Open blockchain networks have different ways of ensuring their shared ledgers are accurate. Many of these consensus mechanisms reward network members with new tokens in exchange for helping to maintain the ledger by validating new batches (or “blocks”) of ledger transactions. One increasingly popular consensus mechanism is “proof-of-stake.”
In a proof-of-stake-network, members “stake” their own tokens for the chance to validate a new block of transactions. The member’s odds of being chosen to validate a new block are proportional to the amount staked. Once a block is validated, the chosen member holds newly created tokens in addition to the originally staked tokens. (If the block is found to be invalid, or if the chosen member acts maliciously, the staked amount may be partially or fully forfeited.)
Applied to proof of stake networks, IRS guidance issued in 2014 to address mining rewards in Bitcoin would suggest that these new tokens should be immediately taxable as gross income. However, this tax treatment fails to account for the inflationary and dilutive effect of newly created tokens and the administrative nightmare of creating a taxable event every time new tokens come into existence — potentially hundreds of times everyday.
Current Tax Treatment Fails to Capture the Dilutive Effect of Staking Rewards
To illustrate this point, let’s examine the tax treatment of staking rewards in a hyper-simplified network.
To begin, let’s assume that the total value of the tokens in our example network remains constant regardless of how many tokens are issued as staking rewards. In addition, let’s assume that in exchange for staking each token for the year, the network’s protocol rewards you with one additional token as a staking reward. At the beginning of the year, you have 100 tokens valued at $1 dollar each. Your “token wealth” in USD is $100.
At regular intervals over the course of the year, you receive your staking rewards until, at the end of the year, you now own 200 tokens (100 initially staked and 100 rewarded). Since the network’s total value remains constant, however, your token wealth remains $100, and you now have 200 tokens valued at $0.50 each.
Now here’s the catch: The first token you receive as a staking reward has a fair market value of $1 and the last token you receive as a staking reward has a fair market value of $0.50. Over the full year, the fair market value of the reward tokens when they are received will average about $0.75.
Current guidance treats staking rewards as gross income when they are received. Thus, even though you are no better off at the end of the year (your token wealth remains $100), you must pay taxes on the 100 tokens you received as staking rewards valued at $0.75 each, i.e. $75 of gross income.
In our simplified example, it is evident that treating staking rewards as gross income fails to account for the dilutive effect of staking rewards on all the tokens in the network.
Of course, holding the total value of the network constant is unrealistic, but the effects described above remain true regardless of the token’s fair market value throughout the year. In other words, no matter the token’s price fluctuations, taxing staking rewards as gross income fails to account for the dilutive effect of the new tokens on all the tokens in the network.
Current Tax Treatment Fails to Accurately Account for the Redistributive Effect of Staking Rewards
To illustrate the redistributive effects of staking rewards, let’s examine a situation in which your staking efforts actually leave you better off, in real terms, at the end of the year. Remember, staking networks reward the individuals maintaining the network (through staking their tokens) by creating new tokens as an incentive. In a network in which some token holders stake and others do not, those who stake will end the year with more share of the total network relative to those who do not stake.
To begin, let’s again assume that the total value of our example network remains constant regardless of how many tokens are issued as staking rewards. In addition, let’s again assume that in exchange for staking each token for the year, the network’s protocol rewards you with one additional token as a staking reward. At the beginning of the year, you have 100 tokens valued at $1 dollar. Your “token wealth” in USD is $100.
This time, your friend also participates in the network and begins the year holding 100 tokens valued at $1 each. Unlike you, however, he does not stake his tokens throughout the year and will therefore not receive any staking rewards.
In sum, the network’s token supply at the beginning of the year is 200 and the network has a total dollar value of $200 (which will remain constant regardless of staking reward distributions).
Now, at the end of the year, you hold 200 tokens: your original 100 and 100 rewarded to you in exchange for your staking contribution. (Your friend still holds 100 tokens.)
Unlike the previous example, you do end the year holding new wealth because of your participation in staking validation. At the beginning of the year, you owned 50% of the total network (100/200), and now you own 67% of the network (200/300). In essence, a portion of your friend’s wealth has been transferred to you as a reward for your efforts to maintain the network.
In dollar terms, your tokens were worth $100 (50% of total network value), and now your tokens are worth $133.33 (67% of the total network value). Your true gain is $33.33.
However, the same issue arises if these rewards are taxed as gross income: In this example, the first token you receive as a staking reward has a fair market value of $1 and the last token you receive as a staking reward has a fair market value of $0.67. Over the full year, the fair market value of the reward tokens when they are received will average about $0.83.
Your resulting gross income for tax purposes will come to about $83, 2.5 times your true gain of $33.33. As with the previous example, the mismatch occurs because your nominal gain of 100 tokens worth $83 at the time of their creation is offset by the real decrease in the value of all your tokens caused by the 50% increase in the token supply.
Solution: Tax Staking Rewards As Created Property
Thankfully, there is a simple solution that elegantly accounts for all potential wealth gains resulting from staking: treating staking reward tokens as created property and taxing them when they are sold.
A good parallel is farming: a corn farmer does not create a tax obligation for every husk harvested. Instead, when he sells all his corn at the end of harvesting season, the farmer incurs one taxable event that accurately reflects the fair market value of all of his corn.
Likewise, instead of having to calculate complicated and unfair tax obligations every-time a reward token is issued, the IRS should use the value of the tokens when they are sold as the taxable event for staking rewards. Doing so eliminates the need to consider the dilutive and redistributive effects of staking rewards on an individual’s wealth altogether.
Moreover, taxing staking rewards as created property eliminates a bureaucratic nightmare: creating taxable events that must be reported every time a staking reward is issued, potentially millions of times per individual per year.
Finally, taxing reward tokens as created property more accurately reflects the economic reality of staking networks: Because a network is simply a group of individuals running the network’s software (if all the individuals left, there would be no network), stakers are in effect awarding themselves with new tokens, the essence of created property.
If applied to proof of stake networks, the 2014 IRS guidance would inaccurately account for the wealth gains of individuals who choose to stake their tokens, discouraging participation in staking networks. Taxing staking rewards as created property would eliminate the distortive effects of current tax guidance, enhance the technology-agnosticism of tax policy, and promote the development of staking networks here in the United States.
Source: Sutherland, Abraham, “Cryptocurrency Economics and the Taxation of Block Rewards” (November 4, 2019). 165 Tax Notes 749 (Part 1; Nov. 4, 2019), 165 Tax Notes 953 (Part 2; Nov. 11, 2019). Available at SSRN: https://ssrn.com/abstract=3466796. Professor Sutherland’s articles were the first to argue for treating staking rewards as created property.