Law, Policy, and the Taxation of Block Rewards

I. Introduction

This report addresses the taxation of block rewards — the rewards offered to validators of blockchain transactions in exchange for maintaining the public blockchain ledger. The main question the report seeks to answer is whether newly minted cryptocurrencies (a component of block rewards) are taxable upon receipt. Some commentators have suggested that there is legal ambiguity about whether block rewards are taxable upon receipt because of the novelty of the blockchain technology.¹ They have asserted that even if block rewards are taxable at receipt under current law, they should not be as a matter of policy.² According to those commentators, the taxation of tokens received as rewards should be deferred until the tokens are disposed of.³

I advance three arguments in this regard. The first is purely positivistic: Under current law and existing guidance, block rewards are clearly taxable upon receipt. There is no legal ambiguity on this issue. Calls for Treasury to issue “clarifying guidance”⁴ and attempts to force courts to issue advisory opinions on the matter⁵ are in fact calls to change exiting law and guidance.

Second, I discuss whether block rewards should be taxable upon receipt as a matter of tax policy. Although reasonable minds can differ on this question, I argue that there is no good policy justification to exempt block rewards from taxation when received. Some commentators have suggested⁶ that one type of block reward — staking rewards — should receive more favorable tax treatment than others (mining rewards). I argue that there is no good policy reason to treat staking rewards more favorably than mining rewards.

Exempting block rewards from taxation at receipt would be inequitable because it would violate the basic standards of horizontal and vertical equity. Exemption would also be inefficient because (1) it would offer a tax subsidy when there is no compelling government interest for a subsidy; and (2) it would simply leave revenue on the table, because current taxation of block rewards seems to have no disincentive effect on the validation process (or the development of blockchain technology in general). Moreover, there is no administrative justification to exempt block rewards from taxation at receipt.

Finally, the report notes a baffling aspect of the arguments to exempt block rewards from taxation: It is just bad tax planning. Validators probably believe the value of their reward tokens will increase significantly over time. If this is true, nontaxation at receipt will likely result in more — not less — tax burden on validators. The reason is that if block rewards are exempt upon receipt, their entire appreciation is subject to tax at ordinary rates. On the other hand, if block rewards are taxed upon receipt, much of the appreciation will be subject to tax at preferred long-term capital gains rates.⁷ It is difficult to identify a rational tax motivation for validators to argue against current taxation of block rewards; the only rational explanation is that validators who make those arguments expect to never pay tax on their block rewards through the use of deferral mechanisms, such as collateralized loans, constructive sales, stepped-up basis at death, or simply through misreporting (whether intentional or not).

II. Block Rewards Are Taxable

A. Consensus Mechanisms

A key innovation of blockchain technology is the ability to validate transactions and record ownership in a decentralized manner, with no reliance on a trusted intermediary.⁸ Ownership is recorded on a public distributed ledger. To maintain the ledger, network users must agree on its authenticity (a consensus mechanism). When users exchange cryptocurrencies, recent transactions are grouped together into a block. Users who choose to participate in the validation process (validators) confirm the authenticity of the transactions in the block and compete for the right to add the proposed authenticated block to the public blockchain ledger.⁹ The winner of the competition adds the block to the ledger and receives a block reward. These block rewards serve as the financial incentive for blockchain users to participate in the validation process.¹⁰

Validators’ rewards may consist of two components: fees from the parties whose transactions they validate, and new cryptocurrencies minted by the blockchain protocol as part of the validation process.¹¹ Thus, validation is the mechanism by which new tokens are “issued.”¹² The fee component of the reward is clearly taxable upon receipt,¹³ and I am unaware of any contrary argument in this regard. I do not discuss the fee components in this report, which focuses on the taxation of newly minted cryptocurrencies. For the rest of the report, I use the term “block rewards” only to refer to newly minted tokens.

Another clarification is in order: I refer to block rewards as having intrinsic value, meaning that they do not represent ownership or a profit interest in some other underlying enterprise. In such a case, the rewards may be treated as securities, and the tax analysis would follow from that.

