Taxation of Cryptocurrency

The IRS recently issued Rev. Rul. 2023-14 which offers guidance on the tax treatment of rewards cryptocurrency holders may receive from proof of stake blockchain validation.  Under the recent IRS guidance regarding the taxation of cryptocurrency, cryptocurrency holders who engage in proof of stake blockchain validation will recognize a taxable gain when they have “dominion and control” over the cryptocurrency awards they receive.

Cryptocurrencies blockchains need to be validated by other cryptocurrency holders. One mechanism cryptocurrencies use to validate blockchains is proof of stake validation. In proof of stake validation, a cryptocurrency holder will stake a sum of cryptocurrency or put up the sum of cryptocurrency as a form of collateral. In exchange for staking the currency, the cryptocurrency network may select the cryptocurrency holder to validate the blockchain. If the cryptocurrency holder correctly validates the blockchain, the cryptocurrency holder may get an award of additional cryptocurrency. If the cryptocurrency holder incorrectly validates the blockchain, the cryptocurrency holder may lose some or all of the staked cryptocurrency.

The IRS previously announced cryptocurrency transactions are taxable. The IRS’s position on the taxation of cryptocurrency is well grounded in the Internal Revenue Code and decades of case law interpreting the Internal Revenue Code. The Internal Revenue Code generally taxes “all income from whatever source derived.”  The courts have broadly interpreted income to mean the receipt of any type of property or thing of value, and cryptocurrency falls within that definition as it has some value.

The Internal Revenue Code and case law does require a taxpayer to actually receive property or something of value or undergo a realization event before a taxpayer is required to pay tax. For example, a crab fisher does not recognize taxable income when he or she drops crab pots in the ocean. The crab fisher does recognize income when the fisher brings the crabs they catch to market and exchanges the crabs for money. The recent IRS guidance applies the same principle to cryptocurrency transactions. While cryptocurrency transactions are taxable, cryptocurrency holders do not have to pay tax until they actually receive something of value (whether it be cash, more cryptocurrency, or anything else of value) and have control over it.

Under the recent IRS guidance, a cryptocurrency that participates in proof of stake validation will recognize a taxable gain when it has dominion or control over its award of additional cryptocurrency.  This is typically when the additional currency is in the cryptocurrency holder’s wallet and the cryptocurrency is free to trade or dispose of the cryptocurrency award.  Just as the crab fisher does not pay tax when he or she merely puts crab pots in the ocean, the cryptocurrency trader will not recognize any gain when he or she merely stakes cryptocurrency or if there is an ongoing validation.

RJS LAW helps taxpayers with audits, tax planning, estate planning, and other matters involving cryptocurrency. Please call us at 619-595-1655 for a free consultation.

Written by Joseph Cole, Esq., LL.M.