to current taxation.
P.S. Insights on Cryptocurrency Legal Issues
Most jurisdictions and authorities have yet to enact laws governing cryptocurrencies, meaning that, for most countries, the legality of crypto mining remains unclear.
Under the Financial Crimes Enforcement Network (FinCEN), crypto miners are considered money transmitters, so they may be subject to the laws that govern that activity. In Israel, for instance, crypto mining is treated as a business and is subject to corporate income tax. In India and elsewhere, regulatory uncertainty persists, although Canada and the United States are relatively friendly to crypto mining.
However, apart from jurisdictions that have specifically banned cryptocurrency-related activities, very few countries prohibit crypto mining.
Our Freeman Law Cryptocurrency Law Resource page provides a summary of the legal status of cryptocurrency for each country across the globe with statutory or regulatory provisions governing cryptocurrency. The globe below provides links to country-by-country summaries:
