Over the past several years, Proof-of-Stake (PoS) cryptocurrencies have emerged as the dominant consensus mechanism used in blockchain networks. PoS has proven to be more energy efficient and scalable than Proof-of-Work (PoW) protocols. As technological innovation and experimentation by PoS networks have progressed at breakneck speeds, definitive guidance from the Internal Revenue Service (IRS) on tax treatment of activities relating to PoS networks has progressed at a glacial pace, contributing to wide-spread uncertainty for US taxpayers.
This article provides a general overview on PoS networks, as well as outlining the various challenges taxpayers face that are unique to PoS networks.
Our aim is to highlight issues that the IRS must consider as they develop tax regulations around staking activities, and also outline potential resolutions that the IRS may consider as they begin to tackle these questions. However, even though IRS regulations around staking activities haven't been specifically addressed, US taxpayers still have the obligation to report their transactions accurately and pay the correct rate of taxation based on the current state of the tax code. It's important to note that this is nothing new: there is ambiguity around many topics of taxation, and taxpayers adopt any position with a certain degree of risk. While this article is not intended to be tax advice regarding any particular situation, nor is it a substitute for the services of a competent tax professional, it will attempt to classify the relative risk in adopting certain positions regarding staking taxation and the tax code, as it presently exists.
PoS was designed to solve some of the emerging problems encountered by PoW-based blockchains such as Bitcoin. PoS node-runners, typically called validators, “stake” a quantity of the network’s token as a bond for entitlement to earn rewards as a block producer on the network. These staked block producers are then algorithmically chosen (like a weighted lottery) to produce a block of transactions. Although the block producers are selected at random, in many PoS networks, the probability of being selected increases as the value of their stake increases, which tends to increase potential yields for those who have placed the most collateral into the network.
To deter bad actors, the penalty for breaking protocol rules is intended to be more costly than what can be gained for following the rules. PoS algorithms pay rewards for desired behavior, and often employ a combination of forfeited rewards (which forego income which would have otherwise been earned by the validator), penalties (which reduce the income earned by the validator), or slashing (which confiscates all or part of the stake bonded to the validator) which disincentive undesired behavior.
A frequent criticism of the PoS model: its design favors the network’s earliest participants and largest stakeholders. The cost of spinning up a new validator on a network drastically increases as the price of the network token increases over time, serving as a formidable barrier to entry as a network matures. This holds true for both investors and infrastructure providers. To combat this discrepancy, other methods for validator selection and iterations on PoS design have been developed by the global blockchain community, the most notable being Delegated Proof-of-Stake (DPoS).
DPoS is a particular type of PoS where any tokenholder of the network may stake by “delegating” their tokens to validators. Staking tokens helps to improve network security by increasing the proportion of tokens a Sybil(1) attacker must acquire on the open market. In exchange for delegating their tokens to one or more validators, delegators share in the earnings attributable to those validators. In addition to sharing transactional revenue with validators (pro rata, based on the amount the delegation represents to the entire amount bonded to a validator), networks usually offer other incentives to delegators to increase their participation, which serves to bootstrap liquidity in their infancy.
In DPoS networks, validators are capable of accepting multiple delegations from numerous token holders. These delegations form a staking pool; the validator is responsible for validating on behalf of the staking pool. Staking on a DPoS blockchain is non-custodial, meaning tokenholders do not lose control or surrender custody of their assets when delegating to a validator. The network protocol merely locks the delegated tokens until they are unstaked by the tokenholder.
The remainder of the article focuses on DPoS networks, raises a number of tax issues and offers proposals on how to treat staking rewards for US tax purposes. The following information is for informational purposes only and is not tax advice. The tax rules surrounding digital assets are complex and any positions being considered should include consultation with a tax advisor.
As of the publication of this article, the IRS has yet to provide any formal guidance on the tax treatment of PoS and DPoS networks and staking rewards. In fact, even the terms “staking” and “Proof-of-Stake” don’t even appear in any notices published by the IRS or in the 2019 FAQs published on the IRS website.
Taxpayers often face some level of uncertainty when faced with complicated tax issues, especially when those issues deal with cryptocurrency. A tax position is how a taxpayer chooses to apply their individual transactions and circumstances against the tax code when determining how to report tax obligations and how much resulting tax to pay based on those obligations. Hence, essentially everything on a return represents some position, as do omissions from a return.
A tax position is reasonable if (1) there is or was substantial authority for the position; or (2) the position was disclosed(2) and there is a reasonable basis for the position(3). Both “substantial authority” and “reasonable basis'' are conceptual levels of confidence—tax professionals often provide a weighted level of confidence that supports the desired tax treatment of the facts of the situation, out of a range of authorities that may be offered when addressing the facts of the situation.
