The IRS recently released Revenue Ruling 2023-14, which describes the agency’s position regarding the tax treatment of a cash-basis taxpayer who receives “rewards” from staking cryptocurrency. According to the IRS, taxpayers must report the rewards as part of their gross income under IRC Sec. 61 in the year in which they gain the ability to exchange, sell or transfer the rewards.
Defining Crypto Staking
Rev. Rul. 2023-14 describes proof-of-stake (“staking”) as the process by which the person holding a cryptocurrency participates in a proof-of-stake blockchain’s consensus process by essentially agreeing to temporarily give up their right to sell, transfer or exchange all or part of a particular kind of cryptocurrency for a set period.
Once their assets are staked, they use software to propose and validate new blocks. In exchange, the validator will receive “rewards” - usually newly created units (or fractions of a unit) of the cryptocurrency they staked.
Validation safeguards the integrity of the blockchain by checking the validity of new entries in the ledger. The validator does not receive rewards unless the validation is successful.
To deter malicious behavior, proof-of-stake blockchains often implement “slashing,” which penalizes the validator by taking some or all of their staked tokens if they propose erroneous blocks or if they are not actively participating. The ruling does not discuss the tax ramifications when units are slashed.
Staking Through Cryptocurrency Exchanges
The new ruling also observes that persons may stake their holdings through a cryptocurrency exchange. Although the ruling does not provide any more details regarding staking through a cryptocurrency exchange, in this type of staking it is possible that the taxpayer would not transact directly with the blockchain.
Staking through a cryptocurrency exchange may occur, for example, if a taxpayer does not have (or does not wish to commit) the minimum number of tokens that is required to transact directly with the blockchain or if they do not wish to operate the validation software. A cryptocurrency exchange may aggregate tokens received from numerous customers and itself directly transact with the blockchain as a form of delegated staking. When the cryptocurrency exchange receives the rewards, it may transfer some of them to the customers and keep a portion for itself as a fee.
How to Report Crypto Staking
Under Rev. Rul. 2023-14, the IRS takes the position that a cash-basis taxpayer who stakes their cryptocurrency, including staking through a cryptocurrency exchange, must report the rewards in their gross income in the year in which they gain “dominion and control” over the rewards. The amount included in gross income is the fair market value (“FMV”) of the rewards at the time the taxpayer gains dominion and control over the rewards.
The ruling does not define how to determine the FMV other than “as of the date and time” the taxpayer gains dominion and control over the rewards, nor does it discuss how to determine when full control was obtained. However, the IRS previously stated in Notice 2014-21 that“[i]f a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars… at the exchange rate.”
The IRS FAQs on Virtual Currency also state that the IRS will accept “as evidence of fair market value the value as determined by a cryptocurrency or blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates the value of the cryptocurrency at an exact date and time.”
Prior to Rev. Rul. 2023-14, the issue of how and when to report staking rewards was arguably murky. Beginning in 2021, the Form 1040 instructions clarified that staking was considered a transaction with a digital asset, but there was no further mention of how or whether to report the value of the rewards received. Some cryptocurrency exchanges took the position that rewards were included in income and instructed users to report it as “Other Income” on their Forms 1040. Others took the position that until the rewards were sold, there was no income to report. A recent Sixth Circuit decision involving staking rewards declined to weigh in on the issue regarding when they should be included in income, making it likely that this issue will make its way back before the courts.
While a revenue ruling is not binding on taxpayers, contrary positions should be disclosed on Form 8275. The treatment of digital assets such as cryptocurrency is still an emerging area for tax law, and, despite being around since 2009, there has overall been little concrete guidance on the nuances of cryptocurrency from government agencies.
While it can be a lucrative pursuit for some, there are also significant risks and potential tax ramifications. As the IRS continues to issue guidance, taxpayers should be sure to engage a trusted advisor to stay compliant with the newest guidelines.