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The Internal Revenue Service (the “IRS“)
published Revenue Ruling 2023-14 on July 31, 2023 (this
“Revenue Ruling”), regarding the tax treatment for
cash-method taxpayers that receive validation rewards in
proof-of-stake transactions. A revenue ruling is an official
interpretation by the IRS of the Internal Revenue Code, related
statutes, tax treaties, and regulations. In short, the IRS
confirmed its long-held position that validation rewards from a
proof-of-stake consensus protocol are treated as gross income for
cash-method taxpayers pursuant to Section 61(a) of the Internal
Revenue Code of 1986, as amended (the “Code“) when
the taxpayer gains dominion and control over the validation
rewards.
Background on Proof-of-Stake Validation Systems
Cryptocurrency is a virtual currency that uses blockchain
technology to secure and digitally record transactions on a
distributed ledger. As noted in previous IRS guidance, convertible
virtual currency like cryptocurrency is treated as property for
federal income tax purposes, so general tax principles for property
transactions apply to cryptocurrency transactions.1
In recent years, cryptocurrency projects have moved away from
“proof-of-work” algorithms (such as Bitcoin) and towards
“proof-of-stake” algorithms (such as Ethereum). These
different types of algorithms are different methods for the
operation of community-run decentralized blockchain protocols and
provide different methods for the protocols to “validate”
proposed transactions to ensure they are legitimate. As stated in
Rev. Rul. 2023-14, “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.”
Proof-of-stake is a validation system where “nodes”
represent stakeholders of a particular cryptocurrency. While the
specifics of each system vary by cryptocurrency project,
stakeholders generally contribute (or “stake”)
cryptocurrency holdings in exchange for the opportunity to validate
transactions. As a reward for staking and validating successful
transactions, validators earn native cryptocurrency tokens in
proportion to the amount they have contributed or staked. Thus, the
protocol incentivizes stakeholders to validate legitimate
transactions taking place on the protocol. A protocol may also
disincentivize bad actors; for example, in some protocols, when a
validator accepts a transaction that is ultimately unsuccessful (or
even malicious), the validator could forfeit a portion of their
staked holdings in a process known as “slashing.”
This proof-of-stake consensus mechanism is designed to maintain
the integrity of blockchain transactions without the significant
computing power required in a “proof-of-work” consensus
system like Bitcoin maintains. When Ethereum transitioned from
proof-of-work to proof-of-stake, it reduced energy consumption
across the network by an estimated 99.9%, while, in theory, increasing the
security profile of the network. Other types of blockchain
protocols may enable a type of “staking,” but without any
corresponding validation function. Although it is unclear whether
this revenue ruling covers these other types of staking protocols
due to the revenue ruling’s brevity, taxpayers should closely
analyze analogous situations to determine the tax consequences for
rewards received in connection to proof-of-stake protocols.
Analysis of Revenue Ruling
Generally, under Code Section 61(a), gross income includes
“all income from whatever sources derived” unless there
is an exception. Confirming how most tax practitioners understood
staking rewards to be taxed, the Revenue Ruling stated that
“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,” citing
Koons2 and Rooney.3 as
precedent. It is important to note that accessions to wealth over
which the taxpayer maintains complete control are includible in
gross income, irrespective of the form the income is received
(e.g., services, accommodations, property, or cash). Thus,
to the extent it was not clear previously, this Revenue Ruling
explicitly states that accessions to wealth under Code Section
61(a) include native cryptocurrency reward payments to validators
in a proof-of-stake consensus protocol.4
Remaining Open Questions
The Revenue Ruling did not address three specific issues, two of
which it noted in footnotes. First, it did not discuss the
tax characterization of transaction fees (often called
“gas”) that may be an expense deducted from the staking
rewards discussed therein. Second, it did not discuss the
transfer of property in exchange for services, which is generally
covered by Code Section 83. The implication is that the IRS and the
Treasury Department are preparing guidance on both issues, which is
a welcome development given the paucity of guidance available.
Third, tax consequences for taxpayers who use the accrual
method of accounting were not discussed, limiting the Revenue
Ruling to cash-basis taxpayers. It would be surprising, if not
altogether astonishing if the limitation were for any reason other
than to issue future guidance on the timing concerns for
accrual-basis taxpayers. The future guidance would discuss the
rules for accrual-basis taxpayers regarding when in time income
from validation rewards would need to be realized.
Conclusion
Prior to the release of this Revenue Ruling, some commentators
maintained the position that rewards from staking only created
gross income at the time the rewards were sold or exchanged.
Indeed, many of the popular cryptocurrency tax calculators have
allowed taxpayers to calculate their cryptocurrency gross income
using this method. However, this Revenue Ruling states otherwise,
concluding that validation rewards are included in a taxpayer’s
gross income at the time of receipt. This may not be the final
word, as revenue rulings may be subject to countervailing
legislation, regulation, or court decisions. Taxpayers who have
income from proof-of-stake validating activities would be wise to
speak with their tax advisor to evaluate their calculation of gross
income in light of this Revenue Ruling.
Footnotes
1. See Notice 2014-21, 2014-16 I.R.B. 938, as modified
by Notice 2023-34, 2023-19 I.R.B. 837.
2. Koons v. United States, 315 F.2d 542 (9th Cir.
1963).
3. Rooney v. Commissioner, 88 T.C. 523, 626-27
(1987).
4. Code Section 61; Treasury Regulation
Section 1.61-1(a); See Commissioner v. Glenshaw Glass Co., 348 U.S. 426,
431 (1955).
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guide to the subject matter. Specialist advice should be sought
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