IRS Rules That Receipt of Crypto Units As Rewards for Staking Is Taxable Income

(Parker Tax Publishing August 2023)

The IRS ruled that a cash method taxpayer that stakes cryptocurrency native to a proof-of-stake blockchain and receives additional units of cryptocurrency as rewards when validation occurs must include the fair market value of the rewards in the taxpayer's gross income in the tax year that includes the date on which the taxpayer obtains dominion and control over the validation rewards. Rev. Rul. 2023-14.

Background

Code Sec. 6045(g)(3)(D) generally defines a digital asset, for purposes of information reporting by brokers, as any digital representation of value which is recorded on a cryptographically secured distributed ledger or nay similar technology as specified by the IRS.

Digital assets do not exist in physical form and include, but are not limited to, property the IRS has previously referred to as convertible virtual currency and cryptocurrency. In Notice 2014-21, the IRS defined convertible virtual currency as virtual currency that has an equivalent value in real currency or acts as a substitute for real currency. Notice 2014-21 provides that convertible virtual currency is treated as property and that general tax principles applicable to property transactions apply to convertible virtual currency.

Many cryptocurrencies utilize blockchain technology, a specific type of distributed ledger technology. 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. In this context, a node generally refers to a device that maintains a copy of the distributed ledger and runs copies of the software associated with the protocol for the distributed ledger at issue.

In general, it is these nodes that maintain the integrity of a blockchain by validating transactions and ensuring that new entries in the ledger, in the form of blocks of transactions, are legitimate and not duplicative so that a new block can be recorded on the blockchain. This can be done, for example, by rejecting transactions that attempt to move the same units to two different wallet addresses at the same time. The creation of new blocks on a blockchain generally requires the participation of multiple validators who are selected and rewarded pursuant to the blockchain protocol. These validation rewards typically consist of one or more newly created units of the cryptocurrency native to that blockchain.

A consensus mechanism is a set of protocols by which nodes reach agreement on updates to the blockchain. One consensus mechanism is commonly referred to as proof-of-stake. In a proof-of-stake consensus mechanism, persons who hold cryptocurrency may participate in the validation process by staking their holdings, if they hold the requisite number of units of a particular cryptocurrency. Persons may also participate in the validation process by staking their holdings through a cryptocurrency exchange. In a proof-of-stake consensus mechanism, validators may be selected by the protocol for the blockchain associated with the specific cryptocurrency based on a variety of factors including the number of coins or tokens staked. These validators confirm transactions and add blocks to the blockchain in accordance with the protocol. If a validator is chosen by the protocol and validation is successful, the validator will receive a reward. If a validator is chosen by the protocol and validation is unsuccessful, the staked units may be subject to penalty in the form of "slashing," a process by which the staked units, or a portion thereof, are forfeited.

Facts

Transactions in M, a cryptocurrency, are validated by a proof-of-stake consensus mechanism. On Date 1, Taxpayer A, a cash-method taxpayer, owns 300 units of M. A stakes 200 of the units of M and validates a new block of transactions on the M blockchain, receiving 2 units of M as validation rewards. Pursuant to the M protocol, during a brief period ending on Date 2, A lacks the ability to sell, exchange, or otherwise dispose of any interest in the 2 units of M in any manner. The following day, on Date 3, A has the ability to sell, exchange, or otherwise dispose of the 2 units of M.

Applicable Law

Code Sec. 61(a) provides the general rule that gross income generally means all income from whatever source derived. Specifically, gross income includes, but is not limited to, compensation for services, gross income derived from business, and gains from dealings in property. In Glenshaw Glass Co., 348 U.S. 426 (1955), the Supreme Court held that "instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion," require inclusion in gross income.

Under Reg. Sec. 1.61-1(a), "gross income includes income realized in any form, whether in money, property, or services. Income may be realized, therefore, in the form of services, meals, accommodations, stock, or other property, as well as in cash." According to the IRS, unless otherwise provided by a Code or regulatory provision, 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.

In Notice 2014-21, the IRS stated that cryptocurrency that is convertible virtual currency is treated as property for federal income tax purposes and general tax principles applicable to property transactions apply to transactions involving cryptocurrency. For example, a taxpayer who receives cryptocurrency as a payment for goods or services or who mines cryptocurrency must include the fair market value of the cryptocurrency in the taxpayer's gross income in the tax year the taxpayer obtains dominion and control of the cryptocurrency. Amounts received as gains derived from dealings in property, or as rents or royalties, also generally must be included in a cash-method taxpayer's gross income in the tax year the taxpayer obtains dominion and control of those amounts through actual or constructive receipt.

Analysis

In Rev. Rul. 2023-14, the IRS held that if a cash-method taxpayer stakes cryptocurrency native to a proof-of-stake blockchain and receives additional units of cryptocurrency as rewards when validation occurs, the fair market value of the validation rewards received is included in the taxpayer's gross income in the tax year in which the taxpayer gains dominion and control over the validation rewards. The fair market value is determined as of the date and time the taxpayer gains dominion and control over the validation rewards. The same is true if a taxpayer stakes cryptocurrency native to a proof-of-stake blockchain through a cryptocurrency exchange and the taxpayer receives additional units of cryptocurrency as rewards as a result of the validation.

Analyzing the facts described above, the IRS found that the 2 units of M represent A's reward for staking units and validating transactions on the M blockchain. According to the IRS, on Date 3, A has an accession to wealth as A gains dominion and control through A's ability, as of this date, to sell, exchange, or otherwise dispose of the 2 units of M received as validation rewards. Accordingly, the IRS concluded that the fair market value of the 2 units of M, as of the date and time A gains dominion and control over the 2 units of M, is included in A's gross income for the tax year that includes Date 3.

For a discussion of sales, exchanges, or other dispositions of virtual currency, see Parker Tax ¶119,610.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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