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Taxation of Virtual Currency Staking Activities

Author: Andrea S. Kramer; McDermott, Will & Emory*

The discussion in this document reflects legal principles as of January 31, 2020.

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Taxpayers involved in proof of stake (PoS) validation (stakers) have no direct tax guidance as to  the tax treatment of their staking rewards, which makes it difficult for them to evaluate possible  tax positions as they prepare their federal and state tax returns. This means that taxpayers must adopt a tax methodology that they believe is supportable on audit, subject of course to judicial  review. This Memorandum discusses federal tax issues — as of the date of this Memorandum  — of income and expenses associated with virtual currency PoS staking activities.  

Virtual currencies are based on blockchains (digital ledgers) that, given the absence of a trusted  third party, require some type of consensus algorithm to achieve consensus among participants  (distributed consensus) as to the validity of groups of transactions (blocks). This validation  process is designed to assure that the next block of transactions added to the blockchain  represents the most current transaction, eliminating the possibility of double-spending coins,  tokens, or units. The two principal mechanisms for achieving distributed consensus are: PoS  and proof of work (PoW). Virtual currencies such as Tezos rely on PoS mechanisms. Virtual  currencies such as Bitcoin rely on PoW. Both PoS and PoW are subject to the terms of the  respective protocol in place for the particular transactions being verified or confirmed.For a discussion of PoW mining activities, see McDermott’s Memorandum, “Taxation of Virtual  Currency Mining Activities.” 

Virtual Currency Staking 

In PoS systems, stakers are chosen by combinations of random selection plus the amount of units  making up their stake and/or the amount of time they have agreed to lock up the stakes in a  specific digital wallet. Staked units support the blockchain operations. Unlike the mining  activities of PoW blockchains miners, stakers validate new blocks by forging on the next block  without mathematical computations. PoS protocols require stakers to hold and stake a minimum  number of units to participate in the validation process. As staking rewards, stakers receive a  specified number of units taken from other participants as transaction fees. These reward units often redistribute the ownership stakes away from computers (nodes) that don’t put up a stake to those nodes that put up stakes.  

When Are Staking Rewards Includable In Taxable Income? 

Before turning to the issues of when staking rewards are included in taxable income, it is useful  to consider what the IRS has said about mining fees in PoW blockchains. IRS Notice 2014-21  sets out the IRS’s position that miners receive taxable income when they receive mining fees.2  Notice 2014-21 is silent, however, about the taxation of staking activities. The Notice says that  miners’ fees are taxable at their fair market value as ordinary income as of the date they receive  

the units. The IRS also asserts that miners cannot wait to include the value of these units in  income until they subsequently purchase goods or services or otherwise convert these units into  U.S. dollars or another currency. According to the Notice, all Bitcoin miners—even small scale  miners that receive minimal fee income—must report their mining fees as ordinary income when  they receive them. 

Because the Notice does not address staking and there is no other governmental guidance,  stakers take a wide range of tax positions with respect to the taxation of staking rewards. Some  taxpayers take the position that staking rewards are sufficiently similar to payments received by  successful virtual currency miners, and that staking rewards should be taxed under the Notice  upon receipt.3 This tax position would need to take into account inflation payments that are  made to all stakers. 

Other taxpayers assert that their staking rewards are not taxable until they sell, exchange, or  otherwise dispose of the rewards. Some of these taxpayers argue that staking rewards are more  like the extraction of actual minerals where some taxpayers do no pay tax until they subsequently  dispose of the extracted minerals.4 Taxpayers seeking to rely on the tax treatment of oil and gas  transactions, however, need to be aware that oil and gas transactions are quite specialized,  “primarily because many of the basic concepts were the result of liberal administrative  interpretations of various sections of the Internal Revenue Code by the Treasury Department  during a period when the Congressional policy was to encourage the development and  production of oil and gas properties.”5 Obviously, there is no assurance that similarly favorable  policies and interpretations will ultimately be applied to virtual currency. 

Other taxpayers take the position that their staking rewards are not taxable at receipt because  their staking activities are similar to harvesting of agricultural products or the offspring of  livestock. They argue that staking rewards should not be taxable until disposed of.  

And yet other taxpayers assert that staking rewards are not taxable under I.R.C. § 61 because  their rewards (or at least some portion of the rewards) do not meet the definition of income,  which requires an “undeniable accession to wealth” that is “clearly realized” and to which the  taxpayer has complete dominion.”6  

There is no direct authority with respect to any of these tax positions, so taxpayers must proceed  with caution. 

Are Stakers In a Trade or Business? 