There are two main methods of validation (and, as a result, the creation of new tokens): mining, also known as proof of work (PoW); and staking, also known as proof of stake (PoS).¹⁴

Under the PoW method, “the right to validate new transactions and add them to the blockchain is allocated to so-called miners in exchange for finding an acceptable solution to an arbitrary cryptographic puzzle (the ‘work’ or ‘mining’).”¹⁵ The more computing power one uses, the higher the chance one has of winning the validation competition. Mining is an expensive process: The difficult cryptographic problems require significant computing power, which in turn requires cooling and electricity. As a result, mining developed into a capital-intensive business, consisting of large facilities dedicated to mining.¹⁶ Because of the electricity-demanding nature of cryptocurrency mining, it has a negative environmental impact.¹⁷

Most individual miners cannot generate enough computing power to win the cryptographic competition on their own. Therefore, many miners pool their computing resources together into mining pools.¹⁸ Pool operations vary. Generally, however, pools use the combined computing power to try to earn block rewards, and then distribute the rewards (minus some fees to the pool operator) based on a mechanism that takes into account the proportional computing effort contributed by each pool participant.¹⁹

In a PoS network, owners of existing tokens can maintain the network by committing (staking) some of their existing cryptocurrencies to the validation process.²⁰ Validators still own the staked tokens, but they cannot use them while committed. In this sense, the staked amount is similar to a loan: The loaned property is still an asset of the lender, but it is not available for the lender’s use until it matures.

While staking mechanisms vary, the amount of reward tokens that stakers receive generally depends on the size of their stake, as well as the staking period, as compared with other stakers. The higher the commitment and the longer the commitment period, the higher the reward (or the chance of receiving a reward). Because staking requires no significant computing power, but merely the financial commitment of existing tokens, it consumes less energy than mining.

Staking may require the stakers to commit their stake for a specific time without the ability to withdraw it. Also, the network protocol may hold staking rewards for a specified period before releasing them to stakers.²¹ Moreover, stakers’ commitment itself is subject to some financial risk.²² PoS protocols require honest and active participation from validators — those who cheat or are passive may be penalized by having their commitment “slashed” — that is, other validators, who are honest and active, can claim some of the stake of passive or dishonest validators.²³

Stakers can also delegate their validation efforts to a third party.²⁴ The third party can use the delegated stake to authenticate transactions and deliver the reward to the original owner, minus a fee.²⁵ Delegation can also be done on a pooled basis (to increase the chances of reward).²⁶

B. Taxation of Block Rewards: The Law

The code and regulations provide that “gross income means all income from whatever source derived, unless excluded by law.”²⁷ Under the standards the Supreme Court prescribed in Glenshaw Glass,²⁸ gross income includes any “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.”²⁹

There is no question that block rewards have value. Otherwise, they would not have fulfilled their role as an incentive to participate in the validation process. Their receipt constitutes an accession to wealth.

Block rewards are clearly realized. The form of income, whether in cash or other property (such as block rewards), does not matter; the regulations specify that “gross income includes income realized in any form, whether in money, property, or services.”³⁰ (Emphasis added.) A block reward is clearly realized because it is a thing of value that validators receive and that they did not have before. It is not different from a person realizing a payment in any other form of property (regardless of what the payment is for). Although not necessary for this conclusion, guidance on property transactions is also helpful here. Under Supreme Court precedent, taxpayers realize income when they exchange a thing for something “materially different.”³¹ In the context of block rewards, taxpayers exchange something (whether it is a service, time, labor, or computing power) for something materially different: a new digital token.

The question of dominion turns on the specific time at which block rewards are available for use by the validators. For example, if staking rewards remain out of reach for the validator for some prescribed period under a network protocol or under a particular delegation mechanism, income arises when the reward is available for use by the validator.

To summarize, block rewards clearly meet the definition of income under Glenshaw Glass. They are taxable to validators at fair market value at the moment they come under validators’ dominion.

Even though it is not necessary for the conclusion that block rewards are taxable upon receipt, section 83 is also helpful guidance in this regard. Under section 83, property received in exchange for services is included in income when that property becomes transferable or no longer subject to substantial risk of forfeiture. Because block rewards are granted in exchange for the services provided by validators (the maintenance of the network),³² validators must include the rewards once they become transferable or otherwise unrestricted. Under section 83, service providers must include in income the FMV of the property they received, minus any amount paid by them.³³ Because validators do not pay for the rewards,³⁴ they must include the full FMV of the rewards at the time of receipt.

The only on-point guidance from the IRS came in Notice 2014-21, 2014-16 IRB 938, in which the agency clearly stated that mining rewards are taxable upon receipt.³⁵ Some commentators have lamented that the IRS offered no rationale in reaching that conclusion.³⁶ However, no rationale is needed because the 2014 notice is consistent with the current law and regulations.

