IRS Clarifies the Tax Treatment for Proof of Staking Validation Rewards
The Internal Revenue Service (the “IRS”) published Revenue Ruling 2023-14 on July 31, 2023 (this "Revenue Ruling"), regarding the tax treatment for cash-method taxpayers that receive validation rewards in proof-of-stake transactions. A revenue ruling is an official interpretation by the IRS of the Internal Revenue Code, related statutes, tax treaties, and regulations. In short, the IRS confirmed its long-held position that validation rewards from a proof-of-stake consensus protocol are treated as gross income for cash-method taxpayers pursuant to Section 61(a) of the Internal Revenue Code of 1986, as amended (the “Code”) when the taxpayer gains dominion and control over the validation rewards.
Background on Proof-of-Stake Validation Systems
Cryptocurrency is a virtual currency that uses blockchain technology to secure and digitally record transactions on a distributed ledger. As noted in previous IRS guidance, convertible virtual currency like cryptocurrency is treated as property for federal income tax purposes, so general tax principles for property transactions apply to cryptocurrency transactions.
In recent years, cryptocurrency projects have moved away from “proof-of-work” algorithms (such as Bitcoin) and towards “proof-of-stake” algorithms (such as Ethereum). These different types of algorithms are different methods for the operation of community-run decentralized blockchain protocols and provide different methods for the protocols to “validate” proposed transactions to ensure they are legitimate. As stated in Rev. Rul. 2023-14, “distributed ledger technology uses independent digital systems to record, share, and synchronize transactions, the details of which are recorded simultaneously on multiple nodes on a network.”
Proof-of-stake is a validation system where “nodes” represent stakeholders of a particular cryptocurrency. While the specifics of each system vary by cryptocurrency project, stakeholders generally contribute (or “stake”) cryptocurrency holdings in exchange for the opportunity to validate transactions. As a reward for staking and validating successful transactions, validators earn native cryptocurrency tokens in proportion to the amount they have contributed or staked. Thus, the protocol incentivizes stakeholders to validate legitimate transactions taking place on the protocol. A protocol may also disincentivize bad actors; for example, in some protocols, when a validator accepts a transaction that is ultimately unsuccessful (or even malicious), the validator could forfeit a portion of their staked holdings in a process known as “slashing.”
This proof-of-stake consensus mechanism is designed to maintain the integrity of blockchain transactions without the significant computing power required in a “proof-of-work” consensus system like Bitcoin maintains. When Ethereum transitioned from proof-of-work to proof-of-stake, it reduced energy consumption across the network by an estimated 99.9%, while, in theory, increasing the security profile of the network. Other types of blockchain protocols may enable a type of “staking,” but without any corresponding validation function. Although it is unclear whether this revenue ruling covers these other types of staking protocols due to the revenue ruling's brevity, taxpayers should closely analyze analogous situations to determine the tax consequences for rewards received in connection to proof-of-stake protocols.
Analysis of Revenue Ruling
Generally, under Code Section 61(a), gross income includes “all income from whatever sources derived” unless there is an exception. Confirming how most tax practitioners understood staking rewards to be taxed, the Revenue Ruling stated that “any receipt of property constitutes gross income in the amount of its fair market value at the date and time at which it is reduced to undisputed possession,” citing Koons and Rooney. as precedent. It is important to note that accessions to wealth over which the taxpayer maintains complete control are includible in gross income, irrespective of the form the income is received (e.g., services, accommodations, property, or cash). Thus, to the extent it was not clear previously, this Revenue Ruling explicitly states that accessions to wealth under Code Section 61(a) include native cryptocurrency reward payments to validators in a proof-of-stake consensus protocol.
Remaining Open Questions
The Revenue Ruling did not address three specific issues, two of which it noted in footnotes. First, it did not discuss the tax characterization of transaction fees (often called “gas”) that may be an expense deducted from the staking rewards discussed therein. Second, it did not discuss the transfer of property in exchange for services, which is generally covered by Code Section 83. The implication is that the IRS and the Treasury Department are preparing guidance on both issues, which is a welcome development given the paucity of guidance available. Third, tax consequences for taxpayers who use the accrual method of accounting were not discussed, limiting the Revenue Ruling to cash-basis taxpayers. It would be surprising, if not altogether astonishing if the limitation were for any reason other than to issue future guidance on the timing concerns for accrual-basis taxpayers. The future guidance would discuss the rules for accrual-basis taxpayers regarding when in time income from validation rewards would need to be realized.
Prior to the release of this Revenue Ruling, some commentators maintained the position that rewards from staking only created gross income at the time the rewards were sold or exchanged. Indeed, many of the popular cryptocurrency tax calculators have allowed taxpayers to calculate their cryptocurrency gross income using this method. However, this Revenue Ruling states otherwise, concluding that validation rewards are included in a taxpayer's gross income at the time of receipt. This may not be the final word, as revenue rulings may be subject to countervailing legislation, regulation, or court decisions. Taxpayers who have income from proof-of-stake validating activities would be wise to speak with their tax advisor to evaluate their calculation of gross income in light of this Revenue Ruling.
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 Code Section 61; Treasury Regulation Section 1.61-1(a); See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).
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