Aug 5 / Phil Gaudiano, CPA

Understanding the Tax Implications of Cryptocurrency Staking: Revenue Ruling 2023-14

Cryptocurrency, specifically its staking mechanisms and its tax consequences continues to be a hot topic. We’ve previously discussed the topic here. Recently released Revenue Ruling 2023-14 clarifies some previously ambiguous areas, especially in the realm of staking rewards. This blog post aims to give a comprehensive view of the IRS's stance on the taxation of staking rewards, combined with insights from the most recent ruling.

What is Cryptocurrency and Staking?
Cryptocurrency, a digital asset, doesn't exist in physical form. It utilizes cryptography to ensure the digital security of transactions on a distributed ledger. These units are often referred to as coins or tokens. Many cryptocurrencies, such as Bitcoin, operate on a technology called blockchain.

Blockchain technology uses nodes (independent digital systems) to validate and record transactions. These nodes maintain the integrity of a blockchain. When a new block of transactions needs to be added to the chain, a consensus mechanism comes into play, and one such mechanism is the proof-of-stake.

In the proof-of-stake mechanism, individuals holding cryptocurrency can participate in validating transactions by staking (or locking up) their cryptocurrency holdings. If chosen by the protocol and validation is successful, these validators receive a reward, typically in the form of new cryptocurrency units.

The Tax Issue at Hand
The core question is: when a taxpayer using the cash method of accounting stakes cryptocurrency and receives staking rewards, when and how should this be treated for tax purposes?

Revenue Ruling 2023-14 – Finally, Some Clarification
In the described scenario, a taxpayer who owns 300 units of a particular cryptocurrency stakes 200 of these units. After successfully validating a new transaction block, the taxpayer receives 2 units as a reward. However, there's a catch. These reward units are locked briefly and only become transferable the following day.

The IRS ruled that this taxpayer must include the fair market value of these reward units in their gross income after they gain "dominion and control" over them, which is the day they become freely transferable. This ruling is consistent with prior guidance, notably Notice 2014-21, suggesting that cryptocurrency rewards from mining activities are taxable upon receipt.

The ruling contradicts the views held by some taxpayers and professionals who believe that staking rewards, particularly newly minted tokens, are self-created properties. They argue that these should only be taxable once they're involved in a taxable transaction. An interesting example is the Jarrett v. United States case. Before the court could deliberate on the matter, the IRS granted the taxpayer's refund request, preferring sub-regulatory guidance over court determinations.

Delving Deeper
According to Section 61(a) of the Internal Revenue Code, gross income is all income from any source. This encompasses gains from property transactions and services compensation. A key takeaway from this is that any undeniable accession to wealth, which the taxpayer has complete dominion over, mandates inclusion in gross income. This is true regardless of whether this income is in cash, services, or other property.

Cryptocurrency, when considered a convertible virtual currency, is treated as property for tax purposes. Therefore, general tax principles for property transactions also apply to crypto transactions. For instance, if someone receives cryptocurrency as a payment or mines it, they must include its fair market value in their gross income for the year when they have control over it.

In a nutshell, if you're a cash-method taxpayer staking cryptocurrency on a proof-of-stake blockchain, the fair market value of the validation rewards you receive needs to be included in your gross income for the taxable year you gain dominion and control over them. This Revenue Ruling offers some clarity but also highlights the complexities surrounding the evolving cryptocurrency landscape and its implications for taxpayers. As the digital asset ecosystem continues to grow, it's crucial to stay informed and seek expert advice when navigating these intricate tax scenarios.