The Right Tax Treatment of Staking Rewards Is Clear: Taxation Only After Sale

Now is the time to call the question on staking taxation, and the answer is clear: Block rewards received by stakers should be taxed only upon sale.

In 2014, the Internal Revenue Service declared that virtual currency is property. In the very same policy decision (made in guidance document IRS Notice 2014-21), the agency gets it wrong on how to tax proof-of-work block rewards. It considers these new tokens immediately taxable “gross income.”

Like all federal agencies, the IRS is compelled to apply federal statute when forming its tax policies. In this case, that is the Internal Revenue Code, or “IRC.” Section 61 of that code defines what is to be considered gross income. Surprising to no one, this section doesn’t specifically address block rewards, nor do any U.S. Treasury regulations.

Bill Hughes is the senior counsel and director of global regulatory matters at ConsenSys Software. He was formerly a senior official in the Department of Justice and White House. Greg Stephens is a third year student at the University of Virginia School of Law.

The IRS had little to go on when taking a position on block reward taxation nearly a decade ago that still impacts a growing industry today. It might not deserve too much scorn for getting it wrong, but it’s time to fix the mistake.

The reason staking rewards ought to be taxable only upon sale, and not before, is clear when scrutinizing existing rules. The IRS has said little relating to cryptocurrency tokens, but affirms that virtual currencies are property and traditional property taxation principles apply.

In that context, there are really two types of property: income that’s taxable when you get it and the type that is not. Property received as payment or compensation is income and taxed based on the fair market value of the property when received.

See also: A New SEC Definition for ‘Exchanges’ Has Big Implications for Crypto | Bill Hughes

Created property

Property you purchase or create is not. Instead, for this category of assets, you are taxed on any gains you realize when you sell it.

This treatment is intuitive with respect to created property. We paint pictures, grow crops, mine raw materials, process raw materials into useful commodities, write essays and engage in countless other creative processes, knowing and expecting that, should our creations actually have some monetary value, they are not taxed unless and until we sell them.

In the world of blockchain, staking is a prerequisite to validation. Validation entails running code that verifies new transactions do not violate rules of the blockchain protocol and are consistent with its transaction history.

By running this code, validators create new tokens for themselves. The rewards that stakers create are not compensation.

A staker never receives the tokens from another person in exchange for goods or services (setting aside transaction fees, which is a topic for another day). There is no accounting ledger under the arm of some other party showing the expense of sending the staker reward tokens.

To say the protocol compensates the validator would be akin to saying the field compensates the farmer with crops or the mine compensates the miner with ore. It is nonsensical.

Staking rewards are, instead, created property. They are a product of validating transactions, just as crops are a product of a farmer’s labor. Created property has a widely applied and time-tested treatment of taxation. Created property isn’t taxed until sale.

Taxing at 'creation'

That the tax system has taken this approach is no big mystery because there is no workable alternative. Taxing assets at creation is rife with serious problems.

For instance, it may be hard if not impossible to know the fair market value of the creation at genesis. The complexity and seriousness of these problems only multiply in the context of staking rewards.

The fair market value of the rewards may not be possible to ascertain when created. A staker’s gain would likely be overstated, both due to costs associated with maintaining a stake and the effects of token dilution.

The number and timing of rewards over a calendar year, as well as having many stakes on many protocols with many different dollar-denominated token values, would make compliance with a taxing-at-creation approach nearly impossible for most taxpayers to comply with.

And where would the average taxpayer look for help? Technical differences among the protocols in how new tokens are created would be daunting to manage, requiring tax advisers to have the technical savvy outpacing many experienced blockchain developers.

See also: Why We Still Need Guidance on Staking Rewards Taxation | Opinion

Such a rule makes broad-based tax noncompliance a certainty. The IRS should favor rules that enable tax compliance. Indeed, they proclaim “our job at the IRS is to help taxpayers.”

Taxing at sale

Taxing staking rewards at sale is the most sensible approach because it is easier to comply with, easier to police and fairer because gains can be more reliably set off by actual costs. It also requires us to apply existing law as we are used to applying it.

Taxing staking rewards only after sale avoids discriminatory tax treatment in relation to other forms of created property. The societal and economic costs of wrong or unclear policy includes staking migrating en masse to overseas jurisdictions that have codified more reasonable tax treatment.

That’s bad for the U.S. in many respects – including in terms of tax revenue, serving as a hotbed of innovation and as an economy that values everyday people improving their lot through their diligence and ingenuity.

Time is of the essence for the IRS to get this right, and for Congress to take a more active interest in this precise question.

Ethereum, the most-used blockchain, will migrate fully to proof-of-stake later this year, and it is expected that hundreds of thousands (and rising) of validators will be supporting the network. U.S. taxpayers control many of those validators, and they deserve certainty and fairness with respect to tax treatment of their rewards. Validators on other consensus networks deserve fair tax treatment, too.

See also: What's at Stake as Josh Jarrett Sues the IRS | Opinion

Moreover, as the community of taxpayers creating virtual currency property becomes more significant, the number of impacted taxpayers rises commensurately. To date, the IRS has not faced a significant volume of challenges to taxation of block rewards, but the case litigated by the Jarretts should make the IRS think twice.

If the IRS thinks crypto is generally property, then the solution here is straightforward. At the very least, if the IRS believes staking rewards are compensation and not newly created property, then it must state unequivocally who is doing the compensating and how one accurately accounts for the gain realized.

Hand-wringing about virtual currencies and taxation noncompliance is overdone. An overwhelming number of stakers seek to pay exactly what they owe. Updated and clear guidance that delivers fair and consistent tax treatment will better enable that outcome.