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Are Proof-of-Stake Block Rewards Gross Income in the Year Received?

Author: Abraham Sutherland, Adjunct Professor, University of Virginia School of Law

The discussion in this document reflects legal principles as of January 30, 2020.

Disclaimer: This paper does not provide legal or accounting advice.

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Conservative answer: Yes.  

Question 8 of IRS Notice 2014-21 (presented below) states the IRS’s position  that proof-of-work mining rewards, such as Bitcoin, are gross income at the FMV of the reward tokens on the date received. Extending this guidance to the newer  technology of proof of stake, proof-of-stake block rewards can also be included in  gross income when received. This result is favorable to the Treasury, and in the  short history of proof-of-stake cryptocurrencies this has emerged as the  conservative approach in light of available guidance. Although the example in the  IRS guidance is Bitcoin, which is not a proof-of-stake cryptocurrency, the Notice’s  description of the taxpayer’s activity as “us[ing] computer resources to validate  [cryptocurrency] transactions and maintain the public [cryptocurrency] transaction  ledger” can also describe proof-of-stake validation activity. See also Section  61(a)(1); reg. section 1.61-2(d) (“compensation paid other than in cash”); and  section 83 (“property transferred in connection with performance of services”). 

Q-8: Does a taxpayer who “mines” virtual currency (for  

example, uses computer resources to validate Bitcoin  

transactions and maintain the public Bitcoin transaction  

ledger) realize gross income upon receipt of the virtual  

currency resulting from those activities?  

A-8: Yes, 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. See Publication 525, Taxable and  Nontaxable Income, for more information on taxable income. (IRS  Notice 2014-21, 2014-16 IRB 938.) 

Alternative answer: No.  

Including proof-of-stake block rewards in gross income at the time received can  result in demonstrably inequitable taxation as well as notable compliance burdens. No statute or regulation clearly mandates this approach. The 2014 IRS  guidance does not carry the force of law, and it does not provide legal analysis in  support of its conclusion. Even if the guidance is persuasive with regard to  Bitcoin and proof of work, it does not necessarily extend to proof-of-stake  cryptocurrencies, which were in their infancy when the IRS released its guidance  in early 2014.  

An alternative approach, following the law and practice of the taxation of  taxpayer-created property, would be to report income from reward tokens at the  time of the reward tokens’ sale.  

Analysis:  

A proof-of-stake cryptocurrency allocates opportunities for validators to create  blocks – and along with these blocks, new and valuable cryptocurrency tokens – on the basis of the validator’s “stake,” or share of ownership, in that  cryptocurrency network. In contrast to Bitcoin users, a high percentage of  taxpayers who hold certain proof-of-stake cryptocurrencies will receive newly  created reward tokens. Proof-of-stake validation enables token holders to offset  the effects of dilution caused by the creation of new tokens and, in many cases,  to increase their stake in the network. But treating a reward token as income at  the time received overstates the validator’s gain from that token, because each  new token dilutes the stake in the network represented by every existing token.  The overstatement of gain can be dramatic.  

Consider a simple proof-of-stake cryptocurrency that increases its token supply  by 5% over the course of the tax year. If every token holder participates in  validation and ends the year with 5% more tokens, every token holder would hold  the same stake in the network and no token holder would improve his financial  position as a result of validation. Applying the 2014 guidance would result in  significant gross income despite the lack of any actual gain caused by validation.  Although comparisons to corporate stock and dividends can be misleading, this  example can be compared to pro rata stock dividends under Section 305(a), or to new corporate shares issued in a stock split, neither of which is included in gross  income.  

More realistically, proof-of-stake block rewards may provide the taxpayer with an  actual gain, because not all of the cryptocurrency’s token holders will share in the  new tokens created as block rewards. However, the overstatement of gain may  still be significant, undermining the rationale for treating block rewards as  immediate gross income.  

Tezos, a proof-of-stake cryptocurrency, provides an illustration. Simplifying the  numbers only slightly, the Tezos reward tokens created during the year 2019  increased the total supply of Tezos tokens by about 5% over the course of the  year. Some token holders did not receive any reward tokens in 2019, so those who did receive block rewards – Tezos validators – increased their number of  tokens by about 7%. Applying the 2014 guidance, validators would be taxed based on this 7% increase in tokens, rather than validators’ actual gain of about  2%, overstating validators’ gains from validation by more than 300%.  

Property that is created by the taxpayer is generally not taxed as income until it is  sold. In a proof-of-stake cryptocurrency, validators create new blocks of  transactions that are added to the blockchain, and at the same time create the  new reward tokens that increase the total token supply. Treating block rewards  as created property eliminates the overstatement of validators’ gains, as reward  tokens and purchased tokens alike are taxed based on their value at the time of  their sale. Reporting income from reward tokens at the time of their sale also  simplifies tax compliance and reduces liquidity concerns. With Tezos, for  example, validators take possession of newly created reward tokens once every  three days. If such tokens are gross income at their FMV on the date received,  this entails approximately 120 taxable events each year – or more than that, if  reward tokens must be sold to obtain the dollars required to pay tax.  

The IRS has not addressed the taxation of reward tokens since its 2014  guidance. In its January 26, 2020 “Report on the Taxation of Cryptocurrency,” the  New York State Bar Association’s Tax Section noted the lack of clarity  concerning the proper taxation of proof-of-stake block rewards and  recommended that the IRS and Treasury Department study the issue further.  (NYSBA Report No. 1433, Recommendation 24 and Section V.G, available at  aboutblaw.com/OpL.) 

Proof-of-work taxation is addressed in the Lukka Library Paper “Are ‘mined’ proof-of-work cryptocurrency tokens gross income in the year received?” (January 30, 2020).  

For an in-depth treatment of block reward taxation, see: 

Abraham Sutherland, Cryptocurrency Economics and the Taxation of Block  Rewards, 165 Tax Notes 749 (Part 1; Nov. 4, 2019) and 165 Tax Notes 953  (Part 2; Nov. 11, 2019). The complete Tax Notes report is available at no charge  at ssrn.com/abstract=3466796. An introduction to the problem of block reward  taxation is available at CoinCenter.org/entry/taxing-cryptocurrency-block rewards.  

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