When discussing conceptual levels of confidence, it's always helpful to apply a quantitative standard. This is especially true when levels of confidence are based on weighing the facts and circumstances of a particular issue. The IRS promulgates the following levels of confidence:
If the IRS determines that a tax position isn't reasonable, and reliance on that tax position resulted in an understatement of the taxpayer's liability, significant penalties can be imposed.
Delegators: In a DPoS network, delegators are tokenholders of the network who “lock up” their tokens in exchange for earning additional tokens, also known as staking rewards. Delegators can vote and elect delegates to validate transactions on the blockchain. Using DPoS, delegators can vote on delegates by pooling their tokens with other holders and share rewards earned with the other participants in the staking pool. Delegators do not transfer their tokens to another wallet or give up custody of their tokens when they stake them.
Delegates: Delegates are also called “witnesses'' or “block producers.” Delegates of DPoS networks have the technical expertise to run complex infrastructure capable of producing new blocks on the blockchain. Delegates receive votes from delegators that increase the likelihood they will be selected to perform work; the “work” performed is validating a block of transactions on the network. In exchange for successfully producing a block, delegates earn staking rewards and share them with the staking pool. The delegate typically charges the staking pool a commission fee. It should be noted that delegates do not take custody of delegators’ tokens.
Nodes: Nodes commit (stake) tokens as collateral for the opportunity to produce the next block of transactions. The node that's chosen — referred to as the "validator" — will receive block rewards. It’s easiest to think of nodes as the machinery working to keep the blockchain live and operational.
Depending on the participant’s role within a DPoS network, new tokens are usually earned in one of three ways: transaction fees, inflation and commissions.
Transaction (“Gas”) Fees: Users are required to pay an out-of-pocket transaction fee (commonly referred to as “gas fees”) to prioritize their transaction in the mempool(7). Transaction fees can fluctuate based on the volume of activity and network congestion at any given moment. Generally, the more people trying to use the network at once, the more it costs to ensure transactions will be included in the next block. Transactions fees are typically paid in the blockchain’s native token; how fees are distributed between the network’s treasury, delegates, and delegators will vary from chain to chain. For most existing blockchains, transaction fees account for a relatively small proportion of the overall staking rewards a delegator earns.
Inflation: Proof-of-Stake protocols have a built-in inflation mechanism that increases the supply of coins in circulation. New coins are distributed proportionally to those that have been staked. If the participation rate — i.e., the amount of tokenholders who stake — is low, then delegators will enjoy outsized returns, not just their pro rata share of the network inflation. Inflation rates across blockchains vary widely and can reach greater than 100% APY. Tokens created through inflation mechanisms are created by the network and sent directly to the staking pool (less commissions).
Commissions: Validators charge tokenholders a commission of anywhere of 0-100% on gross staking rewards. Depending on the network, validators can charge a commission on a share of transaction fees, inflation, or both. Commissions are received directly from the network.
Slashing: Delegates’ bad behavior, inactivity, and dishonest validations are subject to a penalty called slashing. This mechanism is designed to discourage malicious validator behavior and to incentivize network participation, as well as node security and availability. While slashing penalties vary from protocol to protocol, typically the penalty consists of a predefined percentage or fixed amount of a validator’s stake is forfeited. Delegators’ assets are typically also at risk of slashing.
The IRS hasn’t addressed the taxation of PoS networks; fundamental questions about timing, character, and sourcing remain unanswered. Absent IRS guidance, taxpayers have turned to their tax advisors for advice. In uncertain scenarios like this, tax advisors often favor conservative positions (more on this below). While these recommendations place the taxpayer in the safest position available with the IRS, there’s no way of knowing how the IRS will ultimately decide to treat staking rewards. Taking overly conservative positions could wind up costing taxpayers thousands (or millions) of dollars in overpaid taxes that may not be refundable in future years.
Given the lack of IRS guidance, taxpayers must accept the reality they’re faced with: any tax position the taxpayer takes will include some degree of risk & uncertainty. The best advice we can offer is to embrace this uncertainty as an inevitability and determine the level of risk you’re willing to accept when filing your tax return.
Figment has shared three potential tax positions available to taxpayers and attempts to offer a general assessment of the risk level each position assumes(8).
Conservative Position: Transaction fees and inflationary rewards are 100% taxable.
Treating transaction fees and inflationary rewards as 100% taxable assumes IRS Notice 2014-21 extends beyond PoW mining rewards and applies to PoS staking rewards. This position fails to recognize the differences between the two economies. It’s the most conservative position and the least likely to be challenged by the IRS.
Moderate Position: Transaction fees are 100% taxable; inflation rewards are not taxable
Transaction fees are 100% taxable.
