Over the last several years, proof of staking (POS) has become the most popular method for validating cryptocurrency transactions. Other than Bitcoin, which uses a proof of work (POW) solution, most cryptos have turned to POS or staking to validate crypto transactions. Prior to Revenue Ruling 2023-14, the taxation of staking inside or outside an IRA was not firmly established.
On July 31, 2023, the IRS published new guidance regarding the treatment of cryptocurrency staking rewards. In Revenue Ruling 2023-14, the IRS formally stated their position that staking rewards must be included in gross income for the taxable year in which the taxpayer acquired dominion and control of the awarded cryptocurrency and not simply rights to the crypto reward token.
What is Crypto Staking?
The staking of crypto involves a crypto owner pledging their cryptocurrency token to a particular blockchain to help validate transactions. In exchange for validating a crypto transaction and maintaining the blockchain network’s integrity, users are rewarded native crypto tokens of the blockchain.
POS vs. POW
The proof-of-stake (POS) validating solution diverges from proof-of-work (POW) in that with POS, validators are selected to participate in the validation process based on a number of factors, including the volume of the validator’s “staked” coins or tokens. In sum, with POS, the validator locks up his or her staked cryptos for a certain period of time for use in the validation process. The staked tokens are essentially used as collateral to ensure that the validators conduct the validation process in the manner required by the protocol. The idea behind POS is that if one is risking his or her cryptos by using them as collateral, they will act in accordance of the protocol rules and not engage in improper activity so as to not risk their cryptos. One is not required to stake his or her cryptos. Owners of cryptos that do not participate in the validation process simply do not earn staking rewards.
In POS, coins or tokens that are being used as collateral cannot be traded during that period. POS is viewed as more environmentally friendly than POW consensus because the staking process is not as energy intensive.
Notice 2014-21 – Taxation of POW
Until the release of Revenue Ruling 2023-14, there has been no direct guidance focusing on the federal tax treatment of staking rewards. The initial guidance provided by the IRS on the treatment of crypto in IRS Notice 2014-21 addressed the taxation of Bitcoin and crypto mining but did not address staking.
In that Notice, the IRS stated that when crypto is mined, it is includible in gross income of the taxpayer on the date of receipt. Mining occurs through a POW mechanism mainly for Bitcoin, as most other cryptos have moved to a POS model because of the energy consumption issues synonymous with POW. Hence, if an individual uses non-retirement funds to mine Bitcoin, the taxpayer would be subject to ordinary income tax on the amount received,
In the case of a Self-Directed IRA, so long as the IRA is not engaged in a trade or business with respect to the mining activity, the belief is that the mining activity would not be subject to tax. In general, an IRA is exempt from taxation under IRC Section 408 for most income and gains including capital gains, interest, dividends, rental income, and royalties. However, in the case where a Self-Directed IRA triggers the unrelated business taxable income rules (UBTI), a tax of up to 37% would be imposed on the allocated share of income.
In the case of crypto mining activity, if the IRA activity rises to a trade or business, then that activity income would be subject to the UBTI tax, assuming it is over $1,000. However, if the mining activity does not rise to the level of a trade or business, it would appear that the income would not be subject to the tax. Accordingly, since an IRA is tax-exempt and not subject to tax on gross income, the position is that passive crypto mining would not be subject to tax in the case of an IRA even if it triggers ordinary income. Notice 2014-21 is clear that not all mining activity is considered a trade or business.
Revenue Ruling 2023-14
Revenue Ruling 2023-14 states that staking rewards of taxpayers must be included in taxable income when they acquire possession of the rewards under the “dominion and control” standard. Dominion and control basically means that the taxpayer gains the capability to sell or otherwise transfer the asset.
The Ruling details an example in which a taxpayer owned 300 units of an unspecified cryptocurrency, staked 200 of such units, validated a new block of transactions on the blockchain associated with such cryptocurrency, and received two units as a staking reward (reward units), which were nontransferable for a short period of time (lock-up period). On the day following the lock-up period, the taxpayer had the ability to sell, exchange or otherwise dispose of the reward units. The IRS ruled that the taxpayer was required to include the fair market value of the reward units in gross income after the lock-up period because the taxpayer had an accession to wealth when the taxpayer gained “dominion and control” over the reward units. The taxpayer was held to have gained “dominion and control” over the reward units on the day following the lock-up period, when the reward units became freely transferable.
The IRS view set forth in Revenue Ruling 2023-14 that the receipt of staking rewards is taxable when the taxpayer has control over the crypto, whereas, under Notice 2014-21, crypto rewards received as a result of POW are taxable upon receipt.
One of the most significant aspects of Revenue Ruling 2023-14 is that it clearly discards a common taxpayer tax position that staked token received as a reward of POS should not be taxable until the taxpayer disposes of them in a taxable transaction. The Ruling is clear that the taxpayer recognizes income based on the fair market value of the reward token received on the date they have dominion or control, generally after the lock-up period ends.
POS and Your Self-Directed IRA
Similar to Notice 2014-21 treatment of crypto mining, in the case of POS, Revenue Ruling 2023-14 is clear that the reward tokens are subject to gross income or business income when the taxpayer gains control over the cryptos. Thus, the question then becomes whether the Self-Directed IRA’s staking activity rises to a trade or business. If the activity did, the UBTI tax would be triggered. Whereas if the staking activity did not rise to the level of a trade or business, it would appear the IRA would not have any tax on the income.
The fact that the POS or POW activity would generate ordinary income in the hands of a non-retirement taxpayer and not when generated by an IRA seems odd, but other than the UBTI tax regime, a Self-Directed IRA would not be subject to tax on the income generated. The unique aspect of POW and POS is that it could generate ordinary income without being associated with a business. For almost all other activities, the income generated would be passive or ordinary income in the hands of a business.
Conclusion
The IRS has not addressed the specific taxation of POW or POS for retirement accounts. However, we do now know that in the cases of POW and POS, the income generated is deemed ordinary income or business income if done by a business. As outlined above, since the UBTI tax regime is really the only way an IRA can be subject to tax on investment income or gains, the belief is that so long as the POW or POS activity does not rise to a trade or business, a Self-Directed IRA would not seem to be subject to taxation on rewards earned by POW or POS so long as its activity did not rise to a trade or business.
