Crypto staking rewards and their unfair taxation in the US

The U.S. Internal Revenue Service (IRS) has expanded its tax regulations to suit its crypto agenda. At no point in tax history has pure creation been a taxable event. However, the IRS tries to tax new tokens as income at the time they are created. This is a violation of traditional tax principles and is problematic for several reasons.

In 2014, in an FAQ on IRS Notice 2014-21, the IRS stated that mining activities would result in gross taxable income. It is important to note that IRS notices are guidelines only, not laws. The IRS concludes that mining is a commercial or business activity and the fair market value of the mined coins is immediately taxed as ordinary income and subject to self-employment tax (an additional 15.3%). However, this guideline is limited to proof-of-work (PoW) miners and wasn’t released until 2014 – long before staking became mainstream. Their applicability to special bets is incorrect and inapplicable.

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A new lawsuit is currently pending in federal court in Tennessee challenging the IRS who tax bonus bets when they are generated. Plaintiff Joshua Jarrett staked on the Tezos blockchain – staked to Tezos (XNZ) and contributed his computing power. New blocks were created on the Tezos blockchain and resulted in new Tezos being created for Jarrett. The IRS taxed Jarrett’s newly created tokens as gross taxable income based on the market value of the new Tezos tokens. Jarrett’s attorneys correctly pointed out that newly created property is not a chargeable event. That is, new assets (here newly created Tezos tokens) are only taxed when they are sold or exchanged. Jarrett has the support of the Proof of Stake Coalition, and the IRS has yet to respond to Jarrett’s complaint.

Income tax

In US income tax history, newly created assets were never taxable income. If the baker is not taxed when he comes out of the oven, he will be taxed when sold in the bakery. Farmers who plant new trees are not taxed when they harvest and when they sell in the market they are taxed. And when an artist paints a new portrait, it is not taxed when it is finished, but taxed when it is sold in a gallery. The same goes for newly created tokens. Once created, they are not taxed and are only taxed on sale or exchange.

Cryptocurrency is new and there is a lot of evolving terminology to go with it. While it is common to refer to newly created blocks of tokens as “rewards”, this is a misnomer and can be misleading. Calling something a reward shows that someone is paying for it and makes it look like taxable income. In fact, nobody pays the merchant a new token – it’s new. Instead, staking creates new assets that are actually created.

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Some suggest that new tokens be taxable (when created) as there is an established market where value is instantly quantifiable. In other words, they argue that a bakery cake is not taxable when it is made because there is no clear market price to determine the value of the cake. It is true that the Tezos token has an immediate market value, but this fact should also be put into context: prices can vary between markets and not all markets are accessible to everyone. But the existence of market prices often applies to new assets – and not just to standardized commodities or commodities. If the criterion is whether there is a determinable market value, then other newly created properties, including sole ownership, are actually taxable. When Andy Warhol completed a painting, his work of art had a market value; it counts with every stroke from him. However, his images are not taxed when they are created. Newly created properties – in whatever context – have never been taxed, not because their value is uncertain, but because they are not yet income. Cryptocurrencies should be treated equally.

Principles similar to traditional tax principles are out of place and just don’t fit together. For example, staking rewards are not the same as stock dividends. The IRS states in Topic Number 404 Dividends that “a dividend is a distribution of assets that a company pays you when you own shares in that company”. As such, a dividend is a form of payment that comes from one source – the company that generates the dividend. In addition, this dividend comes from the company’s profits and earnings. The same does not apply to newly created tokens. In the case of newly created assets – for example through staking – no one else initiates payments, and certainly no profit-related payouts.

Taxes are too high

Ultimately, the IRS view is unrealistic and overrates income. Staking rewards are generated all the time and user engagement is high. More than three quarters of all users have paid up for both Cardanos ADA and XNZ. In the crypto staking space, the speed at which new tokens are being created is astounding. In some cases there are minute and second creations for new tokens. This could add up to hundreds of taxable events for crypto taxpayers each year. Not to mention the burden of matching those hundreds of events in a volatile market with historical fair market prices. Such a claim is untenable for both the taxpayer and the IRS. Finally, taxing new tokens as income leads to over-taxation as new tokens dilute the value of existing tokens. This is a matter of dilution and means that when taxing new tokens as income, investors will tax a significantly excessive use of their economic interests.

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The IRS’s enthusiasm for taxing cryptocurrencies is fueling inconsistent application of tax laws. Cryptocurrencies are owned for tax purposes and the IRS cannot dismiss them for unfair treatment. It must be treated like any other good (like a baker’s cake, a farmer’s harvest, or an artist’s work of art). It doesn’t matter that the asset itself is a cryptocurrency. The IRS seems to be taken by surprise by its own enthusiasm, so we need to advocate for tax justice.