On July 31, 2023, the U.S. Internal Revenue Service (the “IRS”) released an updated ruling on the tax implications of staking cryptocurrencies that operate on the proof-of-stake model.[1] With reference to the IRS’ evolving definitions of cryptocurrency and digital assets, cash-method taxpayers who hold and stake cryptocurrencies such as Ethereum, Cardano, and Solana, may be required to include in their gross income the value of rewards generated through staking.
What is a ‘cash-method’ taxpayer?
A cash-method taxpayer is a taxpayer that generally reports income in the tax year that it is received.[2] Correspondingly, a cash-method taxpayer also deducts expenses in the tax year in which those expenses are paid. Most individuals and many small businesses are cash-method taxpayers.
The cash-method is contrasted to other methods, such as the accrual method, which is generally used by taxpayers that produce, purchase, or sell merchandise and keep an inventory. The IRS has indicated that their July 31st ruling on cryptocurrency staking is directed at cash-method taxpayers.
How does the IRS define cryptocurrencies?
As of the publishing of this ruling, the IRS has several definitions related to cryptocurrencies, with some degree of overlap.
Digital Asset
For the purposes of information reporting by brokers, the IRS generally defines a digital asset as any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.[3] Digital assets include (but are not limited to): convertible virtual currency and cryptocurrency, stablecoins, and non-fungible tokens (NFTs).[4]
Convertible Virtual Currency
The IRS considers a convertible virtual currency to be a virtual currency that has an equivalent value in real currency or acts as a substitute for real currency. It is treated as property and general tax principles applicable to property transactions apply.[5]
Cryptocurrency
Finally, the IRS defines a cryptocurrency as a type of virtual currency that utilizes cryptography to secure transactions that are digitally recorded on a distributed ledger.[6] The IRS further describes a cryptocurrency as an example of a convertible virtual currency that can be used as payment for goods and services, digitally traded between users, and exchanged for or into real currencies or digital assets.[7] The IRS’ use of the word ‘cryptocurrency’ in this ruling on staking is to cryptocurrency that is convertible virtual currency.[8] Examples of cryptocurrencies that fall within this IRS definition are Bitcoin and Ethereum.
Must the value of rewards generated from staking be included in gross income?
Yes, the IRS has ruled 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.[9] Therefore, most U.S. taxpayers will be required to include in their gross income the fair market value of any rewards they earn from staking cryptocurrency.
The flowchart above visualizes the hypothetical situation that the IRS referred to when determining their ruling. In this situation, a cash-method taxpayer owns 300 units in a cryptocurrency, stakes 200 units on ‘Date 1’, may not sell, exchange, or otherwise dispose of the units on ‘Date 2’ pursuant to the cryptocurrency’s protocol, and earns 2 units as a reward on ‘Date 3’.
The IRS’ hypothetical staking situation describes the most common manner in which cryptocurrency investors will earn rewards through staking. This means that the IRS has cast a wide net and most staking reward schemes will be subject to U.S. income tax.
When is the fair market value of the reward calculated and in what taxable year should rewards be included in?
The IRS has ruled that the fair market value of any rewards generated in the course of staking cryptocurrencies is determined as of the date and time that the taxpayer gains dominion and control over the validation rewards.[10] In reference to the hypothetical described above, the taxpayer gains the ability to sell, exchange, or otherwise dispose of the two staking reward units on ‘Date 3’. The fair market value of the reward would therefore be included in the taxable year in which ‘Date 3’ occurs.
Conclusions
With the release of this new rule, the IRS has identified cryptocurrency staking rewards as a source of taxable income. Investors and holders of cryptocurrencies in the United States should review their holdings and consider whether they have additional tax liabilities. The IRS notes that this latest ruling may contrast with other rules but has chosen not to address possible issues at this time.[11]
This article is not tax, investment, or legal advice and individuals should seek a licensed professional for questions regarding their obligations under this rule.
At Bull Blockchain Law, we specialize in legal matters related to the emerging blockchain industry. If you have any questions related to your relationship to this IRS ruling, do not hesitate to contact us at info@bullblockchainlaw.com.
[1] Rev. Rul. 2023-14, 2023-33 I.R.B. 484.
[2] For more information on cash-method taxpayers as well as alternative methods, see IRS Publication 538 Rev. January 2022 (link).
[3] I.R.C. § 6045(g)(30(d).
[4] See the IRS website for commentary on digital assets (link).
[5] Notice 2014-21, 2014-16 I.R.B. 938, as modified by Notice 2023-34, 2023-19 I.R.B. 837; Rev. Rul. 2019-24, 2019-44 I.R.B. 1004.
[6] Rev. Rul. 2019-24 I.R.B 1004.
[7] See the IRS website for commentary on digital assets (link).
[8] Rev. Rul. 2023-14, 2023-33 I.R.B. 484.
[9] Rev. Rul. 2023-14, 2023-33 I.R.B. 485.
[10] Rev. Rul. 2023-14, 2023-33 I.R.B. 485.
[11] Rev. Rul. 2023-14, 2023-33 I.R.B. 485 (footnote 3).