Taxation of Staking Rewards – Still No Legal Answer
Photo by Towfiqu barbhuiya on Unsplash
Cryptocurrency staking has become a popular way for asset holders on blockchains that use the proof of stake consensus method to earn income from their existing assets. Many publications will tell you that the taxation of staking rewards is a clear and well understood process, but it is actually not clearly defined by current US law or the US courts. Below, we will look more carefully at how the IRS views staking rewards and the case law surrounding the issue.
Position of the IRS
Currently, there are no provisions in the Internal Revenue Code or the regulations thereunder specifically addressing the tax treatment of cryptocurrency. Although the IRS has declared that “virtual currency” is “property” for purposes of federal taxation, there are no other applicable guidelines for taxpayers to rely on when it comes to the taxation of staking rewards for cryptocurrency. Therefore, taxpayers have no choice but to rely on IRS Notices and their relevant FAQs.
The current IRS position regarding the taxation of staking rewards is inconsistent with legal principles and Court precedents, as argued by the plaintiffs in Jarrett et al v. United States of America in a complaint filed May 26, 2021, in the U.S. District Court for the Middle District of Tennessee.
In Jarrett et al v. United States of America, the plaintiffs (Mr. and Ms. Jarrett) argued that newly created cryptocurrency from staking should not be taxed at the time of receipt. Equally, as bread baked by a baker or harvested crops by a farmer, newly created cryptocurrency should only be taxed when sold or upon income realization event.
The following will explain the income tax issues, where different arguments exist, and the potential income tax consequences.
Taxation of Staking Rewards - Are They Income?
The federal government taxes an individual’s gross income minus applicable deductions. The Code simply states that gross income is income from whatever source derived, providing a nonexclusive list of types of income that are included within gross income. None of the types of income listed includes an item of property created by a person, such as newly created tokens from proof of stake.
The Code does use the word derived, which shows that the Code may only require a taxpayer to realize income when such income is actually derived from a source. This interpretation can be supported by the Supreme Court precedents, which developed a general notion of the term “gross income” under the Code.
In Eisner v. Macomber, the Supreme Court held that “income must involve a “coming in””. The Court interpreted “derived from a source” requirement to mean that income must be from outside source; “coming in” towards the taxpayer. 35 years later in Commissioner v. Glenshaw Glass, the Supreme Court developed the “clearly realized accession to wealth” concept of gross income by holding that income is “instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” The Court stressed that income must be “clearly realized” shown by the increase in wealth of the taxpayer that the taxpayer has absolute control over.
Here, stakers do not “receive” new units of virtual currency from external sources. Although they do ultimately end up owning more virtual currency, it is debatable whether stakers have “undeniable accession to wealth” simply because they have more virtual currency due to the high volatility of its value. More importantly, stakers do not have “clearly realized” income until disposal.
Taxation of Staking Rewards and Farming
The taxation of staking rewards should resemble how tax law handles farmers and their crops. New cryptocurrency tokens are not given from outside sources, but rather are created within the dominion of the taxpayer, thus self-created property. A comparable example of self-created property would be harvested crops for farmers.
The Treasury Regulation acknowledges that self-created property, such as unsold harvested crops cannot be included in gross income, until there is a “sale” by the farmer, thereby requiring farmers to realize service income only when the farmer’s personal service is compensated by an external source, such as a buyer. This is consistent with the statutory text of I.R.C. § 61(a) as well as the Court’s precedent, in that to be considered “realized” income, compensation should be “coming in” and must be “derived” from a “source” (from outside).
All these tax law principles and court precedents raise doubts about the current IRS positions on newly created virtual currency. Further, some of such positions are inconsistent.
If we follow the IRS position that crypto is treated as property, the same as for stock, which is considered property under the Internal Revenue Code, stakers should only be taxed when disposing of the virtual currency.
However, according to Notice 2014-21, Q&A-8, the IRS takes the position that a taxpayer who “mines” virtual currency realizes gross income upon receipt of virtual currency resulting from validation of transactions, rather than upon disposal, and “the fair market value of the virtual currency as of the date of receipt is includible in gross income.”
Are Mining and Staking Performance of Personal Service?
Currently, the IRS position treats both mining and staking as the performance of personal service, potentially subjecting stakers to self-employment tax.
The IRS position seems to indicate that similar to mining, staking also includes the “validation of transactions” in exchange for digital asset “rewards” or compensation in the form of virtual currency. Thus, according to the IRS interpretations, both mining and staking should be considered the performance of services and the compensation received should be service income.
However, it is debatable whether staking or mining activities are rendering of personal service because staking rewards are the result of capital rather than personal labor.
If mining and staking are not service income, then what are they? In Jarrett et al v. United States of America, the plaintiffs argued that under Glenshaw Glass, newly created cryptocurrency should be treated equally as bread baked by a baker or harvested crops by a farmer. Now the Court has dismissed the case, we can only wait until another taxpayer tries the arguments in the Court or until there is legislation that addresses crypto staking income.
CaoLaw is highly experienced in solving cryptocurrency asset tax issues.
