The ruling presents an example involving a cash-method taxpayer with 300 units of cryptocurrency M. Transactions in M are validated by a proof-of-stake (PoS) consensus mechanism (generically referred to as “staking”). The ruling contains a thorough explanation of the mechanism itself, noting that a taxpayer’s validation efforts are returned with “rewards typically consist[ing] of one or more newly created units of the cryptocurrency native to that blockchain.” In the ruling, Taxpayer A stakes 200 units of M to validate a new block of transactions on the M blockchain. As a reward for the validation, Taxpayer A receives two additional units of M, which become accessible for sale, exchange, or disposal on a subsequent date, based on the M protocol.
The ruling holds that when a cash-method taxpayer stakes cryptocurrency for PoS purposes and receives additional units as rewards for its validation, the fair market value of these validation rewards must be included in the taxpayer’s gross income for the tax year in which the taxpayer gains “dominion and control” over the rewards. The fair market value is determined as of the date and time the taxpayer gains dominion and control over the rewards.
Directionally, the ruling’s conclusion is a natural extension of previous guidance issued by the IRS addressing proof-of-work (PoW) (sometimes referred to as the closely related concept of “mining”). The IRS cites Section 61(a) of the Internal Revenue Code as well as the United States Supreme Court 1955 ruling in Comm’r v. Glenshaw Glass Co., to support its view that any undeniable accession to wealth, clearly realized, and over which a taxpayer has complete control, should be included in gross income. Having previously concluded that cryptocurrency, as a form of virtual currency, is property for federal tax purposes, the IRS believes that its receipt marks a clear, realized accession to wealth to which the taxpayer has dominion and control.
When the ruling’s taxpayer gains the ability to sell, exchange, or otherwise dispose of the two units of M received as rewards for staking and validation transactions, the taxpayer gains dominion and control, resulting in an “accession to wealth.” Accordingly, the fair market value of the two units of M at the time Taxpayer A gains dominion and control (Date 3) is included in Taxpayer A’s gross income for the taxable year that includes Date 3.
Rev. Rul. 2023-14 is unlikely to be the last word on the issue of staking. Pointing to its own explanation of how staking is rewarded, there are fundamental differences between staking and mining. Mining, or PoW, would seem to fall squarely within bedrock cases like Comm’r v. Glenshaw Glass Co., establishing the constitutional requirements for income recognition, and the United States Supreme Court 1940 ruling in Helvering v. Bruun.
Bruun is a particularly interesting case. In Bruun, a taxpayer-landlord repossessed property from a tenant—property that had been subject to a 99-year lease— after the tenant failed to pay rent and taxes. The lease had allowed for the tenant to construct a new building or make other improvements. The tenant had razed the existing building and built a new one. The value of the new building, as of the date of repossession, was significantly more than the landlord’s basis in the building that had been removed.
The landlord argued that there was no realization of the increased value of the property upon repossession because no transaction had occurred, and that the improvement of the property that created the gain was unseverable from the landlord's original capital. The Court disagreed. The Court held that unseverable as it was, the receipt of the improved property and the landlord’s dominion and control over the improved property meant that realization had occurred and the landlord recognized an accession to wealth due to the increased value of the property – i.e., income. Similarly, in the context of mining, a taxpayer is receiving property for performing a service. There has been an undeniable ascension to wealth, clearly realized, and over which the crypto-miner has dominion and control.
Compare this to the situation in the United States Supreme Court 1920 ruling in Eisner v. Macomber, as well as a several other situations involving the exploitation of existing property to create new property. In this case, Myrtle Macomber owned shares of Standard Oil, which underwent a stock dividend. As a result, Myrtle received additional shares of a known value, which represented earnings accumulated by the company, recapitalized rather than distributed. The government contended that the dividend should be taxed as income to Macomber as if the corporation had distributed money to her. She then sued the collector of Internal Revenue (Eisner), for a refund.
Economically, a stock dividend is the equivalent of a stock split. While there are similarities between a stock split and cash dividend, there are also fundamental differences (much as in the case between PoS and PoW). The question in Macomber was not whether the shareholder had gained in an economic sense, but whether in legal or accounting terms the stock dividend was to be regarded as a taxable event – whether it had been clearly realized. Is a stock dividend more like a situation in which a corporation simply accumulates its earnings and makes no distribution at all? Or is it more akin to the receipt of a cash dividend which is followed by a reinvestment of the cash received in additional shares? The Court’s majority held that it was the former.
Some would argue that after Bruun (which eliminated a “severability” requirement that some had read into cases such as Glenshaw Glass Co.), Macomber no longer controls. But that simply is not true. Stock splits still are not taxable. A taxpayer does not recognize income until the subsequent sale of the stock. And the issue of severability has no bearing on this either. Consider the case when the farmer harvests her crop, or the artist creates a new portrait, or even when the miner extracts his ore. In this respect, some would argue that PoS is “more like” the situation in which a corporation simply accumulates its earnings – the crypto-holder is accumulating the validity of the blockchain, as opposed to an actual receipt of a new unit of cryptocurrency as would be the case in crypto mining.
