The Internal Revenue Service (IRS) recently ruled that if a taxpayer using a cash method of accounting stakes certain cryptocurrency and receives additional units of such cryptocurrency as rewards for staking, the taxpayer must include the fair market value of such rewards in the taxpayer’s gross income in the taxable year in which the taxpayer obtains dominion and control of the cryptocurrency received.

Guidance from the US Treasury Department (Treasury) and IRS was anticipated with respect to the validation of digital asset transactions, including staking, since such guidance was included on the Treasury and IRS 2022–2023 priority guidance plan.

On July 31, 2023, the IRS issued staking guidance in Revenue Ruling 2023-14 (Revenue Ruling) generally holding that rewards received in exchange for cryptocurrency staking are included in a taxpayer’s gross income in the taxable year in which the taxpayer first has the ability to dispose of the cryptocurrency received (i.e., the year in which the taxpayer first has dominion and control of the cryptocurrency).

As a result, taxpayers that stake cryptocurrency should report such staked cryptocurrency as income in the applicable taxable year based on the fair market value of such cryptocurrency or, if applicable, amending prior year tax returns in which taxpayers previously reported such staked assets as income if the taxpayer did not have such dominion or control.

BACKGROUND

Cryptocurrencies are digital assets that utilize cryptography to secure transactions that are digitally recorded on a distributed ledger. [1] A distributed ledger is a database that is consensually shared and synchronized across multiple sites, institutions, or geographies, and is accessible by multiple people.

Participants at each node of the network can access the recordings of past transactions shared across that network and can own an identical copy of it. Any changes or additions made to the distributed ledger are reflected and copied to all participants.

A blockchain is a type of distributed ledger. Validators are responsible for processing transactions on the blockchain, maintaining legitimacy and ensuring transactions are not duplicative such that a new block can be added to the blockchain. Blocks are validated by multiple validators, and when a specific number of validators verify that the block is accurate, it is finalized and closed.

One mechanism of validation, the proof-of-stake consensus mechanism, requires validators to hold and stake (lock-up) cryptocurrency for the privilege of earning transaction fees (rewards) in the form of the cryptocurrency staked. In this mechanism, validators are required to send cryptocurrency to a smart contract (the staking process). This staked cryptocurrency is then used as collateral, which is locked-up in the smart contract, that may be forfeited if a validation is unsuccessful.

Cryptocurrency staked may be locked-up for some period of time such that it cannot be transferred or otherwise used by the validator. The validators that have the highest number of cryptocurrency staked have a greater chance to be chosen to validate a transaction on the blockchain. Successful validations will result in the validator receiving a reward.

THE REVENUE RULING

The facts of the Revenue Ruling involve a cash-method taxpayer that initially owns 300 units of a cryptocurrency. The taxpayer stakes 200 units of such cryptocurrency and validates transactions in a new block, receiving two additional units of the cryptocurrency as a reward.

Under the protocol of the cryptocurrency, during a brief period, the taxpayer lacks the ability to sell, exchange, or otherwise dispose of any interest in the two units of the cryptocurrency that the taxpayer received in exchange for validating the new block. Subsequently, on a future date, the taxpayer has the ability to sell, exchange, or otherwise dispose of those two units of the cryptocurrency.

The Revenue Ruling holds that the two units of cryptocurrency received through staking constitute income for US federal income tax purposes in the taxable year that includes the first date the taxpayer has the ability to dispose of those two units. In reaching its holding, the IRS noted that under the Internal Revenue Code of 1986, as amended (the Code), gross income includes income from whatever source derived.

The IRS also cited case law providing that an accession to wealth over which the taxpayer has complete dominion and control constitutes income. As a result, the Revenue Ruling concludes that when the taxpayer has the ability to dispose of the two units of cryptocurrency, such units should be treated as income for US federal income tax purposes because the taxpayer has the requisite dominion and control at that time.

Notably, the Revenue Ruling is consistent with prior guidance provided by the IRS with respect to cryptocurrency in that the Revenue Ruling appears to treat the staking rewards as the receipt of property in exchange for services. [2] In reaching its holding, the IRS appears to have implicitly, though not explicitly, rejected the argument that newly created cryptocurrency received under the facts of the Revenue Ruling as part of staking is not self-created property (akin to when a baker prepares a loaf of bread). If the newly created cryptocurrency were to be treated as self-created property, it would arguably not be subject to tax until sold.

Finally, while the Revenue Ruling provides the IRS’s opinion of the law, a revenue ruling is not binding law and a court generally is not required to defer to the IRS’s analysis, but such guidance may be viewed as persuasive. In addition, a taxpayer that takes a position on its US federal income tax return contrary to a revenue ruling must generally disclose such position to the IRS to avoid accuracy-related penalties under Section 6662 of the Code.

The Revenue Ruling does not specifically address any type of “gas” or transaction fees. The Revenue Ruling also does not specifically address issues that may arise under any rules not otherwise cited, such as Code Section 83, concerning certain compensatory transactions.

ADDITIONAL CONSIDERATIONS

A similar staking tax issue as that addressed in the Revenue Ruling is currently under consideration in Joshua Jarrett, et al v. USA [3] before the US Federal Court of Appeals for the Sixth Circuit. The petitioners in Jarrett contend that cryptocurrency received through staking should not be taxed as income until such cryptocurrency is sold or exchanged. That position contrasts with the holding in the Revenue Ruling that cryptocurrency received through staking is taxed when a taxpayer is able to dispose of such cryptocurrency.

Interestingly, in Jarrett, the IRS issued a refund to the petitioners with respect to taxes that were disputed as a result of petitioners’ cryptocurrency staking activities, and had the suit dismissed as moot at the District Court level. As such, the Sixth Circuit could decide the case on procedural grounds, avoiding the substantive legal issue.

[1] For purposes of the Revenue Ruling, cryptocurrency is defined to include only convertible virtual currency.

[2] In Notice 2014-21, 2014-16 IRB 938, the IRS concluded that 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 as of the date that the cryptocurrency was received.

[3] Docket No. 22-06023 (6th Cir. Nov. 23, 2022).

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