How are Staking Rewards Taxed for U.S. Citizens?

The U.S. taxmen are looking at taxing new tokens as income as they stretch the tax rules to fit the crypto agenda.

Tax Obligations

In crypto, staking is part of the Proof of Stake (PoS) consensus mechanism that allows participants to reap rewards in the form of new tokens. It is similar to mining rewards for Proof of Work (PoW) protocols. A tax obligation arises when there is a taxable event. Ethereum, the second most valuable crypto asset by market capitalization, will soon be moving from a proof of work protocol to proof of stake. Many are now asking if staking rewards are subject to taxation. There is no clear answer. 

One basis of comparison is to place the same rules that apply to mining activities. 

Source: A guide issued by the Internal Revenue Service (IRS) in 2014 classified virtual currencies received from mining activities as gross income 

In 2014, the Internal Revenue Services issued a Frequently Asked Questions (FAQ) in its IRS Notice 2014-21, and it treated mining rewards as a trade or business for taxation purposes. In 2014, staking as a consensus mechanism was relatively unknown. In a suit filed by Joshua and Jessica Jerrett against the United States of America, the Jerretts sought a refund for federal income taxes paid to the IRS. 

The crux of the argument is as follows:
1.    The property ‘created’ through staking activities was not sold or exchanged. 
2.    The U.S.’s federal income tax law does not permit the taxation of tokens created through a staking enterprise. 


Legality Behind the Jarretts’ Claim

Cryptocurrency has been classified as ‘property’ for tax purposes in America. Staking rewards can be regarded as ‘new property,’ which is neither payment nor compensation received from another party. The taxpayer creates it via staking. An income is only derived when the property is converted. The argument relies heavily on Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955), which ruled that created property is not a ‘realized’ wealth. 

The question that arises is: why should staking rewards not be given the same tax treatment as mining rewards? The notice by the IRS has resolved the issue of whether mining rewards are taxable. The answer is simple: a guide does not create a legal obligation. Therefore, the court must clarify the legality of the entire exercise by the IRS.  

Drawing an Analogy to Other Traditional Tax Principles

One common analogy of a well-established principle is stock dividends. The IRS in Topic No. 404 on Dividends described it as:

‘Dividends are distributions of property a corporation may pay you if you own stock in that corporation.’

The definition here is almost analogous to staking rewards, but with one major difference. Dividends are payments derived from a source or asset while created tokens are not derived from a source or asset. In this case, there is no other party originating a payment. The same rationale applies to interest payments derived from fixed deposits. 


Can Taxpayers Avoid Tax for Staking Rewards? 

The IRS would likely apply the same tax treatment to mining rewards. But, if the argument in Jarrets’ claim above succeeds, the tax obligation is only deferred, not absolved. The taxable event happens when the newly minted tokens are traded or sold. There is no immediate obligation to pay tax upon receipt of staking rewards because the taxable event has not occurred. 

Blank Tax Treatment Will be Confusing

The law has to recognize that the existing legal framework for taxing crypto assets is inadequate. Crypto assets are new asset classes with distinct characteristics that may not fit squarely into the existing classes. Lawmakers must recognize the need to legislate a new regulation with simple and clear rules to deal with this new asset class. These rules, however, cannot be made to apply retrospectively.  

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