Digital Asset Staking: Your Top Tax Questions, Answered
February 14, 2022
At a glance
- The main takeaway: A U.S. District Court case out of Tennessee calls into question the taxability of staking rewards — specifically, whether those rewards generate taxable income.
- Impact on your business: Taxpayers who engage in staking, mining or similar activities currently operate in a tax “limbo,” but that may change with the development of this case.
- Next steps: If you are involved in staking or mining, you may need to consider your potential tax exposure, liability and reporting obligations. An Aprio advisor can help you assess your position.
The full story:
As its name implies, the United States Internal Revenue Code sets forth rules for how income is taxed in the U.S. Income is defined as “revenue received for goods or services, or from other sources, as rents or investments” or “the money, or amount of money, received from one’s employment.” A recent complaint submitted to the U.S. District Court, Middle District of Tennessee, Nashville Division, seeks to confirm that only income is subject to income tax.
In 2019, a Tennessee taxpayer was engaged in a staking enterprise, whereby he utilized his existing cryptocurrency tokens and computing power to create a new block in the Tezos public blockchain. Specifically, the taxpayer utilized his own staking nodes and in the process, created inflationary illiquid staking rewards. Staking is a process by which anyone with existing tokens of a particular cryptocurrency can validate transactions on the public blockchain that use that cryptocurrency. This validation process creates new blocks on the blockchain and the participants who contribute to the process receive additional tokens.
It is important to note that these additional tokens are not wages paid by an employer; rather, the way they work is similar to a farmer who plants seeds that grow into crops or an artist who paints a painting. While the farmer or the artist can sell their crops or painting to generate income, it is well-established that the mere creation of property is not taxable under the Internal Revenue Code.
A development in the U.S. District Court case has raised questions
In early February 2022, the IRS would refund the taxes paid by the taxpayer for the income included based on the value of the tokens created in the staking enterprise. This seemingly sets a precedent that the IRS will not consider tokens generated from staking as income.
However, the issue is far from settled. The mere granting of the refund does not provide taxpayers with reliable, long-term comfort on the matter. In fact, the instructions for Form 1040 consider receipt of new virtual currency as a result of mining and staking activities” as income. Based on the progression of this case, the instructions for this activity are at odds with the recent decision of granting the refund. We may need further guidance from the IRS in order to set a lasting precedent that all taxpayers can rely upon sincethere are many different types of staking enterprises and the tax implications might vary from one form to another.
In a prior article, we explored the taxation of virtual currency airdrops for microtasking, which has been determined as taxable by the IRS. That determination appeared to be in line with existing tax principles, as users were compensated for completing small tasks with virtual currency. For more information, be sure to check out Questions 9 and 10 in the IRS’s FAQs about virtual currency, linked here. This treatment is vastly different from tokens received from a staking enterprise, which should not be considered as income.
One approach might be that a digital asset mining company will be considered more like a manufacturer for income tax purposes. The costs of mining — including electricity, rent, labor costs and depreciation of equipment — might all go into a category for raw materials of inventory; the output would be the creation of certain inventory, such as Bitcoin or Eth. The digital assets are considered finished goods, available for sale. When the digital asset is sold, there is a specified sales price, and the cost of goods sold is determined using cost accounting rules for all the costs it took to create the asset.
The bottom line
If you regularly engage in mining, staking or similar activities, you may need to consider your potential tax exposure, liability and reporting obligations. The IRS doesn’t make this a simple process, so consider working with a knowledgeable Aprio advisor to assess your position.
Aprio has been a pioneer in the intersection of virtual currency and tax liabilities since 2013, and we constantly monitor the IRS for new guidance and information.
Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding this matter.
About the Author
Mitchell is the partner-in-charge of Aprio’s Tax practice as well as the Technology & Biosciences group. He has been a partner since 1990 with Aprio, which is the largest Georgia-based tax, accounting and consulting firm. Mitchell works with companies in the software, gaming, clean tech, financial technology (FinTech), health care IT, processing, biosciences (biotech and medical device) and manufacturing industries. Whether a company is pre-revenue, starting up, growing or preparing for a liquidity event, Mitchell works with them to maximize their potential at each stage. He is known for promoting research, innovation and entrepreneurship by enabling companies to be successful, regardless of where they are in their business lifecycle.