Taxing Cryptocurrency Block Rewards
An argument for taxing rewards, including proof of stake rewards, only upon sale, rather than upon distribution
This expert commentary is adapted from the introduction to Cryptocurrency Economics and the Taxation of Block Rewards, a two-part Special Report published in Tax Notes. 165 Tax Notes 749 (Part 1; Nov. 4, 2019), 165 Tax Notes 953 (Part 2; Nov. 11, 2019). Also available at SSRN: ssrn.com/abstract=3466796
The views expressed here are those of the author and not necessarily those of Coin Center.
Cryptocurrency networks have no dollars or other real currency to be spent on their own maintenance. Instead, newly minted cryptocurrency tokens are used to encourage people to help maintain the network. These reward tokens should not be included in gross income when they are first created. The better approach is to tax them when they are sold or exchanged.
A crude metaphor will help in understanding the way cryptocurrencies actually work and why it matters for taxation. Those who hold a public cryptocurrency’s tokens pay for the maintenance of that cryptocurrency network. Token holders do this by (figuratively!) taking a handful of their tokens and putting them in a communal fund — let’s call it a cryptocurrency kitty. A sign on the kitty reads, “These tokens are for those who maintain the network.” Those who maintain the network are allowed to take tokens from the kitty and keep them.
The Treasury Department wants to tax those who take tokens from the kitty. The taxation problem arises most clearly when the token holders who put tokens into the communal fund are the same people who take tokens out. When a token holder both pays into the kitty and is paid out of it, it’s not fair to ignore the extent to which that token holder is effectively paying himself. If he put in as much as he now takes out, how can that be income? IRS guidance published in 2014 asks this token holder to pay tax on the tokens taken out of the kitty without considering the tokens he put in.
As a matter of fact, a cryptocurrency could be designed to use a kitty as just described. But this is not literally the way cryptocurrencies are designed. Real cryptocurrencies, at least the ones developed thus far, involve the creation of new tokens. But to understand the tax puzzle, it’s helpful to keep the kitty metaphor in mind.
Cryptocurrency research and development is increasingly focused on proof-of-stake technology, and proper tax treatment is especially important for these newer proof-of-stake cryptocurrencies. A proof-of-stake cryptocurrency, such as Tezos, differs from Bitcoin and proof-of-work cryptocurrencies in how network maintenance responsibilities are distributed. Proof-of-stake technology allocates the opportunity to maintain the cryptocurrency network according to participants’ ongoing stake, or proportion of ownership, in that network. This means that in proof of stake, those who put tokens into the kitty are the same people who take tokens out.
Continuing with the metaphor, those who own Tezos cryptocurrency tokens pay for the maintenance of the Tezos network by putting about 5 percent of their tokens in the kitty each year. For those token holders who help maintain the network, the amount they get to take back out depends on how many others are also helping with network maintenance. If every single token holder helped maintain the network, each would put 5 percent of their tokens into the kitty and then would take that same 5 percent back out. In this limiting case, no one would increase their stake in the network.
As it stands right now with the real-world Tezos cryptocurrency, a little more than two-thirds of Tezos tokens are held by those who are helping with this maintenance, so the way the math works out, these token holders get to take back their 5 percent, plus about 2 percent on top of that. This extra 2 percent comes from those who pay for, but don’t help with, the network maintenance.
Again, this is just a metaphor. But what literally happens is just an accounting trick to achieve what really happens, which is that the helpers gain 2 percent and the non-helpers lose 5 percent. Because the helpers do gain, they will be taxed. But they should be taxed at the appropriate time and on the appropriate amount.
The accounting trick that leads Tezos token holders to either gain 2 percent or lose 5 percent is the same trick used by most every public cryptocurrency, including Bitcoin. To provide an incentive for people to maintain the network, instead of having token holders put some of their own tokens into a kitty, new tokens get created out of thin air. These reward tokens are valuable, but even though we can assume they have an exact dollar value when they are created, their value is not as straightforward as it may appear. This is because the function of reward tokens is to redistribute the share of ownership (or stake) in a cryptocurrency network away from those who don’t participate in the maintenance of the network to those who do. The new tokens dilute the stake of all token holders while on net increasing the stake only of those who participate. By necessity, this dilution effect partially offsets any gains from participating in network maintenance. Including these rewards in gross income when they are received fails to account for this dilution effect and complicates the proper taxation of these tokens.
Using the kitty metaphor as applied to Tezos, treating these tokens as immediate gross income results in taxing seven tokens as income when the validator’s true gain is only two tokens. This is not equitable and would discourage U.S. taxpayers from participating in this new technology. It could also invite creative but economically pointless redesign of cryptocurrencies to better align how they literally function with how they really function in order to prevent improper taxation.
The full argument for how block rewards should be taxed requires a detailed explanation of the mechanics and economics of public cryptocurrency networks. But analogies and metaphors remain an important part of the argument for two reasons. First, cryptocurrency is unique in terms of its tax implications, and neither Congress nor Treasury has addressed these issues. We are left with a variety of potentially relevant policies and principles, so analogy is necessarily a primary means of engaging with existing law.
Second, cryptocurrency itself makes sense only through analogy and metaphor. Cryptocurrency tokens exist, but in calling them tokens, we come to understand them by reference to another, older idea of a token.Some of these analogies and metaphors are far from perfect, which has led to some pervasive confusion about cryptocurrency. For example, it does more harm than good to describe reward tokens in proof-of-stake cryptocurrencies as “interest” or “dividends.”