Other commentators have suggested that some ambiguity remains in the context of staking rewards because the 2014 notice addressed only mining rewards.³⁷ As noted, however, even in the absence of the 2014 notice, there is no ambiguity in the law: Staking rewards are clearly taxable upon receipt under the Glenshaw Glass standard, as well as section 83. Moreover, there is no qualitative difference between staking and mining that warrants a different interpretation of the law, regulations, or Supreme Court precedent.³⁸ Staking rewards are undeniably accessions to wealth, clearly realized, and over which stakers have complete dominion.

C. Legal Arguments Against Taxation

Despite the clear legal standards, some cryptocurrency advocates argue that “the creation of block rewards should not be a taxable event.”³⁹ They suggest instead that block rewards be taxable only when sold or exchanged.⁴⁰

Given that the 2014 notice makes it explicit that mining rewards are taxable upon receipt, this argument is advanced mostly in the context of staking rewards. Most notably, in Jarrett, the taxpayers filed a claim for refund for about $4,000 of taxes they paid on income earned as block rewards.⁴¹

Treasury had issued a refund to the taxpayers and asked the court to dismiss the case because of the extinguishment of the controversy.⁴² As I have explained elsewhere,⁴³ the IRS likely issued the refund to avoid lengthy litigation over miniscule amounts and did not concede any legal position. Apparently, the taxpayers believe so as well. Rather than taking the full refund they sued for, the taxpayers rejected the refund⁴⁴ and are trying to force the court to issue an advisory opinion to “clarify” the tax treatment of staking rewards.⁴⁵ In an amended complaint, the taxpayers have asked for a permanent injunction against taxation of their future staking rewards.⁴⁶ Because staking rewards are clearly taxable under current law, a request for such remarkable relief regarding potential future income is nothing short of an attempt to change the law.

Below I respond to three categories of common legal arguments against taxation of block rewards upon receipt: (1) block rewards do not constitute gross income because they are created property; (2) block rewards are not income because of some inflationary/dilutive effect; and (3) miscellaneous other arguments.

1. Block rewards are not income because they are created property.

One of the most common arguments against taxation of block rewards is that they constitute property created by the taxpayer.⁴⁷ In Jarrett, the taxpayers claim that their staking rewards should not be taxable upon receipt because “new property is never income in the hands of its creator or discoverer.”⁴⁸ Validators are sometimes analogized to bakers⁴⁹: Just as bakers are not taxed upon completion of a cake, but only upon its sale, validators should not be taxed until selling their newly minted (“created”) digital coins.

There are two problems with this argument. First, as a matter of law, when a taxpayer meets the Glenshaw Glass standard, the taxpayer has gross income unless a specific exception applies.⁵⁰ Stakers who make the manufacturer analogy fail to identify a specific exception for the inclusion of staking rewards in income. Instead, as in Jarrett, they offer blanket generic statements, such as that the principle under which staking rewards are not taxable at receipt “is so fundamental that it is rarely invoked and makes no appearance in the code or regulations. Indeed, it is so deep an assumption underlying the tax code that it appears no court has ever had occasion to declare it.”⁵¹ In other words, the argument is that there is no explicit exception from inclusion, but that the exception is so basic that we just know it is there. To borrow from Justice Potter Stewart’s opinion in Jacobellis,⁵² the Jarretts do not attempt to define the kinds of exemptions they understand to be embraced within that shorthand description of income; and perhaps they could never succeed in intelligibly doing so. But they know it when they see it.

This argument is not only unusual, it is wrong. When Congress or Treasury wishes to exempt income from inclusion, it does so explicitly.⁵³ For example, under standard accounting rules, income from manufacturing or mining business is explicitly included only when the manufactured or extracted inventory property is sold, at the retail value minus the cost of goods sold.⁵⁴ Similarly, farmers (again, under explicit regulations) can choose their method of accounting⁵⁵: If they choose the cash method, they include income upon sale of their farming products (minus COGS). If they elect the accrual method, they have to include income based on their inventories, not sales.

Even if we accept the manufacturing analogy (and we should not⁵⁶), to defer taxation until sale, stakers would have to show that they are in the business of manufacturing new tokens. That showing is likely beyond the reach of most stakers, who are unlikely to have a trade or business of token manufacturing.⁵⁷ Moreover, it is clear that nonbusiness lucky finds of treasure troves are included in income.⁵⁸ Similarly, prizes and awards are included in income.⁵⁹ When Congress wants to exclude specific awards from income, it makes the exception explicit.⁶⁰ Cryptocurrency proponents fail to point to a legal exception to inclusion of block rewards in income because none exists.

