As defined by the IRS, gross income is essentially the total amount of money you earn before any taxes or deductions are taken out. It includes all income you receive in the form of money, goods, property, services, and rewards produced by crypto staking—the topic of this article.
Until July 31, 2023, the IRS had not provided any binding guidance on the timing of when staking rewards are includable in gross income. Due to a lack of guidance, we’ve observed some debate among taxpayers. Some argued that staking rewards are generally includable in gross income at the time the taxpayer received dominion and control over the rewards. Yet, others argued that staking rewards are generally not includable in gross income until the rewards are later converted to cash or other property. Let’s dive into both sides and review how the IRS ultimately concluded.
Jarrett v. United States
The IRS has firmly maintained that cryptocurrencies are viewed and taxed as property. This is why the taxation of mining and staking rewards as income seems inconsistent. For U.S. taxpayers and investors, this inconsistency is a main source of contention, and where the Jarrett couple find themselves in Jarrett v. United States.1
Taxpayers in Jarrett initially paid their 2019 taxes on staking rewards in compliance with the then interpretation of IRS guidelines.2 In December 2021, the IRS decided to refund the taxpayer in the amount paid plus interest. The taxpayer declined the offer and instead filed a lawsuit. They felt that without a court-ordered ruling, the IRS could challenge their tax status in the future.
The taxpayer argues that these rewards are akin to new property creation rather than income generation. In their perspective, taxing these rewards as income is like taxing a baker for the bread they have baked, rather than the bread they have sold. They believe the tax should take place only upon disposal, and not when they are received, aka mined or staked.
IRS Guidance: Revenue Ruling (Rev. Rul.) 2023-14
Just days before the Jarrett case was set to be heard, the IRS published an advanced version of Rev. Rul. 2023-14. According to the ruling, cash-method taxpayers who stake cryptocurrency and receive additional units of cryptocurrency as rewards must include the fair market value of the rewards in their gross income for the tax year in which they gain dominion and control. Rev. Rul. 2023-14 clarifies that in some situations, the IRS’ approach to taxing cryptocurrency is to do so immediately, even though the value can greatly fluctuate and might not ever be converted into fiat currency.
Those arguing that staking rewards should not be includable in gross income until converted at a later time may draw a parallel to gold mining. Imagine being a miner back during the American gold rush of the 1800s, and regulations have been set so that gold miners must recognize income upon the extraction of gold from the earth. In this hypothetical situation, income is taxable, irrespective of whether the gold is sold or exchanged. It is reasonable to imagine that such a ruling would garner significant opposition from miners, who could argue against its premature taxation on their profits, especially considering the volatility of gold prices which could prevent them from realizing the income. Moreover, the policy could cause cash flow challenges for miners, as their valuable gold did not translate into immediate liquidity until it was sold.
Tax Planning Questions You May Ask Yourself
- Rev. Rul. 2023-14 specifically addresses cash-method taxpayers. If I set up a corporate entity that uses the accrual method of accounting, can I defer the income?
- In general, no. There is generally a two-prong test for accrual-method taxpayers to work through to determine the timing of the income and, in many cases, the test is met before staking rewards are later converted. The two-prong test is:
- All events test – Are all events fixing the right to receive income? If there is a contingency, the right to receive income may not be fixed.
- Can the amount be reasonably determined?
- In general, no. There is generally a two-prong test for accrual-method taxpayers to work through to determine the timing of the income and, in many cases, the test is met before staking rewards are later converted. The two-prong test is:
- At what tax rate are staking rewards taxed?
- In general, ordinary income tax rates, and there may be additional taxes to consider such as net investment income tax, self-employment tax, or additional Medicare tax.
- If I am staking tokens on a Proof of Stake network, but haven’t yet claimed my rewards, are they includable in income?
- There is an argument to be made that you do not have dominion and control over your staking rewards until they are claimed.
- Conversely, if you are staking through a custodian, such as Coinbase, your staking rewards can be automatically credited to your account without any such claiming process. This would likely result in staking rewards being included in gross income in the year they are automatically credited to your account.
- If I am staking a rebasing token, how do I determine my staking rewards and the year in which they should be included in gross income?
- There is currently no clear guidance; however, there may be an argument that rebase tokens are treated as capital gain or loss upon conversion and not included income until that conversion. This could be considered an aggressive position.
The Bottom Line
Rev. Rule. 2023-14 states that those who partake in staking and use a cash method of accounting will need to include the value of the reward they receive from the activity in the year they gained complete control over the currency.
With the implementation of Rev. Rul. 2023-14, taxpayers involved in staking can generally expect to pay taxes on their rewards upon acquisition, even if they have not converted their cryptocurrencies into fiat. Taxpayers involved in staking find themselves subject to taxation on potential earnings that may not materialize if the market value declines or if they choose not to convert their holdings into cash. This could result in an unfair tax burden and brings into focus the need for more nuanced tax regulations in the crypto space.
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- 1“Investor Opts for Ruling Over Refund in Crypto ‘Staking’ Row,” law360.com, February 3, 2022
- 2Failing to pay taxes when due, even if one disagrees on the basis for taxation, can lead to penalties, interest charges, and potential legal repercussions. By paying the tax first, potential complications are often mitigated, thereby allowing the taxpayer to contest the tax by requesting a refund.