Cryptocurrency Rewards Included in Income When Taxpayer Gains Dominion and Control Over Rewards

At a glance

• IRS Guidance on Crypto Taxation: The IRS issued Rev. Rul. 2023-14, offering guidance on taxing rewards from staking native-to-blockchain cryptocurrencies for cash-method taxpayers.
• Inclusion of Rewards in Gross Income: Fair market value of staking rewards must be included in taxpayers’ gross income when they gain dominion and control over the rewards.
• Complexities and Gaps Remain: The ruling lacks coverage of complex staking scenarios, partnership implications, and certain taxation aspects, requiring careful consideration and professional advice for full compliance.

Aprio offers expert advisory and tax planning assistance with crypto and digital assets. Contact our team today to start a conversation.

The full story:

The Internal Revenue Service (the “IRS”) has issued an advanced version of Rev. Rul. 2023-14, offering important general guidance on the tax treatment of cryptocurrency for cash-method taxpayers. According to the ruling, if a cash-method taxpayer stakes a cryptocurrency that is native to a proof-of-stake blockchain, and as a result of the validation process, they receive additional units of cryptocurrency as rewards, the fair market value of these rewards must be included in the taxpayer’s gross income. This inclusion applies to the tax year when the taxpayer gains full control and ownership (dominion and control) over the rewards.

The ruling specifies that the fair market value of rewards received should be assessed based on the date and time at which the taxpayer gains dominion and control over these rewards.

Dissecting the Revenue Ruling

While this new revenue ruling offers general guidance primarily focused on simple staking transactions, the Ruling leaves certain types of transactions without guidance. Notably, it does not cover the taxation of taxpayers who use the overall accrual method of accounting. Additionally, the Ruling does not account for other types of staking, including more complex transactions.

Specific areas that remain unclear include situations where taxpayers lack dominion or control over the assets but still carry the risk of loss or might be in constructive receipt of income during staking activities. The treatment of staking pools for tax purposes, which could potentially be construed as partnerships for U.S. income tax purposes, is also not covered in the Ruling.

Moreover, complex transactions involving staking derivatives, collateralized and non-collateralized lending, and those involving multiple parties in U.S. and foreign jurisdictions are not addressed, leaving taxpayers uncertain about their tax obligations. Furthermore, the Revenue Ruling does not delve into the sourcing (U.S. or foreign source) or the characterization of income (passive, investment, trade, service, or intangible property income) associated with these various staking activities.

Aprio is here to help you manage through these gaps. We have assisted clients on blockchain tax matters for more than 10 years; we can help you properly navigate the intricate tax landscape and ensure compliance with relevant tax laws and regulations.

Taxpayer Reliance on Treasury Guidance

Revenue rulings are official IRS interpretations of the Internal Revenue Code and are authoritative interpretations issued by the IRS concerning tax laws, regulations, treaties, and statutes as they apply to specific factual situations. These rulings provide taxpayers with some clarity and direction when navigating their tax obligations. However, it is important to recognize that revenue rulings do not have the same authority level as U.S. Treasury Regulations.

Nonetheless, taxpayers can rely on revenue rulings as a valuable reference when their own factual circumstances align closely with those addressed in a specific ruling. Generally, such reliance fosters consistency and informed decision-making in tax matters. Nevertheless, taxpayers should remain vigilant, as later sub-regulatory guidance may supersede or modify the application of a revenue ruling.

International and Other Tax Considerations

Establishing the source of income assumes critical importance when dealing with staking activities. If staking income is determined to originate within the United States, the nature of the income assumes significant relevance for tax purposes.

If your company or Fund is remitting rewards to non-U.S. investors, these payments may be considered staking and you should be aware that the distribution of passive investment income to foreign persons, such as income, if not effectively connected income (ECI), may be considered fixed, determinable, annual or periodic (FDAP) income and subject to gross basis withholding at 30% (or lower by treaty). While direct guidance on this matter is presently unavailable, the periodicity of rewards payments may share resemblances with known FDAP items.

Further, if income distributed to foreign individuals is ECI, it may be subject to withholding at the highest applicable rate based on the recipient’s U.S. tax classification (e.g., 37% for individuals and 21% for corporations). For example, if a fund were considered to have a “U.S. trade or business” and such income was effectively connected with the conduct of that business, there would be such an occurrence.

Regarding U.S. individuals, diverse tax considerations may surface, particularly for trade or business income. Income disbursed to tax-exempt entities could potentially be categorized as unrelated business taxable income (UBTI).

Lastly, prudent attention must be given to the state taxation, including certain types of activities that may give rise to sales tax obligation or other taxes.

Proof of Stake

Proof of Stake (“PoS”) is a consensus mechanism in blockchain and cryptocurrency that validates transactions. Unlike Proof of Work (“PoW”), PoS does not require users to consume high energy through computing power. Instead, users stake their cryptocurrencies to gain the right to validate new blocks of transactions and add them to the blockchain.