The best possible read of the “created property” argument is that proponents of nontaxation see block rewards as some form of imputed income. Imputed income — income from services one provides to oneself or from property one owns — is de facto excluded from gross income.⁶¹ It is probably the only form of economic income that is clearly excluded, even though no clear legal or regulatory exception for that exclusion exists.⁶² The Jarretts even analogized staking rewards to imputed income in their court brief.⁶³ However, block rewards do not represent imputed income by any reasonable definition of the term. If block rewards are rewards from services, they are certainly not from services that validators provide for themselves. Validators provide services to the blockchain community at large. If block rewards are created property, it is not property that validators create for their own use or consumption. There is no utility for those rewards other than their potential sale at market value. Even the case cited by the Jarretts in their brief — Morris⁶⁴ — does not support their analogy. In that case, the Board of Tax Appeals concluded that the value of farm produce consumed by a farmer and his family is not included in gross income.⁶⁵ Stakers cannot consume the rewards they supposedly create.⁶⁶ Under Morris, a farmer is clearly distinguishable from a staker.

The second problem with the manufacturing analogy is that it is wrong. Stakers (and miners) are not creators of new tokens.⁶⁷ They do not create anything by themselves. They provide a service of validating transactions of other network participants. In exchange, validators are paid in newly created tokens. The fact that the tokens are newly created is completely irrelevant because the validators are not the ones who created them. Validators did not program the new tokens into existence. They follow a fixed protocol. At best, validators pull the lever of a coin-manufacturing machine in a factory where they work.

Unlike a true proprietary baker, salaried bakers in a bakery cannot decide which cakes to make or when to make them. They cannot tweak the recipes. They have no control whatsoever over whether a cake is baked in the first place. If a baker who provides baking services decides not to show up for work, he will not earn wages, and he may even lose the job, but another baker who is willing show up will bake the cake.

The same applies to validators: They do not own the blockchain (no one does). Instead, validators provide services for the blockchain community at large, just like salaried bakers work for a bakery. Just like our salaried bakers, validators cannot decide to change the issued token in any way. They cannot tweak its properties. They are bound by the software’s “recipe.” Validators cannot even decide whether a coin is created. If a particular validator decides not to participate in the validation process, some other validator will create the exact same coin. If validators do not show up for work, they may be penalized by slashing.

It is hard to see how one can claim to create property when one lacks the power to decide whether the property is created in the first place. It is hard to see how one can claim to create a thing when one has no creative control over the thing’s properties.

In fact, the Jarretts admit in their court filing that “public cryptocurrency must not be maintained by a single person, or else it wouldn’t work as designed — because, in short, that person could cheat.”⁶⁸ A painter cannot cheat himself, because a painter can paint whatever he wants to paint. Cheating becomes possible only when you transact with someone else under pre-agreed terms. In other words, there is nothing unique about a particular validator creating a particular token, and this lack of uniqueness is imperative for the network’s operation.

To summarize, validators create their reward tokens just as much as Ford assembly line workers create Ford F-150s. If an assembly line worker is paid with an F-150 from the assembly line, it is clearly taxable at the time of receipt.⁶⁹ Validators are assembly line workers at a decentralized blockchain factory who are paid new tokens in exchange for the service they provide. The New York State Bar Association similarly concluded recently that “while the taxpayer’s actions led to its receipt of the staking rewards, the staking rewards were not created by the taxpayer’s actions (which simply involve validating transactions involving other units of the same cryptocurrency).”⁷⁰

2. The dilution/inflationary effect.

Another frequent set of legal arguments made against taxation of block rewards at the time of receipt is that they do not represent accession to wealth when received. These arguments can be boiled down to two. First, the inclusion in income of rewards at their FMV is wrong because it does not take into account a so-called dilution effect.⁷¹ Even if the dilution effect results in income, it is impossible to calculate the true income. Second, because staked amounts are subject to a risk of loss (because of dilution or slashing), it is wrong to include rewards in income without accounting for potential losses.⁷² Only taxation at sale “fixes” the true accession to wealth, according to those arguments. This as an implicit call to treat validation as an open transaction.⁷³

Let us start with the dilution argument. Under this line of reasoning, “increasing the token supply means that new tokens dilute the value of all tokens. Each new token reduces the stake in the network represented by each existing token, and in turn each existing token loses value because it represents a smaller fraction of total network value.”⁷⁴ Sometimes proponents of that argument use analogies to Macomber,⁷⁵ in which the Supreme Court held that a proportional stock dividend is not taxable.⁷⁶ Similar arguments are sometimes presented in inflationary terms — that is, because validation creates new coins, the inflation in the number of coins deflates the value of each coin.

