One of the many joys of working in web3 is the enthusiasm of young professionals, looking to learn what they need to learn to dive into this exciting and developing space. In that vein, I have the opportunity this summer to work with Mark August (a current JD candidate at the University of Denver - Sturm College of Law), as an extern with BSL Group, where he is working to support our clients by, among other things, researching emerging regulatory regimes, including the subject of this post - the approch BigTech is taking to broach the ever-shifting regulatory regime surrounding web3 projects and cryptocurrencies.
So, without further ado, I give you Mark:
"26 CFR 1.61-1: Gross income" (Rev. Rul. 2023-14) (the “Rev. Rul.”) discusses the tax implications of rewards received from staking cryptocurrency native to a proof-of-stake blockchain, specifically whether a taxpayer using a cash method of accounting must include the value of validation rewards in gross income and, if so, in which taxable year.
Digital assets as defined for the purposes of information reporting by brokers as any digital representation of value recorded on a cryptographically secured distributed ledger or similar technology. Digital assets include, but are not limited to, what the Department of the Treasury and the Internal Revenue Service have previously referred to as “convertible virtual currency and cryptocurrency.”
The Rev. Rul. highlights Section 6045(g)(3)(D) of the Internal Revenue Code and references previous rulings and notices, including Notice 2014-21, which defines convertible virtual currency as virtual currency with equivalent value in real currency or as a substitute for real currency. Notice 2014-21 also clarifies that convertible virtual currency is treated as property, and general tax principles applicable to property transactions apply to convertible virtual currency.
So, what does it say?
According to the Rev. Rul., for a cash-method taxpayer, the fair market value of the validation rewards is included in gross income in the taxable year when the taxpayer gains dominion and control over the rewards. The implication is that the timing of income inclusion for proof-of-stake validation rewards depends on when the taxpayer gains dominion and control, not when the rewards are generated through staking and validating. This provides clarity for taxpayers on the proper tax treatment of these rewards. The ruling also implies that general tax principles applicable to property transactions apply to cryptocurrency validation rewards. The fair market value is included as ordinary income when dominion and control arise.
Discussion & Analysis
The Rev. Rul. acknowledges cryptocurrencies as digital assets and classifies them as property, aligning with Notice 2014-21. This classification means that cryptocurrencies are subject to capital gains and losses, which could lead to different tax liabilities compared to treating them as currency. The core issue revolves around whether rewards received from staking cryptocurrency, a process in proof-of-stake blockchains, should be included in gross income. If considered part of gross income, these rewards would be subject to income tax, requiring taxpayers to accurately report and value these rewards. Determining the taxable year for such rewards might involve complexities, given the fluctuating value of cryptocurrency. Accurate timing and valuation would be essential. The document also implies an alignment with regulations governing information reporting by brokers, connected to Section 6045(g)(3)(D) of the Internal Revenue Code. This connection suggests that brokers and exchanges dealing in cryptocurrency might be subject to similar reporting requirements as traditional securities, increasing the regulatory compliance burden. The ruling's broader implications include serving as a legal precedent for future cases involving cryptocurrency and contributing to greater regulatory clarity. This clarity can foster growth and innovation in the cryptocurrency space while ensuring legal compliance. However, it may also pose challenges in terms of compliance, valuation, and reporting. Stakeholders, including taxpayers, brokers, and legal professionals, will need to navigate these complexities to ensure adherence to the law, thereby integrating cryptocurrency into the existing legal and tax framework.
Conclusion
While the ruling addresses timing for cash-method taxpayers, it leaves open questions about how accrual method taxpayers should account for validation rewards. The vast majority of companies utilize the accrual method, making the Reg. Rul. much less helpful than it might have been, and in fact may be stirring up more confusion and, as the crypto world would say, “FUD” than is really necessary. Further, the Rev. Rul fails to address other potential issues such as whether rewards could be considered compensation income or self-employment income, given certain facts and circumstances. That said, we do seemt to be able to glean some baseline principle regarding timing of income inclusion.
What kind of lawyer would I be without a disclaimer?
Everything I post here constitutes my own thoughts, should only be used for informational purposes, and does not constitute legal advice or establish a client-attorney relationship (though I am happy to discuss if there is something I can help you with). I can be reached via email at dlopezkurtz@crokefairchild.com or david@bsl.group on telegram @davidlopezkurtz on twitter @lopezkurtz and on LinkedIn here.