Recent trends in the cryptocurrency marketplace have indicated an increased interest in activities connected with Proof of Stake (PoS) cryptocurrencies, whether used with the intent of receiving regular income from PoS rewards or engaging in other income generating activities in a decentralized finance (DeFi) ecosystem. While each way of generating income through DeFi has nuances, today we will take a closer look at PoS rewards — particularly staking and minting and the related tax considerations for each.
1. What is Staking and Minting?
In general, a PoS blockchain relies on a system of consensus among its users to maintain the reliability and security of the network. Such a system works best when many users each commit enough resources such that responsibility for integrity is widely distributed and no one party has too much individual clout. A PoS blockchain, accordingly, provides users incentive opportunities to participate in the process of securing the blockchain. The processes involved are frequently referred to as staking and minting.
Staking is the more common activity of the two because it generally requires less cryptocurrency to participate. A person participating in staking agrees to lock up cryptocurrency in a specific wallet for a period of time. Doing so generates rewards for the participant by assisting to secure the network with committed cryptocurrency.
Minting is the process of validating transactions and updating the blockchain. Typically, blockchains will require a higher amount of cryptocurrency to be staked to allow participation in minting, but the rewards available for validating may also be greater. Additionally, some participants may use a process called delegating where they provide cryptocurrency to another party engaged in minting in exchange for a portion of the rewards. Delegating allows for participants to generate an income stream without directly operating a node. These activities may be collectively referred to as staking in some publications, but it is important to note the difference between the two, as it may be impactful to how the income is properly treated.
Unfortunately, the current level of tax guidance with respect to these transactions does not match their popularity. As such, there are a few important considerations with respect to PoS activities that taxpayers should consider in consultation with a tax advisor.
2. When is Staking or Minting Income Considered to be Earned?
Staking and minting income tends to result in income streams that happen with readily determinable regularity. Generally, the rewards from these activities should be included in income as received. Absent the availability of an accurate Form 1099 from an exchange or a custodian, the amount of income to recognize would be based on a taxpayer’s best reasonable estimate available for the fair market value of the reward upon receipt.
Methodologies for estimating fair market value could include using:
- An average value from the exchanges on which a cryptocurrency is traded,
- Available information from an aggregator like CoinMarketCap, or
- Another public source.
In general, whichever methodology is used should be similar across all similar transactions.
One challenge to be mindful of is if a reward other than the one being staked and/or minted is paid in a cryptocurrency. This can be especially problematic if the cryptocurrency being received does not have a robust circulation. In these cases, reward recipients may be unable to ascertain the fair market value of the reward immediately upon receipt, and may have to use a reasonable estimate or one established after the transaction has closed once circulation of the rewarded cryptocurrency increases.
Additionally, the timing of income recognition may not always adhere to the general rule. Rev. Ruling 2019-24, which pertains to hard forks and airdrops, provides that a recipient of airdropped cryptocurrency must have “dominion and control” over that cryptocurrency to have earned it for purposes of determining income. Under this view, taxable income is not generated until a newly received cryptocurrency is accessible by its owner and able to be exchanged. Thus, if any rewards received are subject to a lock-up or other restriction, it may be possible to defer income recognition until the restriction lapses. While receiving rewards from staking or minting is not perfectly analogous to receiving the rights to a cryptocurrency split from a hard fork, this is presently the most relevant guidance available.
3. What Tax Character Does Staking or Minting Income Take?
The tax character of income received in staking or minting is presently understood to be ordinary income. The IRS has not yet issued definitive guidance in this regard, but the presentation of Notice 2014-21 suggests that proof of work mining, which is the closest similar transaction to have any suggested treatment, is taxed as ordinary income. Beyond that, staking or minting straddles the line between two forms of ordinary income. The periodic payment of rewards for the use of cryptocurrency makes the activity like passively generated income. However, it can also be argued that, because participating in these activities provides a service to the decentralized blockchain network, the income should be regarded as trade or business in nature akin to other income received for services.
At present, it is believed that minting, due to the validation component, is trade or business income while staking income is passive investment income. While, again, no formal guidance currently exists, this appears to be the treatment of these income sources most consistent with existing tax law. The allure of minting is receiving the extra bonuses associated with validation, and the allure of staking is a passive income stream. Thus, PoS participants running masternodes or otherwise engaging in more than a de minimis amount of minting should consider themselves in a trade or business.
Read about Revenue Ruling 2019-24 in “IRS Releases Anticipated Cryptocurrency Tax Guidance”
4. How is Staking or Minting Income Sourced?
Unlike many classes of assets, cryptocurrency does not have an attachment to a particular jurisdiction due to its decentralized nature. However, a great deal of taxation has a basis in where an item of income is sourced. As such, some mechanism must be used to establish a source for cryptocurrency income. Currently, the two most logical approaches, pending further guidance, are to source the income to the domicile of the participant or to the location of the cryptocurrency exchange. The New York State Bar Association suggests that the most appropriate choice would be whichever of the two is the residence of the private key holder.
5. What Issues are Created by Character and Source of Income?
First, a source for the income should be established. If the source of staking income is deemed to be U.S., then the character of the income is likely to be vitally important.
If a U.S. person is engaged in staking and distributing any passive investment staking income to foreign persons, this income may be taxed as fixed, determinable, annual or periodic (FDAP) income for U.S. tax purposes. Though no direct guidance is presently available, the regularity of the rewards payments is like that of known FDAP items.
If a U.S. person is engaged in minting, several tax issues may arise that are associated with trade or business income. Such income distributed to tax-exempt entities is likely to be unrelated business taxable income (UBTI). Income distributed to foreign persons is likely to be effectively connected income (ECI) and subject to withholding at the appropriate rate based on the classification of the recipient. Lastly, U.S. persons operating a minting operation in the U.S. may have state tax issues to contend with depending on where the masternode computer is situated.
Due to the current understanding on sourcing of income, it may be possible for U.S. persons interested in staking and minting rewards to contract a third party, typically offshore, to engage in the activities on behalf of the U.S. persons. This approach is typically referred to as outsourced staking and it may help mitigate some of the tax issues described earlier.
The tax environment for staking and minting in a DeFi world is complex due to the overall uncertainty in the space and the unique characteristics of these activities as outlined by the above questions. It is important to emphasize the dearth of direct guidance from the IRS does not eliminate a taxpayer’s responsibility to report on and pay taxes on income from all sources derived.
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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.