U.S. Federal Income Taxation Of Staking Rewards

Cahill Gordon & Reindel LLP is pleased to submit this memorandum on the U.S. federal income tax treatment of staking rewards. Staking enables retail users and other digital asset holders to help secure blockchain networks. As staking is foundational to many networks and increasingly common among retail participants, getting the tax treatment of staking rewards right is essential to crafting coherent U.S. digital asset tax policy.

As explained in greater detail below, staking rewards consist of two components: (1) newly minted tokens programmatically produced by the open-source software that validators, or “stakers,” run on their computers; and (2) fees paid to stakers by blockchain users for inclusion of their transactions on-chain. Revenue Ruling 2023-14 concludes that cash-method taxpayers (i.e., non-institutional and other non-business stakers) who “receive” staking rewards must include, as ordinary income, the fair market value of those rewards in the year in which they gain dominion and control over them.

Revenue Ruling 2023-14 is incorrect as applied to newly minted tokens. As described in greater detail below, “income,” within the meaning of the tax law, requires a realization, or coming in from a source.¹ Consistent with that requirement, income tax has never previously been—and cannot legally be—imposed on a cash-method taxpayer’s production of property, such as newly harvested crops, newly bred livestock, newly extracted minerals, newly created intellectual property, or newly manufactured goods.² The tax law refers to that property as “self-produced,” or “self created,” property.³

Newly minted tokens do not come in from another person; taxpayers produce them by running open-source (i.e., unowned) software on their computers. Those taxpayers are analogous to farmers vying to harvest fruit from unclaimed, common, or public property. Fees they receive from blockchain users for including transactions on-chain are taxable income, just like farming subsidies or other service payments; the fact that those fees are paid concurrently with the production of newly minted tokens does not cause newly minted tokens to be taxed at production, just as farming subsidies do not cause crops to be taxed at harvest.

Moreover, clear reflection of economic income is one of the tax law’s guiding principles and underlies the realization requirement.⁴ Taxing newly minted tokens at acquisition fails to reflect a staker’s economic income because it taxes stakers before they have exited (or even can exit) their investment and ignores the dilutive effects of newly minted tokens.

Treasury and the Internal Revenue Service (the IRS) should amend Revenue Ruling 2023-14 to clarify that a taxpayer’s acquisition of newly minted tokens is not income.

Part I of this memorandum provides factual background on staking. Part II describes how Revenue Ruling 2023-14 has created uncertainty among taxpayers by purporting to tax property production in a manner inconsistent with the history of the income tax. Part III explains why newly minted tokens are not income to non-business stakers. Part IV explains why treating the production of newly minted tokens as income results in a poor reflection of stakers’ economic income. Part V distinguishes the production of newly minted tokens from amounts that historically have been treated as income. Part VI explains how Revenue Ruling 2023-14 can be modified to clarify that only the transaction fee component of staking rewards is income under current law. 

I. Staking secures public blockchain networks, and newly minted tokens arise programmatically from that security function

Public blockchain networks are virtual ledgers maintained by multiple computers, or nodes, running open-source software.⁵ Anyone can run one or more nodes without requiring permission from another person. Although each node acts independently in its own economic interest, the software’s incentive structure—referred to as a consensus mechanism—is designed to result in the emergence of a canonical ledger, including network address ownership balances and transactions.

Many blockchain networks use a proof-of-stake consensus mechanism, which requires nodes to ante up, or stake, a material amount of the network’s native token into the software. Nodes that stake the requisite amount are eligible to participate in two activities, collectively referred to as network validation: (1) proposing new blocks of data for inclusion in the ledger; and (2) voting on the validity of blocks proposed by other nodes. The network software programmatically selects nodes to propose or vote on blocks.

Nodes earn “rewards” for network validation. Very generally, those rewards consist of two components:

• Transaction fees. The software transfers, to the proposing validator, a portion of the fees paid by network users for inclusion of their transactions in the ledger.⁶
• Newly minted tokens. The software programmatically mints new tokens to validators for proposing and voting on blocks of data to be added to the ledger. New token issuance is not dependent on or correlated with the amount of transaction fees paid by or received from users. 