Anytime a user submits a transaction, the transaction includes a small fee payable to the validator in exchange for including the transaction in the next block. Like the sale of a token, a taxpayer’s receipt of an existing token may also be a taxable event. A token sent from one person to another as a payment or compensation for services will be that recipient’s taxable income, at its proper dollar valuation. The validator is performing a service in exchange for this fee(9). It seems reasonable to assume transaction fees should be treated as taxable income.
Inflation rewards are not 100% taxable.
For tax purposes, virtual currency is property. New property – essentially, property not received from someone else as payment or compensation, but newly created or discovered by the taxpayer – is never treated as taxable income to its first owner. Inflation should be treated as newly created property, rather than some form of income.
Economically, any gain from staking can be viewed as a transfer of economic value from those tokenholders who do not obtain the new reward tokens. New tokens dilute existing tokens; only those who obtain new tokens offset this dilution – and perhaps, end up with a gain.
The IRS’s decision in the Jarrett(10) case will embolden more taxpayers to take the position that inflation should not be treated as taxable income until sold. This position certainly comes with associated risk but we believe the position under current tax law is justified.
Aggressive Position: Transaction fees and inflationary rewards are taxable when sold.
Given the IRS’s position that virtual currency is property, tax professionals have argued creating new property should not be treated as taxable income until sold. This position defers recognizing staking rewards as taxable income until sold. The future sale will result in the taxpayer recognizing capital gains equal to sales proceeds.
Once the taxpayer has established when to report staking rewards as taxable income, they should consider the character of the income.
Conservative Position: Ordinary income - active trade or business income.
While no guidance has been offered on how to properly characterize staking rewards for tax purposes, the IRS has shared their view on the character of PoW mining rewards. Notice 2014-21 informs readers “when a taxpayer successfully ‘mines’ virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.” This statement provides taxpayers who “mine” virtual currency with sufficient guidance. Mining rewards should be treated as ordinary income. Assuming the taxpayer chooses to recognize staking rewards at the time of receipt, it’s reasonable to assume the taxpayer should also report them as ordinary income.
Notice 2014-21 also acknowledges mining virtual currency may give rise to a trade or business. Active trade or business income depends on the level and frequency of the taxpayer performing the activity. From a tax perspective, operating nodes on DPoS networks require a high level of technical expertise, time, and energy to maintain. It’s reasonable to assume node operators are actively engaged in the business of earning staking rewards.
Delegators in DPoS don’t have the technical expertise, time, or commitment to maintain staking infrastructure. They are not in the active trade or business of producing blocks. It’s difficult to believe these two market participants should both be considered actively engaged in the staking infrastructure business. For this reason, delegators reporting staking rewards as active trade or business income is the most conservative position a delegator can take(11).
A note to tax-exempt investors
An organization recognized as a tax-exempt entity, may be liable for tax if it engages in and derives income from unrelated business activities. This type of income is referred to as Unrelated Business Taxable Income (“UBTI”). The Internal Revenue Service (IRS) defines the income generated from unrelated business activities as “income from a trade or business regularly carried on, that is not substantially related to the purpose that is the basis of the organization's exemption from tax.” If a tax-exempt organization recognizes too much UBTI, they can lose their tax-exempt status. They are incredibly sensitive to UBTI exposure. Tax-exempt organizations operating their own nodes should be wary that such an activity could generate UBTI.
Moderate Position: Ordinary income - portfolio income
DPoS networks were intended to offer tokenholders the ability to contribute to network security without the technical expertise to run their own infrastructure. Tokenholders can delegate their tokens to a qualified validator and begin earning block rewards immediately. Delegators are clearly relying on the infrastructure and expertise of node operators, suggesting these tokens resemble a portfolio investment.
The role of a delegator is so far removed from the activities associated with operating a node that income recognized by delegators is arguably best suited to be treated as portfolio income(12). In fact, most delegators have a “set it and forget it” mentality when it comes to staking. Investors who stake tokens view their holdings as investments and send a clear signal that the delegator has no short-term intention to sell their initial position.
The level of activity being performed by delegators is limited to checking a computer, deciding whether to claim constructively received rewards, and staking newly created tokens.
Aggressive Position: Selling staking rewards triggers capital gain.
If the taxpayer chooses to defer taxable income until their staking rewards are sold, 100% of the sales proceeds will be treated as capital gain. Capital gains are recognized whenever an asset is sold or exchanged. If the taxpayer has held the asset for 1 year or less, the gain is treated as a short-term capital gain/(loss). If the taxpayer has held the asset for greater than 1 year, the gain is treated as a long-term capital gain. Long-term capital gains are taxed at a preferential tax rate(13).
Unlike many classes of assets, cryptocurrency does not have an attachment to a particular jurisdiction due to its decentralized nature. However, a great deal of taxation has a basis in where an item of income is sourced. It’s important for taxpayers to establish a process to determine the source of staking income and apply it consistently.