The constitutional underpinnings of the Macomber case presently are before the Supreme Court on a slightly different, but related issue in Moore v. United States (taxpayers challenging the constitutionality of the one-time Section 965 transition tax). Depending on the outcome of that case, it will be interesting to see if Rev. Rul. 2023-14 withstands challenge from a savvy industry.
Proposed Cryptocurrency Guidance
Less than a month after releasing Rev. Rul. 2023-14, the IRS again dipped into the cryptocurrency waters, issuing proposed regulations on broker information reporting for digital assets. As background, the Infrastructure Investment and Jobs Acts of 2021 (the “2021 Act”) amended the Tax Code to include “digital assets” in the group of assets that brokers must report information on when they facilitate transactions. The 2021 Act also gave Treasury the authority to implement regulations.
The big items contained in these proposed regulations include definitions for the terms “broker” and “digital asset.” Under the proposed regulations, the concept of who is a broker is expanded to include anyone providing services that facilitate the sales of digital assets and who would know or be in a position to know the identities of the parties involved (called “digital asset middlemen” by the proposed regulations). Using examples, the proposed regulations make clear that any business that facilitates the sale of digital assets, whether through physical kiosks or online trading platforms, is considered a broker, as are platforms holding custody of customers’ digital assets or controlling non-custodial trading platforms. The proposed regulations go on to include wallet providers, payment processors, stablecoin issuers that offer to redeem their coins, and even real estate reporting persons (e.g., a title company or law firm) to the extent digital assets are used in a real estate transaction. Fortunately, the expanded definition of broker would not include miners, stakers, retailers who merely accept digital assets, and non-fungible token (NFT) artists.
Similarly, the definition of what constitutes a digital asset is expanded to match the intent of the 2021 Act. The proposed regulations’ definition is intended to be expansive and at the same time, is drafted to capture future innovations. A digital asset is defined as any digital representation of value recorded on a cryptographically secured distributed ledger, but does not include cash. While this broad definition includes newer technologies such as stablecoins, NFTs, and tokenized commodities, it perhaps is easier to define by identifying what is not included in its definition. The proposed regulations specifically exclude digital assets used in a closed system, such as tokens that can only be used in a video game. The term also excludes central bank digital currencies. Further, the proposed regulations would not apply to uses of distributed ledger technology or similar technology for ordinary commercial purposes that do not create new transferable assets, such as inventory tracking or processing orders for purchase and sale transactions. Importantly, the determination of whether an asset is a digital asset is made without regard to whether each individual transaction is actually recorded on a the cryptographically secured distributed ledger; and thus, the definition covers transactions involving digital representations of value that are recorded cryptographically by a broker on its own centralized internal ledger (e.g., broker records each transaction on own internal ledger and only records the resulting net transactions on the secured distributed ledger).
The proposed regulations leave the existing reporting rules largely intact, although they do offer guidance on how to determine an amount realized when selling a portion of, but not all, of the same digital asset. A specific identification method is permitted in determining a seller’s basis. Otherwise, the units of the digital asset deemed sold are determined in the order of time from earliest purchase date of the units of the same digital asset (or the earliest date of units first transferred to a broker if trading from a broker account).
Finally, the proposed regulations provide rules for the allocation of transaction costs involved. The proposed regulations explain that except in the case of the exchange of one digital asset for a digital asset differing materially in kind or extend, the digital asset transaction costs paid by the taxpayer are entirely allocated to the digital assets received. However, in the exchange of digital assets for other digital assets that differ materially in kind or extent, 50 percent of the transaction costs involved in the exchange of digital assets are allocable to the to the transferred digital assets for purposes of determining the amount realized while the remaining 50 percent are allocable to the acquired digital assets for purposes of determining the basis of the received digital assets.
Pursuant to the proposed regulations, the required additional reporting by brokers of gross proceeds would apply to sales and exchanges of transactions effected on or after January 1, 2025. Consequently, the filing of the information returns reporting these 2025 transactions would be required in 2026. However, the additional reporting requirements regarding adjusted basis and character of gain or loss would apply to any sale of such assets if the sale or exchange is effected on or after January 1, 2026. The adjusted basis reporting would be required to the extent the broker held custody of the digital asset on or after January 1, 2023 or if such options or forward contracts were granted, entered into, or acquired on or after January 1, 2023.
The proposed regulations provide that any broker that voluntarily undertakes the reporting requirements laid out in the proposed regulations prior to the effective dates will not be subject to penalties under IRC Sections 6721 or 6722 for failure to report or furnish such information correctly. Since a new reporting form has not yet been provided, such brokers would use Form 1099-B until such new form is available (Form 1099-DA).
The summary information in this document is being provided for education purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.
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