Tax Treatment of Block Rewards: A Primer

Abstract

• An unsettled issue of immense practical and economic importance: how to tax the new “reward tokens” created in public cryptocurrency networks. • The wrong policy would drive innovation elsewhere. Fortunately, the correct policy is mandated by existing law: these new tokens – like all forms of new property – do not give rise to income until they are sold. • Informal, seven-year-old IRS guidance – not law – geared to Bitcoin and proof of work suggests reward tokens are immediate income at their fair market value on the date “received.” • For the newer proof-of-stake technology, this would create a compliance nightmare and punitive overtaxation. • Ethereum, Tezos, Cosmos, and many other proof-of-stake cryptocurrencies: compliance would be a daunting task – for the IRS as well as taxpayers. New taxable events would occur every few seconds. • “Income” under such a policy would overstate taxpayers’ actual economic gain – significantly, in many cases – resulting in demonstrable, systematic overtaxation. • The overtaxation is equivalent to taxing a 21 for 20 stock split by counting the “new” share – that is, 20/21 the value of an old share – as taxable income. • Like any property, cryptocurrency tokens can indeed be “income” – when received as payment or as compensation. • But new property – property created or discovered by a taxpayer, not received as payment or compensation from someone else – is never income, and never has been. • Cattle, corn, gold, widgets, wild truffles, artworks, novels – think of any new property created or discovered by the taxpayer: It’s no one else’s expense, and it’s not income until sold. • As a factual matter, new reward tokens are indeed created by stakers. • Understanding how tokens are created is complicated; resorting to flawed financial analogies is easy. • Block rewards are nothing like “stock dividends.” They are not “compensation for services” – try to imagine taxable “compensation” that doesn’t come from another person. • Reward tokens cannot be taxed as immediate income under section 61 of the Internal Revenue Code. But not to worry: they’ll be fairly taxed when sold. • Policy problems remain for cryptocurrency taxation – fortunately, new reward tokens are not among them. • It’s not too late to clarify this issue before the effects of a wrong or uncertain policy are felt by millions of taxpayers and the IRS alike. Related scholarship: Cryptocurrency Economics and the Taxation of Block Rewards, https://ssrn.com/abstract=3466796. Dilution and True Economic Gain From Cryptocurrency Block Rewards, https://ssrn.com/abstract=36724616.