Taxpayers have used a variety of factors to determine the source of their staking income. These determining factors include the location of the exchange, domicilie of the recipient, geolocation of the delegate’s validator, the location of the private keys, or the location where the rewards are claimed and re-staked. It should be noted the IRS has never signaled their approval for any of these factors.
If the source of staking income is deemed to be US, then the character of the income is likely to be vitally important.
US sourced - Active trade or business income
If delegators determine their staking activities rise to the level of an active trade or business, they will immediately be concerned with the source of the income. Income distributed to foreign persons is likely to be deemed Effectively Connected Income (ECI) and subject to withholding at the appropriate tax rate. Exposure to ECI requires foreign persons to disclose private personal information to the US government and technically triggers a filing obligation.
US sourced - Portfolio income
If delegators determine their staking activities are portfolio income, it’s possible US-sourced income may be taxed as fixed, determinable, annual or periodic (FDAP) income for U.S. tax purposes. Non-US delegators are typically subject to withholding on US FDAP, however many countries have bilateral tax treaties with the US that reduce the applicable withholding rate. While the IRS hasn’t explicitly stated staking income is FDAP, the regularity of the rewards are common characteristics in existing FDAP items.
It may be possible to avoid US sourced staking income entirely by delegating tokens to a third-party staking infrastructure provider located outside the United States. This approach may help mitigate some of the tax issues described earlier. Figment is a Canadian-based company without any staking infrastructure located on US soil.
The tax environment for staking has become complex due to uncertainty and the lack of IRS guidance. Tax authorities should take the appropriate steps to ensure taxpayers have the tools and information onhand to file complete and accurate tax returns. The IRS’s current strategy has left tax advisors offering inconsistent advice to their clients, leaving taxpayers vulnerable to filing inaccurate tax returns.
Whenever taxpayers take a position on an issue with an uncertain outcome, we always recommend the taxpayer document their rationale and remain consistent in their recognition and reporting standards. There’s a saying in taxation, “it’s better to be consistently wrong than it is to consistently take inconsistent positions.” Consistency demonstrates the taxpayer’s attempt to report taxable income and loss based on an interpretation of the rules.
It’s important to emphasize that the lack of direct guidance from the IRS does not eliminate a taxpayer’s responsibility to report their cryptocurrency transactions and report income from all sources derived.
We hope this article has offered helpful insights and provided you with a basic understanding of staking and its complex relationship with tax. If you have any questions about something you read in the article or would like to get in touch with us, please reach out to us at firstname.lastname@example.org
(1) A Sybil attack is a kind of security threat on an online system where one person tries to take over the network by creating multiple accounts, nodes or computers. For a detailed, explanation: https://dyor-crypto.fandom.com/wiki/Sybil_Attack
(2) As provided in Sec. 6662(d)(2)(B)(ii)(I)
(3) As required by Sec. 6662(d)(2)(B)(ii)(II)
(4) See AICPA, Interpretations of Statement on Standards for Tax Services No. 1, Tax Return Positions, p. 4, citing Joint Committee on Taxation, Study of Present-Law Penalty and Interest Provisions as Required by Section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998 (Including Provisions Relating to Corporate Tax Shelters) (JCS-3-99), Vol. 1, p. 152 (July 22, 1999)
(5) See preamble, T.D. 9436 and Regs. Sec. 1.6694-2(b)(1) before amendment by T.D. 9436
(6) As required by Sec. 6694(a)(2)(C)
(7) The “mempool” (memory pool) is a smaller database of unconfirmed or pending transactions which every node keeps. When a transaction is confirmed by being included in a block, it is removed from the mempool.
(8) The following commentary is not tax advice. This subject is complex and taxpayers should seek the advice of a tax professional.
(9) Bartering is an exchange of property or services and must be included in income, at the time received. To the extent property is received (virtual currency is property), the FMV of the asset should be reported as income.
(10) Blockworks article: “In Win For Crypto Stakers, IRS Offers Refund on Untraded Token Rewards”
(11) Even though the most conservative position a taxpayer can adopt, it’s not uncommon for investment funds to characterize staking income as active trade or business income, even when they delegate to a third party like Figment. There are several reasons why investment funds have chosen to take this position. For one, tax advisors tend to recommend conservative positions when it comes to crypto because it hedges against general uncertainty surrounding the IRS's undisclosed views on the issue. Perhaps most importantly, if the IRS attempts to retroactively apply any rules, the fund won’t be liable for backup withholding.
(12) Portfolio income is money received from investments, dividends, interest, and capital gains. Royalties received from investment property also are considered portfolio income sources.
(13) [Share preferred tax rates].