To the extent there are literal truths about how cryptocurrencies work, sometimes those truths are important, but sometimes they’re not. For example, a detail in a cryptocurrency’s code could lead to a particular tax consequence, while a different method of solving the same design problem could lead to a different tax consequence.
This is worrisome. Today there are about 300 cryptocurrencies (or other digital assets of a type that didn’t exist a decade ago) that by at least one measure have a dollar value of $10 million or more. New variations are emerging, and even proof-of-stake cryptocurrencies make up an evolving and sometimes amorphous category. Unless we’re careful, cryptocurrency will be taxed on the basis of bad metaphors and flawed analogies.
This risk is illustrated by the IRS’s Notice 2014-21, released in March 2014, which states that Bitcoin mining rewards are gross income when received. This informal IRS guidance is not law, but as the government’s only pronouncement on this issue to date, and given the legal uncertainty surrounding many cryptocurrency issues, the advice is influential and risks being applied to technology that might not have been understood when it was drafted. On October 9, 2019 the IRS expanded on Notice 2014-21 with additional guidance, but the new guidance does not revisit the issue of block reward taxation.
The 2014 tax notice doesn’t present the reasoning behind its conclusion. But given the state of the technology in 2014, embodied primarily by Bitcoin, the analogies on which the guidance appears to be based were not then unreasonable. Applied to Bitcoin and similar cryptocurrencies, the advice is defensible. But it doesn’t make good sense in light of the newer proof-of-stake technology, and a clear understanding of cryptocurrency economics shows why a single taxation policy can and should apply to both proof-of-stake and proof-of-work cryptocurrencies.
Although cryptocurrency is an evolving technology, the fundamental economics of network maintenance are clear. An appropriately cautious approach to taxation should therefore be based on these fundamental economics. Taxation should not be based on features of particular cryptocurrencies that, on examination, are idiosyncrasies of how those particular cryptocurrencies were designed.
Accordingly, I argue for a single taxation policy with broad application.
The creation of block rewards should not be a taxable event. Instead, reward tokens should be taxed only when they are sold or exchanged. This ensures the fair market valuation and equitable taxation of all tokens. It also reduces administrative burdens, and these burdens should not be underestimated. Relatively few Bitcoin miners are U.S. taxpayers. But with proof of stake, potentially every token holder can create reward tokens. With Tezos, this would result in 150 taxable events each year if these tokens are income at the time they are created and received by the taxpayer.
Of course, how block rewards should be taxed could differ from how they must be taxed under current law. Although cryptocurrency would benefit from legislative and regulatory clarity and certainty, I also argue that in the meantime no act of Congress or new Treasury regulation is required to ensure the proper taxation of block rewards.
The kitty metaphor helps explain how cryptocurrencies work, but a different metaphor explains how reward tokens should be taxed. This second metaphor is also closer to the literal truth for cryptocurrencies designed thus far, given that we are discussing intangible strings of ones and zeroes: Those who maintain a cryptocurrency network create reward tokens.
There is a meaningful if rarely invoked distinction between property that is received as compensation and property that is created. Received property typically is income when it is received. Created property, on the other hand, typically is not income when it is created. It results in income or a taxable gain only when it is first sold or exchanged. Reward tokens are best understood as property created by those who maintain a cryptocurrency network. In this sense, the tokens are similar to common goods such as crops, minerals, livestock, art, and even manufactured goods.
Each of these things can be obtained as compensation, which will typically render it gross income under the tax code and regulations. But each of these forms of property can also come into one’s ownership without triggering a taxable event — namely, when it is grown, mined, raised, painted, or otherwise created in the course of business. The same logic applies to block rewards. New cryptocurrency tokens are indeed created in the course of maintaining the cryptocurrency network. These tokens often do have value at the time they are created, just as wheat has value both before and after its harvest, and just as widgets have value as they come off the assembly line. But like wheat in the field, block rewards should not — and need not — create taxable income until they are sold or exchanged.
Cryptocurrency is a new invention. Its various features, especially when analyzed in isolation, invite analogies to a wide range of tax provisions and policies. Tokens can look a lot like shares in a public corporation, with reward tokens analogous to stock distributions or, for proof-of-stake cryptocurrencies, stock dividends or other distributions paid to shareholders. From a different angle block rewards look a lot like compensation paid to those who help maintain a cryptocurrency network, and this may be the basis for Notice 2014-21, which would deem Bitcoin block rewards gross income at their fair market value when received. But neither characterization quite fits.
Cryptocurrency is unique, and there is no perfect analogy in existing law or policy to determine its tax treatment. That said, current doctrine — some of it still implicit over 100 years after the 16th Amendment legalized the federal income tax — provides ample precedent for the proper income tax treatment of cryptocurrency block rewards. As briefly sketched out above, like many other forms of property, reward tokens are best understood as property that is created by those who are the first to own them. For reasons that rarely require articulation, property that is created — or grown, mined, raised, cut, fished, hunted, trapped, painted, coded, assembled, or manufactured — is generally not taxed until it is first sold or exchanged. So too should it be with newly created cryptocurrency tokens.
For an in-depth treatment of this topic, see: “Cryptocurrency Economics and the Taxation of Block Rewards,” by Abraham Sutherland. Article in two parts, published by Tax Notes. Available on TaxNotes.com free, outside the paywall, until (at least) December 2019:
Formatted PDF version (full article), available at no charge at SSRN: https://ssrn.com/abstract=3466796
Abraham Sutherland (abraham@virginia. edu) is an adjunct professor at the University of Virginia School of Law.