Congress is currently working on comprehensive reforms to both the regulation and taxation of digital assets. Until now, both matters have been largely left to the interpretations of federal agencies, with the IRS issuing notices to address cryptocurrency taxation since 2014.
The novelty of the blockchain technology upon which digital asset transactions are settled cannot be overstated, and that is especially true for staking and mining. Staking, used in Proof-of-Stake blockchains, requires locking tokens into the blockchain in exchange for rewards that typically come in the form of newly formed additional cryptocurrency. Mining, used in Proof-of-Work blockchains, also yields newly formed additional cryptocurrency but through a process that involves solving complex cryptographic problems.
Despite plenty of cryptocurrency tax proposals in circulation, legislators have been unable to come to a bipartisan agreement around when these rewards should be taxed. Policymakers are right to question whether taxation of staking and mining should look more like self-created property, which is taxable upon sale, or compensation, which is taxable upon receipt. The answer to this question will likely vary based on specific facts and circumstances of the underlying protocol and other factors, making hasty tax legislation difficult to defend.
There is no perfect analogy in current law where taxpayers receive assets of value by completing an action with a self-executing digital protocol without the approval from or payment by another individual. Even where another individual created the protocol, which is often the case for staking, that individual is not responsible for paying the taxpayer or determining the value of the asset received. It makes sense then that current law is inadequate to deal with this new technology, therefore Congress must step in.
Recent Tax Disputes
Two recent court cases demonstrate the complexity of staking and mining taxation. While some lawmakers may point to one recent case as a sign that rewards from such activity are taxable upon receipt, a better interpretation is that these decisions are case specific.
Most recently, the Tax Court issued a memorandum decision in Paschall v. Commissioner on June 4 declaring that the taxpayer’s staking rewards were taxable. This type of decision is often reserved for fact-driven cases. The Court came to its conclusion without expert testimony, relying on the facts provided by a self-represented taxpayer, as well as case law outside of cryptocurrency.
The case clearly exemplifies the dilemma of determining who is ultimately responsible for the creation and distribution of the rewards, which would help to categorize them as either self-created property or compensation. In disputing treating the rewards as dividends, the court claims “token holders did not automatically receive staking rewards in proportion to their ownership. They had to stake their tokens and risk potential forfeiture.” Yet it also claims, “[P]etitioners were not owners or operators of a staking pool; unlike the baker or writer, they lacked the power to decide whether (and when) the property was created.”
Another case, Jarrett v. United States, came to a much more opaque result. In 2022, the IRS provided a refund to the Jarretts for taxes paid on staking rewards after they argued that their rewards were not taxable income, therefore causing the case to be dropped. But the IRS did not provide further instruction as to whether the future rewards are taxable. A refiled case by the Jarretts is currently pending in the U.S. District Court for the Middle District of Tennessee.
Why Tax Policy Matters
The nuances of these cases demonstrate the importance of balancing longstanding tax policy principles with recognition in law that this technology creates transactions that are different from those the tax code is used to dealing with.
In its markup of the Digital Asset Tax Certainty Act (H.R. 10357), the House Committee on Ways and Means decided to remove a compromise provision that would delay taxation of staking and mining rewards by five years after their receipt. This proposal would have produced a more fair outcome than the status quo for taxpayers engaging in activity that does resemble self-created property. However, it is sensible for Congress to take more time to develop a framework that outlines specific facts and circumstances of staking or mining protocols to determine the taxability of those rewards.
Digital assets often have highly volatile prices. Furthermore, they are not currently usable as cash equivalents. While they can be readily exchanged for cash via a third-party exchange, their volatility often makes it unrealistic to expect staking and mining rewards to have similar value on the next Tax Day as they did when they were received. Delaying taxation of newly formed additional cryptocurrency (staking and mining rewards) until their disposition is a commonsense way to avoid cash-flow and valuation problems. It also aligns with the principle that taxpayers should not owe tax on an asset until they have actually realized its value.
Since Congress is choosing to delay legislative intervention to resolve uncertainty around staking and mining, taxpayers will need to continue to rely on IRS guidance that declares nearly all such assets as taxable at the time the taxpayer obtains dominion and control. Yet this does not change the complex dynamics at hand, nor the nuances of this novel technology.
Even if other cryptocurrency tax proposals are signed into law this year, Congress must continue to work in bipartisan fashion to define the taxability of staking and mining rewards. IRS guidance does not represent the intent of Congress nor the best interest of taxpayers, as demonstrated by Congress’s recent overturning of overly burdensome cryptocurrency tax guidance. Staking and mining may be taking a sidestep for now, but the issue is far from resolved.