August 3, 2023

Charting a Path Forward: Impact of Recent Crypto Taxation Updates

By Adnan Islam, Esq., LL.M., EA, MBA, CPA, Partner, Tax & Business Services

Charting a Path Forward: Impact of Recent Crypto Taxation Updates Digital Assets & Blockchain

July 2023 has now potentially become the most transformative month in US crypto taxation history. The month witnessed a groundbreaking Senate Finance Committee letter (“SFC Letter”) on July 11, 2023, calling for detailed and clarified crypto tax law, specifically addressing the tax implications of staking. Alongside this, the ongoing Sixth Circuit Court of Appeals case in Jarrett v. United States, has been under the spotlight, and, adding more fuel to the fire, the IRS has recently announced in a Revenue Ruling that cryptocurrency stakers using a specific method of accounting should include the fair market value (FMV) of their staking rewards as gross income. This article takes a closer look at these significant developments and presents our observations. For clarity in this article, the terms crypto, cryptocurrency, digital assets, tokens, and digital currency are used interchangeably.

The SFC Letter posed questions to solicit feedback on the income tax treatment of crypto and digital asset transactions, including but not limited to: Marking-to-Market (MTM) for traders and dealers under IRC Section 475; trading safe harbor under IRC Section 864(b); treatment of loans of digital assets under IRC Section 1058 (treated as property, not currency or money per 2014-21); wash sales under IRC Section 1091; timing and source (IRC Section 861) of income earned from staking and mining; and informational and compliance reporting for digital asset accounts, holdings, and transactions.

This appeals case continues from a federal District Court in Tennessee, where the taxpayers sought legal recourse after their claim to refund income recognized from staking was rejected. The IRS granted the taxpayers a refund check and is now arguing that the IRS has no further obligation to issue a ruling, decision, or analysis on a substantive tax issue being escalated by taxpayers. Taxpayers are trying to obtain what would be seen as an industry-wide favorable tax position, in that staking rewards (“earned” from staking activities) should be taxed when the staker, participant, or validator sells, exchanges, converts, or otherwise disposes of the staking rewards. However, before the Sixth Circuit Court of Appeals could render a decision on procedural and substantive grounds, the IRS ruled on its position on the income taxation of staking rewards in specific circumstances.

Note that this asserted income tax treatment of staking activity is unlike mining, whereby the taxpayer must recognize the FMV of the mined digital as a current year, ordinary income inclusion when acquired through mining, with a subsequent income recognition event when the mined digital asset is sold, converted, exchanged, or otherwise disposed of. That event is usually a capital gain or loss that may not be netted or offset with the first income recognition event. This may create a whipsaw position for taxpayers with a sizeable ordinary income event from the initial acquisition of a digital asset through mining and a capital loss within the same calendar year from the sale of those digital assets.

The IRS guidance in Rev. Rul. 2023-14 states that taxpayers that (1) participate or perform crypto staking (services) and (2) use a cash method of accounting will need to include in their gross income the FMV of the reward they receive from the activity in the year they gained complete control over the currency. The guidance also contains a detailed example of a staking reward activity and the resulting U.S. federal income tax treatment.

If a cash-method taxpayer stakes cryptocurrency native to a proof-of-stake blockchain and receives additional units of cryptocurrency as rewards when validation occurs, the fair market value (FMV) 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.” Emphases added through bold font.

Staking is a process by which participants may earn somewhat passive income when using their digital assets, crypto, or tokens to help validate transactions (run nodes) on a blockchain. Once the transaction is validated, a staker may receive a reward of additional units/amounts of digital assets, crypto, or tokens.

Tax Observations and Considerations for Taxpayers

This Revenue Ruling is not new tax legislation passed through Congress. It is the current stance of the IRS on the taxation of staking in a specific circumstance. The SFC Letter poses relevant and tax technical queries to hopefully provide a proper and thorough income tax law framework for the crypto / digital asset industry, including the character and timing of staking rewards. Even without comprehensive guidance and tax law, the taxpayers in the Jarrett case hope to obtain a favorable outcome that staking rewards or units are not income until the staker or validator disposes, converts, or exchanges the staking rewards or units. In general, the crypto community asserts that the value of the earned staking units may fluctuate drastically, even becoming worthless, within a short period of time after receipt by the taxpayer, in this case, the staker.

Apart from the absence of substantive and procedural tax law on many crypto transactions, the output (e.g., net rewards, units, income) from staking activity is not easily tracked or measurable by those that the IRS may hold accountable, such as taxpayers, tax preparers, validators, stakers, etc. The underlying accounting required for mandatory income tax reporting purposes may be difficult and tedious to capture wholly and accurately. Future crypto tax laws should address this apparent gap between evolving technological advances in conducting business and generating revenue and tax compliance.

Navigating the Future

The rapid developments in crypto taxation during July 2023 underscore the complex and evolving interplay between technology and tax law. With the landmark Senate Finance Committee letter, the pivotal Jarrett v. United States case, and the IRS’s recent ruling, stakeholders are on a shifting landscape that requires vigilance and adaptability. While these developments bring some clarity, they also highlight the urgent need for comprehensive tax legislation that aligns with digital assets’ unique and fluctuating nature. For stakers, miners, and all involved in the crypto industry, these changes are not just theoretical legal matters but practical considerations that could impact their financial futures. The dialogue between lawmakers, regulators, and the crypto community must continue, fostering a balanced and robust framework that embraces innovation while ensuring fair and transparent taxation.

If you have any questions about what these developments may mean for you or your business, please get in touch with Marcum’s Digital Assets Tax Team or International Tax Services team.