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The IRS Should Be Encouraging Staking Activity in the U.S.

April 25, 2022, 8:45 AM

Tax season has never been easy in the crypto space, and this year has been no exception. The IRS recently announced that it is stepping up its enforcement of crypto tax matters, most notably through “Operation Hidden Treasure,” which seeks to ferret out unreported income related to cryptocurrencies. Enforcement of tax laws is a critical part of any well-functioning tax system.

Likewise, providing guidance to the public as to how the government interprets the tax laws is a key component of any system where taxpayers voluntarily report taxable income. To date, the IRS has failed to provide taxpayers with clarity about the correct tax treatment of various crypto-related transactions, notably for those who earn token rewards from staking on proof of stake blockchains.

With approximately 40 million Americans, or some 16% of American adults, having purchased cryptocurrency—more than double the number in 2018—this lack of clarity affects more and more taxpayers. This is especially true for those involved with proof of stake blockchains, a growing part of the cryptocurrency ecosystem in which individuals can create new tokens through staking, an environmentally responsible process of validating transactions on proof of stake networks. Between 2020 and 2021, proof of stake activity grew 571%, and it now comprises 31% of the crypto market, with 25 of the top 100 cryptocurrency networks utilizing this consensus mechanism.

Because there has been no guidance issued by the IRS on the appropriate tax treatment of staking rewards, the lack of clarity is leading many proof-of-stake stakers and staking businesses to take a conservative approach. Those taxpayers report the value of reward tokens as income the moment they are created instead of when they actually receive income by selling their reward tokens.

Taxing staking rewards as income at the time of creation is inconsistent with more than 100 years of tax law. For example, the artist does not realize income upon the completion of their painting. Rather, income is realized when the artwork is sold. Likewise, the farmer realizes income only when crops are sold, not when they are harvested. The same is true when the staker creates the reward tokens through efforts to secure a blockchain.

Aside from being inconsistent with established law, taxing staking rewards upon their creation—as opposed to disposition—is bad policy and risks disincentivizing participation in an emerging technology with implications for American competitiveness. Entities that engage in staking as a service are generating tens of thousands of reward tokens per hour and could have millions of taxable events per year if staking rewards are taxed as income at the time of creation. Recordkeeping, accounting, and paying taxes on each token at the time it is created results in an immense administrative burden that could deter participation in the industry for the vast majority of participants in the U.S.

In addition to the administrative burden on the taxpayer if reward tokens are taxed at the time of creation, this treatment has other adverse impacts on the taxpayer. If a staker is required to recognize gain on the staking reward at the time of creation, the staker will need to take one of the following steps to ensure that the income tax is paid: sell the recently created tokens; set aside—i.e., not stake—a portion of the validator’s tokens; or set aside other liquid assets to pay the tax owed on the reward tokens. Each of these options has adverse consequences.

First, because the security of the protocol partially depends on the amount of staked tokens, by requiring the staker to sell those tokens, the protocol becomes comparatively less secure. Second, if the staker is required to set aside other liquid assets (like cash) to pay tax, those liquid assets have effectively been utilized to invest in the protocol. Third, due to the infancy of the technology, it is not unusual for tokens associated with a proof of stake network to heavily fluctuate in value, even in the course of a 12-month period. Fourth, there may not be a liquid market or even a market at all for the particular tokens in order to sell them. Taxing the value of the token on creation could very easily result in a tax on illusory income.

Taxpayers who want to avoid this unfair treatment are left with limited, expensive, and time-consuming options when considering how to receive appropriate tax treatment on staking rewards.

This has been demonstrated by a former client of mine, Josh Jarrett, who sued the U.S. for a tax refund in an attempt to obtain a court decision that reward tokens should only be considered income when they are sold. Jarrett, a Tennessee SmartGym owner and a staker on the Tezos blockchain, created 8,876 XTZ tokens through validating transactions in 2019. Though he did not sell or exchange these tokens, he took the conservative approach and paid income tax on the value of these tokens at the time of their creation. In 2020, he filed a claim for refund on this tax, arguing that he had not earned income through the generation of reward tokens, and they should only be considered income when they are sold—in line with the way all newly created property is taxed.

The IRS failed to either accept or deny his request for a refund. After six months, in May 2021, Jarrett sued the U.S. in the U.S. District Court for the Middle District of Tennessee to obtain a refund as well as a ruling that staking rewards would not be taxed as income at the time they are created. In December 2021, in an attempt to settle the case, the U.S. Department of Justice informed Jarrett that it would be instructing the IRS to issue the refund. The government’s goal was simple: By issuing the refund the case, the government could say it provided the relief sought by Jarrett so there was no dispute left to resolve because he received the result he sought by bringing the lawsuit. The government, therefore, is attempting to use the offered refund to side-step a potential binding court ruling that staking rewards are only taxed upon disposition. Jarrett has attempted to reject the refund, but his case may be dismissed for mootness.

The current tax landscape for stakers is untenable, as taxpayers are stuck between choosing prejudical tax treatment on one hand or going through a multi-year administrative and legal process to receive fair treatment on the other. This is unfortunate because providing appropriate and fair tax treatment for all staking rewards is one way for the government to encourage the responsible growth of blockchain technology within the U.S. The Internal Revenue Code is filled with provisions designed to encourage or discourage certain activities, including the research and experimentation tax credit, the deductibility of home mortgage interest, favorable tax treatment for depreciable property used in a trade or business, and capital gains for funds invested in opportunity zones. Each of these Code provisions exist because, as a policy matter, the U.S. wanted to encourage a particular activity.

Proof of stake protocols use substantially less energy than proof of work protocols and offer a platform for a tremendous amount of technological innovation. By taxing reward tokens in the same way that the IRS treats all other newly created property, the U.S. could encourage this fledgling industry to develop deeper roots in this country as the security of the proof of stake protocols depends, in part, on the number tokens staked in the network.

It’s time for the U.S. to treat proof of stake fairly for the sake of American innovation.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Stephen J. Turanchik is an attorney in the tax practice of Paul Hastings LLP and is based in the firm’s Los Angeles office. Mr. Turanchik’s practice focuses on tax controversy and litigation at the state and federal levels and tax advice on international reporting and cryptocurrency transactions.

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