In light of Internal Revenue Service (IRS) Revenue Ruling 2023-14 (Ruling) that provides for the timing of income recognition upon receipt of staking rewards from a proof-of-stake (PoS) blockchain protocol, taxpayers should be aware of other considerations and scenarios that will require further analysis and professional guidance to determine taxable income from these activities.
In a PoS protocol, tokens are randomly selected to validate transactions on the blockchain protocol. If successful, the validator/node operator receives staking rewards in the form of the protocol’s native token.
IRS Revenue Ruling 2023-142:
The fair market value of the validation rewards received is included in the taxpayer’s gross income in the taxable year in which the taxpayer gains dominion and control over the validation rewards.
Before the Ruling, certain taxpayers receiving staking rewards argued for its deferred gain recognition until the time of sale. While the Ruling only references cash-method taxpayers and simplifies a PoS transaction, it does lay the groundwork for the timing of income recognition on future receipt of staking rewards.
Timing of income recognition – In the Ruling, staking rewards are includable in the taxpayer’s (token holder) gross income when the taxpayer gains dominion and control over the staking rewards.
What this means: Taxpayers should consider the timely tax reporting of staking rewards received. Further analysis may be required to determine when the taxpayer gains dominion and control over the tokens. Staking rewards usually come with a multi-year lock-up period (i.e., vesting period) in which token holders are restricted from selling, trading or transferring the tokens. Other parameters set by the protocol may also affect the analysis of dominion and control, an issue the Ruling does not address.
Characterization and sourcing of income – The Ruling casts a wide net under Internal Revenue Code Section 61(a), defining gross income to mean all income from whatever source derived, including but not limited to compensation for services, income derived from business and gains from dealings in property.
What this means: A separate analysis will be required to determine the character of income for federal tax purposes (i.e., trade or business, investment, property, etc.). The character of income determines its source as domestic or foreign and, thereby, its taxability for U.S. purposes. Sourcing of staking rewards will depend not only on the character of the income for tax purposes, but also (depending on the specific facts) on the information available related to the native token’s node operator locations and whether they are domestic- or foreign-based (hosted outside of the U.S.).
In situations where token holders receive staking rewards sourced to offshore validator nodes used to perform staking services, such taxpayers may need to consider foreign-sourced income tax reporting requirements. Likewise, foreign token holders receiving U.S.-sourced staking rewards may be subject to foreign withholding tax requirements at varying rates dependent on whether the income is considered effectively connected income (trade or business) or fixed, determinable, annual or periodic (FDAP) income.
However, sourcing could get more complicated if there is a side service agreement between the token holder and an outsourced validator node operator(s). Service agreements usually incur a transaction fee between the sender (token holder) and the validator. In the absence of any transaction fee, any compensation received in the form of staked tokens considered as property may possibly be construed as rental or royalty income. Different types of staking scenarios require further, in-depth analysis.
Value of staking income – In the Ruling, the fair market value is determined as of the date and time the taxpayer gains dominion and control over the validation rewards.
What this means: The fair market value of the staking rewards will be based on its property value. The IRS treatment of virtual currency/digital assets as property remains unchanged since IRS Notice 2014-21, and general tax principles applicable to property transactions apply to virtual currency transactions. Assessing the property value of the tokens at the time the taxpayer gains dominion and control requires an analysis of the facts and circumstances and whether there is readily available market data.
Digital asset reporting considerations
For individuals, staking rewards will need to be reported under the revised sections on Form 1040 concerning digital assets under IR-2023-12: “At any time during the year, did you: (a) receive (as a reward, award or payment for property or services); or (b) sell, exchange, gift or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”
The Department of Treasury and the IRS-proposed regulations require brokers to report sales and exchanges of digital assets by customers on a new Form 1099-DA, IR-2023-153. Under the proposed regulations, brokers are mandated to commence reporting information on sales and exchanges of digital assets in the year 2026, covering transactions from the year 2025. These rules would apply to digital asset trading platforms, digital asset payment processors and certain digital asset hosted wallet providers. Additionally, staking rewards received through a custodied account on a cryptocurrency exchange platform may fall into this reporting guideline.
U.S.-based crypto companies or digital asset fund managers distributing staking rewards to foreign investors or partners will need to determine foreign withholding tax obligations and reporting requirements. Staking rewards and digital asset transactions with international tax relevance are subject to Schedules K-2 and K-3 reporting.
The Ruling is unlikely to deter future blockchain protocols from offering staking rewards and/or token holders from participating in the validation process. There are opportunities for tax planning to structure staking arrangements and establish best practices for digital asset reporting. BPM can assist with getting your blockchain and digital assets company up to speed with current and proposed reporting obligations.
BPM has served as advisors to investors and other stakeholders in digital assets for nearly ten years. Our Blockchain and Digital Asset Industry Group is a leading provider of Assurance, Advisory and Tax services in the industry.
BPM is here to help with all services relevant to investors and companies involved with blockchain and digital platforms and assets, including the following: Global Tax Structuring and Transfer Pricing; Financial Statement Audits; Valuations; R&D Tax Credits and Incentives; IT Security Services (ISO Advisory, IT Security, IT Security and Compliance, Security Operations Center); and Cryptocurrency and Token Technical Accounting, Tax and Reporting, among others. Contact us today.