Cryptocurrencies are a form of digital currency used worldwide to exchange goods and services. While Bitcoin is the most well-known and used crypto coin, there are over 6,700 different cryptocurrencies with a total market value of over $645 billion as of the end of 2020. And the market cap has changed dramatically even since the end of 2020—peaking at around $2 trillion before settling back down in the $600 billion range. Supporters of cryptocurrency admire that processing and recording of most digital crypto coin transactions are decentralized –free from management and potentially harmful manipulation by any central authority. Crucially, rather than rely on third-parties to validate transactions, crypto networks need decentralized means to securely validate and record user transactions. Most crypto networks still validate transactions using the original proof of work (POW) method. However, POW is riddled with challenges, prompting an increasing number of crypto networks to switch to the proof of stake (POS) method for validating transactions.
A detailed discussion of all of the challenges motivating crypto networks to switch to POS is beyond the scope of this article. Instead, we will briefly introduce our readers to a few reasons for the trending switch and then turn our focus to a federal tax rule that can create significant over-taxation relative to actual economic gain (widely interpreted to be generally applicable to both POW and POS). More importantly for POS network validators, we will clarify how this rule is more burdensome for POS validators.
If one envisions a crypto network as a decentralized ledger being updated by everyone, then it won’t take long to understand the need for a consensus mechanism to ensure that each and every transaction is legitimate. POW and POS are both consensus mechanisms—ensuring that all transactions are legitimate. As consensus mechanisms, POW and POS both have different rules for who is permitted to update the ledger. Below is a very simplistic look at the two mechanisms.
Perhaps most basically, the POW method only bestows the right to update the ledger upon the one that can provide the network with the answer (the “proof”) to a challenge. In the case of Bitcoin, the ledger is updated with new “blocks” of transactions. Miners create blocks via expensive (lots of computing power/electricity) guesswork. Only by trial and error will a miner identify and ultimately offer the “proof” to a challenge—specifically, find the random number that may be added to the miner’s block of transaction without exceeding or equaling the system’s target number. The miner has then earned the right to update the ledger, and the network is assured that the transaction is legitimate.
Equally simplified, the POS method is just another lottery mechanism that ultimately maintains the ledger’s integrity. POS, generally considered to be a cheaper and more environmentally friendly method, requires a validator to stake a certain amount of coins. The more coins staked, the more likely to be randomly chosen as the next validator. In other words, in a Bitcoin context, the coin owner would stake coins and, if lucky, be “rewarded” for participating in and maintaining the network by being chosen as the next validator to create new blocks.
From the outset, validation of crypto networks was dominated by POW; however, within the last few years, an increasing number of networks have been making the move to POS. Recently, for example, Ethereum (the world’s second-largest cryptocurrency network) announced that it will be moving from POW to POS. The move from POW to POS is understandable given all the POW challenges that POS solves. More specifically, as compared to POW, POS:
Significantly, prospective cryptocurrency validators should consider the benefits of POS relative to POW in the context of a federal tax rule that inequitably taxes POS network validation rewards.
Validating transactions is not expense-free, and both POW and POS incentivize users to validate by rewarding coins for successful validations. According to IRS Notice 2014-21, the fair market value of the rewarded coins as of the date of receipt must be included in a validator’s gross income. In other words, the day a validator mines and receives coins, the validator owes tax on the entire value of the coins that same day. Afterwards, the rewarded coins are treated just as any other asset, and tax will be due on any gains from the coins’ eventual sale. Per the IRS, work is being done (validating), and income (coins) is received as a result.
This rule creates a dilution effect on coin holdings, because new coins are received at a rate that is offset by inflation not yet absorbed by the market value. As such, validators are taxed according to market value when they receive new coins and not when they later sell their coins. Ultimately, validators are taxed on an amount disproportionate to their actual gains—i.e., income is overstated using this method.
X coin network is made up of 1 million X coins each valued at $10 (total valuation of $10 million). The network inflation rate is 50% (500,000 new coins per year) and coin-holder, Maks, owns 4,000 coins (total worth $40,000). Assume that every coin-holder participates in validations equally, and the total network value ($10 million) remains constant. Maks will end the year with 2,000 new coins (a 50% increase); however, because the total network value remains constant and Maks owns the same proportion of coins to the total network, Maks’s 6,000 coins (4,000 plus the new 2,000) will still be worth $40,000. Maks started off owning .4% of the total coins (4,000/1 million) and still owns .4% at year-end (6,000/1.5 million). Unfortunately for Maks, per IRS Notice 2014-21, he will have to pay taxes on the new 2000 coins that he received at an average rate of $8.33 per coin. At an income taxation rate of 25%, Maks would have to pay $4,165 (8.33 * 2,000 *.25) in taxes at the end of the year despite no actual gross earnings. The above example is a worst-case scenario, because in reality there is always less than 100% of coin-holders validating and earning new coins.
Using the same facts in Example 1, what if only 50% of users participate in validation? Maks will have twice the validation work to do, earn twice the validation rewards, and earn 4,000 new coins by the end of the year. Moreover, Maks started off owning .4% (4,000/1 million) of the total coin supply and now owns .53% (8,000/1.5 million). Assuming, again, that the total value of the network ($10 million) remains the same, Maks would now have coins worth $53,000 (a gain of $13,000). Unfortunately for Maks, per IRS Notice 2014-21, he will owe taxes on the new 4,000 coins that he received at an average rate of $8.33 per coin. At an income taxation rate of 25%, Maks would have to pay $8,330 (8.33 * 4000 *.25) in taxes at the end of the year despite only earning $13,000 in gross income.
Using the same facts in Example 1, what if only 10% of coin holders participate in validating? Maks will have 10 times the validation work to do, earn 10 times the validation rewards, and earn 20,000 new coins by the end of the year. Moreover, Maks initially owned .4% (4,000/1 million) of the total coin supply and subsequently owns 1.6% (24,000/1.5 million). Assuming, as in the previous example, that the total value of the network ($10 million) remains the same, Maks would now have coins worth $160,000 (a gain of $120,000). Again, unfortunately for Maks, per IRS Notice 2014-21, he will have to pay taxes on the new 20,000 coins he received at an average rate of $8.33 per coin. At an income taxation rate of 25%, Maks would have to pay $41,650 (8.33 * 20,000 *.25) in taxes at the end of the year despite only earning $120,000 in gross income.
In reality, the strain of validation taxation differs dramatically according to the coin and validation system used (either POW or POS). While the inflation rate in the examples above is 50%, typical crypto-coin networks have a much lower inflation rate. For example, Bitcoin, a POW network, currently has 1.8% inflation while Tezos, a POS network, is at 4.87%. The higher the inflation rate, the higher the overstatement of actual gain. Moreover, while validation participation rates are typically high for POS networks (currently 77.5% for Tezos), most POW networks have a very low rate (approximately 1% for Bitcoin) because of the high barrier to entry necessitated by the massive computing power used to mine. Thus, overstatement of actual gain is a much larger issue for POS networks.
Overall, as more cryptocurrencies transfer their network to POS validation systems, an increasing number of crypto-coin users will participate in POS validations and earn POS staking rewards. Considering the current way that the IRS taxes POS rewards, validators are being overtaxed relative to their actual economic gain. Although some members of Congress have expressed concern to the IRS in an August 2020 letter, until the IRS reacts, POS validators will continue to be treated unfairly by the tax code.