June 28, 2021

Cryptocurrency Proof of Stake Validators Face Inequitable Tax Treatment

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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. 

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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.

POW and POS Basics

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.

More Networks Switching from POW to POS

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:

  • transactions require significantly less energy to validate;
  • creates an even more decentralized network; and
  • network users are charged less in transaction fees.

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.

Cryptocurrency is Taxable Income at FMV Upon Acquisition

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.

Example 1:
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.

Example 2:
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.

Example 3:  
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.

Conclusion

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.

Footnotes

  1. James Royal, What is Cryptocurrency? Here’s What You Should Know, NERDWALLET (Jan. 11, 2021), https://www.nerdwallet.com/article/investing/cryptocurrency-7-things-to-know; see Jake Frankenfield, Cryptocurrency, INVESTOPEDIA (May 5, 2020), https://www.investopedia.com/terms/c/cryptocurrency.asp. 
  2. Decentralized means that the crypto network is operated (by network users) across a large number of independently managed computers. Frankenfield, supra, note 1.
  3. Royal, supra, note 1; Frankenfield, supra, note 1. Examples of manipulation by central authorities such as national banks include inflation and deflation. Id.
  4. Id.
  5. See Jake Frankenfield, Proof of Work, INVESTOPEDIA (June 28, 2020), https://www.investopedia.com/terms/p/proof-work.asp; see also Mark Prvulovic, The Best Proof-of-Stake Cryptocurrencies to Buy in 2021, https://marketrealist.com/p/best-proof-of-stake-cryptocurrencies/.
  6. Ryan Browne, Ethereum, the world’s second-largest cryptocurrency, soars above $4,000 for the first time, CNBC (May 10, 2021), https://www.cnbc.com/2021/05/10/ethereum-eth-price-soars-above-4000-for-the-first-time.html.
  7. Matthew Leising and Bloomberg, This breakthrough could make Ethereum more environmentally friendly than Bitcoin, FORTUNE (May 24, 2021), https://fortune.com/2021/05/24/ethereum-bitcoin-buterin-carbon-footprint-proof-of-stake/.
  8. As an example, the energy cost per Bitcoin transaction is about 830,000 Watt-hours, while the energy cost per Tezos transaction is .03 Watt-hours. Proof of Work vs. Proof of Stake: the Ecological Footprint, TQ TEZOS (Mar. 16, 2021), https://medium.com/tqtezos/proof-of-work-vs-proof-of-stake-the-ecological-footprint-c58029faee44. The difference is a factor of 28 million. Id. As of November 20th, 2017, Bitcoin network energy consumption was higher than 159 individual countries! Bitcoin Mining Now Consuming More Electricity Than 159 Countries Including Ireland & Most Countries In Africa, POWERCOMPARE, https://powercompare.co.uk/bitcoin/ (last visited March 23, 2021).
  9. POS networks have higher validation participation rates (and thus more decentralized networks), because no powerful hardware, optimized software, or complex electrical installation is needed for coin users to participate in validating. Consider that Tezos (a POS coin) currently has a 77.5% validation participation rate. Anders Langberg, Inflation in Bitcoin & Tezos, XTZ NEWS (Mar. 27, 2021), https://xtz.news/opinion/inflation-in-bitcoin-and-tezos/. In contrast, Bitcoin (a POW coin) has approximately a 1% validation participation rate.  How Many Bitcoin users Are There?, BUY BITCOIN WORLDWIDE https://www.buybitcoinworldwide.com/how-many-bitcoin-users/ (last visited June 7, 2021) (“[I]t seems quite likely there are over 100 million owners of bitcoins.”); How many bitcoins are left to mine?, BITNOVO (Oct. 1, 2020), https://blog.bitnovo.com/en/how-many-bitcoins-are-left-to-mine/#:~:text=How%20many%20bitcoin%20miners%20are,around%201%20million%20miners%20exist (“It is estimated that around 1 million miners exist.”).
  10. Marc Blinder, Making Cryptocurrency More Environmentally Sustainable, HARVARD BUSINESS REVIEW (Nov. 27, 2018), https://hbr.org/2018/11/making-cryptocurrency-more-environmentally-sustainable.
  11. Supra, note 14. POW systems generally award successful validators with newly “minted” coins and fees charged to transacting users, while POS systems generally rely on transaction fees to make up the rewards. See id. POW validators are more commonly termed “miners,” while POS validators are known as “forgers.”
  12. See IRS Notice 2014-21, Section 4, Q6/A6. The gain would be equal to the amount realized (the amount received upon sale) minus the base (the fair market value at the time the coin was rewarded).
  13. See IRS Notice 2014-21, Section 4 Q8/A8.
  14. Dilution is “a lessening of real value (as of equity) by a decrease in relative worth.” Meriam Webster Dictionary. In the case of POS, dilution is the loss in value of new coin holdings relative to the network’s rate of new coin production.
  15. This example is based on Professor Sutherland’s Standard Oil hypothetical. Abraham Sutherland, Cryptocurrency Economics and the Taxation of Block Rewards, 165 Tax Notes 749 (Part 1; Nov. 4, 2019), 165 Tax Notes 953 (Part 2; Nov. 11, 2019).
  16. Note, all numbers have been rounded to the hundredths place.
  17. Fair market value of an X coin at the start of the year is $10 ($10 million network worth divided by 1 million coins), and fair market value at the end of the year is $6.67 ($10 million network worth divided by 1.5 million coins). Assuming that Maks participates in validations and receives coin rewards evenly throughout the year, the average value of all the new coins he received by year-end will be equal to ($10 + $6.67)/2 or $8.33.
  18. The previous example is also unrealistic, because the value of coins naturally fluctuates on its own according to supply and demand of the market.
  19. Supra note 31.
  20. Anders Langberg, Inflation in Bitcoin & Tezos, XTZ NEWS (Mar. 27, 2021), https://xtz.news/opinion/inflation-in-bitcoin-and-tezos/.
  21. See supra note 37; see also supra note 41. As T (inflation rate) increases, the output (overstatement of actual gain) of the equation in footnote 37 (gross income per notice 2014-21) divided by the equation in footnote 41 (actual income) increases.
  22. Id.
  23.  My 1% estimate is conservative (it could be much lower). It is calculated by dividing 100 million bitcoin owners by 1 million bitcoin miners. “[I]t seems quite likely there are over 100 million owners of bitcoins.” How Many Bitcoin users Are There?, BUY BITCOIN WORLDWIDE  https://www.buybitcoinworldwide.com/how-many-bitcoin-users/ (last visited June 7, 2021). Ellery Davies, co-chair of the Cryptocurrency Standards Association, estimates that there are upwards of 150,000 Bitcoin miners. Ellery Davies, How many bitcoin miners are out there?, QUORA (June 2021), https://www.quora.com/How-many-bitcoin-miners-are-out-there. Another estimate though is that there are about 1 million miners worldwide. MAD, How many bitcoins are left to mine?, BITNOVO (Oct. 1, 2020), https://blog.bitnovo.com/en/how-many-bitcoins-are-left-to-mine/#:~:text=How%20many%20bitcoin%20miners%20are,around%201%20million%20miners%20exist.
  24.  See Bogart supra note 18.; see also supra, note 11.
  25. Letter to Commissioner Rettig from David Schweikert, Bill Foster, Tom Emmer, and Darren Soto on the subject of blockchain and cryptocurrency, Congress of the United States, July 29, 2020, https://schweikert.house.gov/sites/schweikert.house.gov/files/Final%20Proof%20of%20Stake%20IRS%20Letter%207.29.20.pdf.
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