Many investment funds have participated in cryptocurrency staking to earn staking income. Unlike mining, which requires expensive specialized equipment and consumes a large amount of energy, Proof of Stake (PoS) only requires certain cryptocurrencies (staking currencies) that would be staked (locked up) for the security and operations of the blockchain. The protocol randomly assigns the right to one of the staked cryptocurrencies to validate the next block. The staking reward (staking income) is shared among those who staked the cryptocurrencies. We previously published an article on the tax implications of staking income, including the character, timing, and sourcing of the income, and how investment funds can manage exposure to unrelated business taxable income (UBTI) and effectively connected income with a U.S. trade or business (ECI) by allocating expenses (without providing details), and/or setting up blocker corporations to block the income. In this article, we dive into details on how investment funds can allocate and/or apportion expenses to staking income.

Staking income is generally considered ordinary income and may be UBTI and/or ECI. By allocating and/or apportioning expenses (which otherwise may be non-deductible portfolio deductions), an investment fund could substantially reduce ordinary income, UBTI, and/or ECI.

While there is no clear guidance on this point, we can look to how expenses are allocated and apportioned for other tax purposes, such as for foreign tax credit purposes, as a road map for this allocation. Treasury Regulation 1.861-8 provides that expenses definitely related to certain income would be allocated to that income, and expenses not definitely related to specific income would be apportioned among all gross income ratably based on the relative amount of gross income. For instance, expenses incurred to earn staking income would be directly allocated to (and offset) staking income, whereas general expenses (e.g., management fee, accounting fee) would be apportioned among all gross income proportionately based on the relative amount of gross income. The allocation and apportionment method seems reasonable, as expenses definitely related to certain income are clearly incurred to earn that income, whereas expenses not definitely related to any income can be viewed as incurred to earn all income.

Note that an investment fund may not be able to allocate or apportion any expense to (and offset) flow-through staking income from a lower-tier partnership, based on IRS rulings against allocating investment fund expenses to flow-through ordinary business income from lower-tier partnerships.

The Takeaway

We anticipate additional guidance from IRS and its foreign counterparts, and we will continue to monitor any significant developments. Before engaging in transactions in or investments involving cryptocurrencies, it is important to consult with a tax expert specializing in this area.

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