When a validator is selected to propose one or more blocks, the transaction fees the validator earns can be a significant part of their staking rewards for those blocks. However, because there can be only one block proposer at a time—whereas block voters typically represent all or a broad segment of active validators—validators spend most of their time voting on blocks, and only rarely are selected to propose new blocks. Accordingly, newly minted tokens represent the substantial majority of staking rewards a validator acquires over any extended period of time.

The requirement that nodes stake a material amount of a blockchain network’s native token to validate helps to secure the network by ensuring that validators are economically aligned: a successful effort to attack the network by proposing or voting on invalid data blocks would reduce the value of the validator’s own assets. In addition, some networks penalize validators that propose or vote on invalid blocks by destroying, or burning, all or a portion of their staked tokens.

To prevent rapid reductions of a network’s economic security, and to ensure accountability for validator misbehavior, blockchain network software enforces a waiting period during which validators cannot withdraw their stake, which often includes all or a portion of staking rewards they have earned. The waiting period typically is dynamic, depending on the aggregate number of staked tokens seeking to exit, and can be significant.

Retail investors who want to participate in securing a blockchain network while acquiring staking rewards can run their own nodes from home, called “solo staking.” However, retail investors might not have enough of a network’s native currency to activate a node, and might not have the requisite hardware or technological wherewithal to maintain a node. Accordingly, many retail investors instead make their tokens available to a third-party service provider that runs a node on their behalf in exchange for a fee. Those investors continue to own their tokens at all times and, for tax purposes, generally are required to treat their share of any staking rewards as if they directly earned the rewards.⁷ U.S. service providers are taxed at ordinary rates on any fees they earn for staking on behalf of a retail investor (including any fees paid by that retail investor in newly minted tokens), and this memorandum does not address service providers in their capacity as service providers.

II. Revenue Ruling 2023-14 treats the production of property as income, departing from longstanding income tax principles

Revenue Ruling 2023-14 addresses a hypothetical situation where a cash-method taxpayer “receives” cryptocurrency for validating blockchain transactions. The ruling concludes that the value of the cryptocurrency is ordinary income to the taxpayer when the taxpayer obtains “dominion and control” over that cryptocurrency, which is “the ability to sell, exchange, or otherwise dispose of” it, because, at that time, the taxpayer “has an accession to wealth.” The ruling’s statement of law lists service payments, gains from property dealings, rent, and royalties as analogous income types.

The ruling does not distinguish between the two components of staking rewards—transaction fees and newly minted tokens—and its use of the term “receives” suggests that Treasury and the IRS view both components as payments by a person, notwithstanding the reality that only transaction fees are received from a person and newly minted tokens are produced by stakers running open-source software on their computers (and are not received from any person). Treasury officials have informally advised that the ruling’s conclusion is intended to apply to both components of staking rewards.

If that informal advice is correct, then it would be the first time in the history of the income tax that the first owner of a commodity is taxed on the value of that commodity on acquisition, even if the owner is a cash-method taxpayer. As discussed below in Part III, newly harvested crops, newly bred livestock, newly extracted minerals, newly created intellectual property, newly manufactured goods, and other self-produced property might all be “accessions to wealth,” but they are not income that is derived from a source, and so their production is not taxed. The analogies posited in the revenue ruling are distinguishable from newly minted tokens in that they involve a payment by another person, the property’s previous owner—an employer, property buyer, landlord, or licensor.

Revenue Ruling 2023-14 has created uncertainty among taxpayers. Some taxpayers appropriately treat the production of newly minted tokens as nontaxable.⁸ Others treat it as taxable but have different approaches to determining when they have obtained dominion and control. As mentioned above, blockchain network software enforces a waiting period during which validators cannot withdraw their stake, which often includes all or a portion of their newly minted tokens. Does a taxpayer have “the ability to sell, exchange, or otherwise dispose of” tokens that would, if a withdrawal process were activated, need to first sit idly and nontransferable in a long exit queue?⁹ Analogous questions—the precise timing of a harvest, or when a manufactured good comes into being—do not need to be answered for other commodity producers, because those producers are taxed only at sale, not acquisition.