To deduct business expenses related to staking operations, stakers need to “be traders” (who seek  profits based on market fluctuations not from passively overseeing their virtual currency  investments) or “dealers” (who enter into virtual currency transactions with their customers in  the ordinary course of their business). Whether a staker’s activities rise to the level of a trade or  business boils down to two things: the volume of their transactions and their ability to establish  that these activities constitute an active trade or business.7  

If staking activities rise to the level of a trade or business, stakers can deduct appropriate trade or  business expenses.8 Deductible staking expenses include, for example, office rental and other  office expenses, salaries, computer equipment, software programs, Internet access fees, and  electricity. Deductible business expenses and depreciation reduce their taxable income. 

Those stakers who engage in staking activities for investment or as a hobby are not in a trade or  business. As a result, they do not have deductible business expenses.9 Limited itemized  deductions might be available for some investment expenses, but they don’t have business  expenses deductible against income.10  

Selling, Exchanging, or Disposing of Staking Rewards 

Without regard to whether stakers treat their rewards as taxable upon receipt or only at the time  when they sell their rewards, all stakers have a taxable event when they dispose of the units they  receive from successful staking operations.  

Staking Pools and Entity Considerations 

Stakers often join together with others to pool their units to increase their stake and to, thereby,  increase the likelihood that they will successfully validate blocks and receive staking rewards.  These business relationships are subject to a wide range of financial relationships. Stakers who  join with others, therefore, need to consider whether they will be treated as being in a partnership  or taxable association, and they need to consider the federal and state tax implications of their  entity selection. Stakers deemed to be in an entity are subject to the federal and state tax rules  and tax reporting requirements that apply to such an arrangement. 

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As with all taxpayers, stakers should carefully document their staking activities, staking rewards,  and related expenses to support their federal and state tax positions. Because stakers are in  totally unchartered tax waters, they need to work closely with their tax advisors to prepare their  federal and state tax returns. In addition, they need to keep in mind the fact that many states vary  from federal tax rules in computing state taxes. 

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* This material is for general information purposes only and should not be construed as legal advice or any other advice on  any specific facts or circumstances. No one should act or refrain from acting based upon any information herein without  seeking professional legal advice. McDermott Will & Emery makes no warranties, representations, or claims of any kind  concerning the content herein. McDermott and Andrea S. Kramer expressly disclaim all liability to any person in respect of  the consequences of anything done or not done in reliance upon the use of contents included herein. For a complete list of  McDermott entities, visit mwe.com/legalnotices.  

©2020 McDermott Will & Emery. All rights reserved. Any use of these materials including reproduction, modification,  distribution or republication, except as part of the Lukka Library is strictly prohibited without the prior written consent of  McDermott. This material may be considered attorney advertising. Prior results do not guarantee a similar outcome. 

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1 There are wide variations between and hybrids of PoW and PoS blockchains. 

2 Notice 2014-21, 2014-16 I.R.B. 938, Q&A 8. 

3 See McDermott’s Memorandum, “Taxation of Virtual Currency Mining Activities.” 

4 Taxpayers should consider Rev. Rule 77-176 and the oil and gas and mining industry responds with structuring tax  partnerships to minimize the current taxability of certain extraction operations. See Bitkker and Lokken, federal  Income taxation and Income, Estate and Gifts. 

5 BNA Tax Portfolio, Oil and Gas Transactions, No. 605, 2017, A-1. 

6 Commir v. Glenshaw Glass, 348 U.S. 426 (1955). 

7 Paoli v. Comm’r, 54 T.C.M. (CCH) 1574 (1988); Chen v. C.I.R., 87 T.C.M. (CCH) 1388 (2004). The phrase  “trade or business” is not defined in the Internal Revenue Code or Treasury Regulations. Whether mining activities  quality as a trade or business is a question of fact. Various factors are considered, with no one factor dispositive.  Elements of a trade or business include (1) activities that occupy “the time, attention and labor” of the taxpayer for  the purpose of “a livelihood or profit”; (2) the continuity and regularity of the taxpayer’s activities; and (3) a profit  motive. In Commissioner v. Groetzinger, the Supreme Court held that a professional gambler could be in a “trade or  business” if a gambler devotes his full-time activity to gambling and it is his intended livelihood source, his activity  should be regarded as a trade or business “just as any other readily accepted activity.” 480 U.S. 23 (1987).

8 I.R.C. § 162. 

9 See McDermott’s Memorandum, “Virtual Currency Losses Disallowed on Infrequent Activities.”

10 See Chapter 10 of Publication 334, Tax Guide for Small Business, for more information on self-employment tax  and Publication 535, Business Expenses, for more information on determining whether expenses are from a business  activity carried to make a profit.

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