Navigating the Potential Tax Implications of Staking Cryptocurrencies

Proof of Stake (PoS) has emerged as a popular alternative to cryptocurrency mining to add new blocks to a blockchain. Unlike mining, which requires expensive specialized equipment and consumes a large amount of energy, PoS only requires investments in 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. Staking reward (staking income) is shared among those who staked the cryptocurrencies. Treasury and IRS have provided no direct guidance regarding the federal income tax treatment of cryptocurrency staking income. This tax release discusses key U.S. federal income tax issues to consider regarding the income and expenses associated with cryptocurrency staking activities.

Characterization of Staking Income

While there is no official guidance on the taxation of cryptocurrency staking income, we look to guidance on cryptocurrency mining income, due to their apparent similarity. In 2014, IRS issued Notice 2014-21 (the Notice) to address the taxation of convertible virtual currency, which is virtual currency (including cryptocurrency) that has an equivalent value in real currency, or that acts as a substitute for real currency. The Notice states that miners of virtual currency must recognize as gross income the fair market value (FMV) of mined virtual currency at the time of receipt. This becomes the miner’s cost basis in the virtual currency. This is different from typical manufacturing where gross income is not recognized until a product is sold.

It is conceivable that staking income would be viewed similarly, i.e., ordinary income upon receipt of staking award. It would be considered trade or business income if the staking activities rise to the level of a trade or business. Since staking income is generated from collective efforts of many participants, for some of which the activities likely rise to the level of trade or business, it is prudent to assume that some or all of the staking income is ordinary trade or business income.

UBTI and ECI for Investment Funds

For funds that earn staking income, the main concern is whether staking income is unrelated business taxable income (UBTI) and/or income effectively connected with a U.S. trade or business (ECI). Tax-exempt partners are subject to tax on UBTI, while foreign partners are subject to U.S. tax on ECI. Given the discussion above, staking income likely would be considered UBTI. It is less clear whether it is ECI, as the blockchain network is usually run on a worldwide basis, and the participants can be located anywhere in the world (and are unknown to the staking income recipients). Since the U.S. accounts for 4% of the world’s population, perhaps 4% of staking income can be viewed as ECI.

For funds concerned about UBTI and/or ECI, there are ways to mitigate them. Expenses may be reasonably allocated to staking income to reduce or eliminate UBTI and/or ECI. Funds can also set up blocker corporations to hold the staked cryptocurrencies to block the UBTI and/or ECI. If most or all of the staking income is considered ECI, a domestic blocker corporation would be recommended, as it is only subject to corporate income tax and not branch profits tax, and any dividends paid by the corporation to the funds would be qualified dividends. Whereas if none or only a small portion of the staking income is considered ECI, an offshore (e.g., Cayman) blocker corporation is typically more tax efficient, as it would only be subject to U.S. tax on ECI, notwithstanding that any dividends paid by the corporation to the funds would be non-qualified dividends.

The Takeaway

There are important U.S. federal income tax issues to consider regarding the income and expenses associated with cryptocurrency staking activities. 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 specialist familiar with this area. Please contact your Andersen advisor if you would like to discuss the tax impact as well as tax planning considerations in advance of participating in any cryptocurrency transactions.