III. Newly minted tokens are not “income” because their creation does not involve a realization or a source

The Constitution’s “apportionment clauses” limit Congress’s ability to impose property taxes.¹⁰ However, the Sixteenth Amendment authorizes Congress to tax “incomes, from whatever source derived.”¹¹ The Code, in turn, defines gross income as “all income from whatever source derived.”¹²

By their terms, each of the Sixteenth Amendment and the Code requires income to be derived from a source. In Eisner v. Macomber, the Supreme Court interpreted that language to precondition income taxation on a realization, or

Footnotes

1. See, e.g., Constitution, amendment XVI (authorizing Congress to tax “incomes, from whatever source derived”) (emphasis added); I.R.C. § 61 (defining gross income as “income from whatever source derived”) (emphasis added); Eisner v. Macomber, 252 U.S. 189, 207 (1920) (income requires a “coming in”); Commissioner v. Glenshaw Glass, 348 U.S. 426, 431 (1955) (income requires an accession to wealth, “clearly realized”).

Except as otherwise specified, all section references herein are to the Internal Revenue Code of 1986, as amended (the Code), and Treasury regulations promulgated thereunder.

2. See, e.g., Tatum v. Commissioner, 400 F.2d 242 (5th Cir. 1968) (harvesting crops); IRS Publication 225, “Farmer’s Tax Guide,” at 61 (grain harvesting and animal breeding); Revenue Ruling 86-24 (animal breeding); Revenue Ruling 77-176 (oil and gas extraction).

3. Cf. 26 C.F.R. §1.263A-1(c)(2) (for determining property “produced” by the taxpayer, “[p]roduce means construct, build, install, manufacture, develop, create, raise, or grow”); 26 C.F.R. § 1.197-2(d)(2) (a “self-created intangible” includes an intangible “to the extent the taxpayer makes payments or otherwise incurs costs for its creation, production, development, or improvement, whether the actual work is performed by the taxpayer or by another person under a contract with the taxpayer entered into before the contracted creation, production, development, or improvement occurs”).

4. See Tootal Broadhurst Lee, infra note 15.

5. Open-source means the software is free to use, modify, and distribute.

6. The network typically destroys, or burns, the fees not transferred to the proposing validator, which might wholly or partially offset the inflationary effects of block rewards.

7. See Revenue Ruling 2023-14 (staking rewards are taxed the same whether earned directly or through a third party service provider); see also, e.g., Commissioner v. San Carlos Milling Co., Ltd., 24 B.T.A. 1132 (1931) (a farmer’s transfer of sugarcane to a refinery in exchange for warehouse receipts redeemable for a corresponding amount of refined sugar, less a paid-in-kind fee, was a bailment because the refinery “always had on hand sufficient sugar to cover outstanding warehouse receipts,” even though it commingled cane juices from multiple farmers), aff’d 63 F.2d 153 (9th Cir. 1932); Revenue Ruling 65-218 (treating ownership of American Depositary Receipts as ownership of the underlying stock, even though ADRs do not reference specific stock certificates held by the ADR issuer).

A “loan” of tokens to a third-party staking business in exchange for a “fee” that is not determined by reference to the business’s staking yield generally would not be treated as a bailment, so that the staking business’s activities would not be imputed to the lender. Cf. Provost v. United States, 269 U.S. 443, 455 (1926) (broker becomes the owner of securities on loan where the broker has the ability to dispose of the securities). This memorandum does not address token loans. 

8. Revenue rulings are not binding on taxpayers or the courts.

9. While the ruling concludes that a staker is not taxed until the end of “a brief period” during which the staker “lacks the ability to sell, exchange, or otherwise dispose of” their tokens, it does not address the more realistic scenario where a staker has the ability to activate a withdrawal, but the withdrawal process requires tokens to sit idly for a period of time.

10. See Constitution, article I, section 2, clause 3 (“Direct Taxes shall be apportioned among the several States…according to their respective Numbers.”); Constitution, article I, section 9, clause 4 (“No capitation, or other direct Tax, shall be laid, unless in proportion to the Census or Enumeration herein before directed to be taken.”).

11. Constitution, amendment XVI.

12. Section 61.

Originally published by CahillNXT.

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