The forger’s role within the network is to validate transactions and generate new blocks. This process, referred to as “forging,” is a fundamental aspect of the PoS system. In PoS, the likelihood of being chosen as the validator to forge the next block increases with the size of one’s stake in the network. Thus, participants with higher stakes have greater opportunities to become the next block forger.

PoS proves that the number of cryptocurrencies staked entitles users to earn staking rewards. This process of staking ensures the security and operation of the blockchain network.

Different Types of Staking

Staking refers to holding specific cryptocurrencies for a designated period to receive rewards. These rewards incentivize users to actively participate in or support blockchain activities.

The reward amount is determined by two key factors: the number of coins staked and the duration of the staking period. The beauty of staking is that it allows your cryptocurrency holdings to generate passive income without the need to sell them.

Staking in crypto currency involves three primary types:

• Hard or Validator Staking: Users lock cryptocurrency as collateral to actively validate transactions and create blocks. It offers higher rewards but carries higher risk due to constant online involvement.
• Soft or Liquid Staking: Users delegate their staking power to a third-party service, retaining liquidity and flexibility for their coins. It offers convenience and lower risk with slight reductions in rewards due to service fees.
• Cold or Offline Staking: Users keep their staking wallets offline using hardware wallets or offline devices, ensuring security against hacking attempts. It results in lower rewards but provides enhanced protection from potential threats.

Each type of staking presents distinct benefits and considerations, allowing users to choose based on their preferences and risk tolerance. A few staking transactions do not fall into the categories above and will require separate analysis (facts and circumstances).

Staking Risks

Staking in cryptocurrency does come with certain risks that users should be aware of before participating in staking activities. Some of the key risks associated with staking include:

1. Market Price Volatility: The value of the cryptocurrency being staked can fluctuate significantly. If the price drops during the staking period, the rewards earned upon unstacking may be worth less in terms of fiat currency or purchasing power, resulting in potential losses.
2. Slashing: In some proof-of-stake (PoS) blockchains, validators or stakers can face penalties, known as slashing, for malicious behavior or failing to follow the network’s rules. Slashing can lead to a loss of a portion or even the entire staked amount, impacting the user’s investment.
3. Smart Contract Risks: Some staking systems rely on smart contracts, which can be vulnerable to bugs or exploits. Staked funds could be at risk if a smart contract is flawed or attacked.
4. Network Security Concerns: PoS blockchains are reliant on a sufficient number of validators to maintain network security. If many validators act maliciously or go offline, it can weaken the network’s security and potentially affect rewards.
5. Staking Platform Risks: Users are exposed to platform-specific risks when participating in staking through third-party platforms or staking pools. These risks may include technical issues, operational failures, or even potential fraud.
6. Lock-Up Periods: Staking often involves a lock-up period during which users cannot access their staked funds. If a user needs immediate access to their cryptocurrency for unexpected expenses or investment opportunities, this lock-up period could be a disadvantage.
7. Regulatory and Tax Risks: The regulatory landscape for cryptocurrencies and staking is evolving. Users may face tax implications and regulatory compliance uncertainties, impacting their overall returns.
8. Unsuccessful Transactions: Over the course of several years, the staking platform designs led to various instances where certain users encountered issues with receiving their rewards. Some users did not receive their rewards as expected, while others received incorrect allocations of rewards.
9. Custodial Concerns: Following the collapse of FTX, it has become imperative to conduct additional due diligence to ensure the safety and security of the digital assets being held in custody during the staking process, which could impact both the principal and the awards.
10. Security Risks: Staking platforms and exchanges will face vulnerabilities that can potentially be exploited by hackers. The industry continues to grapple with the challenge of addressing and fortifying against potential hacks and exploits.

To mitigate these risks, investors engaged in staking or other related activities should conduct thorough research before engaging in any activities, choose reputable staking platforms or validators, diversify their staked assets, and consider their risk tolerance carefully, including potential significant market volatility that could result in compliance, regulatory and tax risks. Additionally, keeping track of the latest developments in the digital assets market and understanding the specific staking mechanics of each blockchain network is essential to make informed decisions and minimize potential losses and risks.

A final word

The staking activity in the digital assets space has attracted considerable attention from U.S. regulators, prompting significant regulatory scrutiny. In particular, several crypto exchanges (i.e., Kraken and others) are currently under SEC regulatory action due to their involvement in offering and selling crypto assets through unregistered staking-as-a-service programs.

Consequently, numerous U.S. investors are actively exploring alternatives to stake their cryptocurrencies outside the United States or in other jurisdictions. However, these strategies require meticulous tax planning, necessitating the assistance of seasoned securities counsel familiar with the U.S. and foreign regulatory landscapes. Such experienced professionals can help navigate the complexities and ensure compliance with relevant regulations and tax implications.

If you need help with audit, advisory or taxation services related to your crypto or other digital assets, connect with Aprio today. Our blockchain and crypto accounting team prepares clients for the new 1099 and 8300 tax reporting regulations, and simplifies anti-money laundering (AML) and information security compliance.

Let’s talk.

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