There are several flaws with these arguments, both legal and conceptual. First, one could reasonably question the idea of dilution in the first place. Unlike corporate stock, which represents shareholders’ proportional interest in the assets and profits of the undelaying corporation, holding a token as a currency represents an interest in nothing other than that particular token. When the number of corporate shares is doubled (without distribution to existing shareholders), existing shareholders literally own half as much interest in the corporate assets and profits as they did before. When the number of digital tokens is doubled, anyone who did not receive a new token still owns the exact same assets as they did before. The value of the asset may change as a result of inflationary effect, but the owners’ interest has not been diluted. Cryptocurrency holders (who hold the currency for its intrinsic value) have no interest in underlying assets or an entity;⁷⁷ their only interest is in communal belief of the value of the token.⁷⁸

Second, even if we accept that there is an element of dilution, the Macomber analogy is not representative of reality. Not all cryptocurrency owners participate in the validation process. By definition, newly created cryptocurrencies are almost always distributed disproportionally among network participants and thus represent an accession to wealth.⁷⁹ Going back to the dividend analogy, when a corporation disproportionately issues new stock, there is a redistribution of value from some shareholders to others. Current law is clear that this is a taxable event.⁸⁰ If dilution is real, there is redistribution of wealth from non-validators to validators.

Nontaxation proponents, of course, recognize that disproportionate stock distributions are subject to taxation.⁸¹ Their counterargument is that because of the inflationary/dilutive effect, including staking rewards in income at FMV does not capture the true value received by validators.⁸² Under those arguments, the real value would have to account for these deflationary effects. Inclusion at FMV would be an overinclusion. This is a bizarre argument. As a conceptual matter, these commentators ask us to believe that the “market value” of reward tokens is not, in fact, the market value of reward tokens. In an efficient market, market participants incorporate available information into the pricing of assets. The rate of coin creation is a known quality in cryptocurrency markets. Network participants presumably are taking into account inflationary/dilutive effects when pricing coins at any given time.

Moreover, even if an inflationary effect exists, it does not change the legal outcome. Under explicit law, the amount included in income is the FMV of property received at the time of receipt.⁸³ There is no law that reduces the amount of inclusion to “value at the time of receipt, minus anticipated inflation or dilution.” When taxpayers receive their salaries in cash, they include the face amount of cash in income — not the face amount minus any expected rate of inflation between the time of receipt and the time of consumption. When Congress wants to take into account inflation for tax purposes, it does so explicitly. Multiple code provisions are inflation-adjusted.⁸⁴ There is no code provision that allows inflation adjustments for the receipt of cryptocurrencies as block rewards.

The second line of argument suggesting that staking rewards are not taxable upon receipt relies on the fact that staking has an inherent risk of loss (from slashing and inflation), and that the potential of loss is not accounted for until disposition of the reward. Thus, it is argued that it would be inequitable to tax rewards on receipt but defer a potential loss.⁸⁵

It is not clear to me if this is a normative argument, or a legal one advocating for an open transaction treatment of block rewards. Assuming it is a legal argument,⁸⁶ it is wrong. Shareholders risk that the value of their stock may decrease in value, but dividends are taxable upon receipt. They do not get to deduct losses until disposition of the stock. Bondholders are subject to the credit risk of a borrower who may be unable to repay the debt, yet they pay tax on interest as they get it. They do not get to deduct losses until disposition of the bond or until it is written off as worthless debt. Real estate owners are subject to multiple risks when renting out their assets, yet they pay tax on rental income as they receive it. There is nothing unique about staking rewards in this regard. If stakers experience any loss from their activities, they are welcome to identify a code provision that allows them some loss deduction.⁸⁷ The possibility of loss does not serve as exemption from income under the law. When Congress decides to offer open transaction treatment for property transfers, it does so explicitly.⁸⁸ There is no open transaction treatment for cryptocurrency validation under current law.

3. Other arguments against inclusion.

While “created property” and “dilution effect” are probably the most frequent arguments against inclusion, commentators have suggested several others.

One common argument is that the tokens “are not received from any counterparty.”⁸⁹ The argument is factually questionable and legally irrelevant.

The argument is factually questionable because there are, in fact, counterparties: network participants whose transactions are cleared by the validators. As proponents of nontaxation note (against their own interest in this context), the disproportionate issuance of new tokens to validators dilutes the holdings of those who do not participate in the validation process.⁹⁰ New tokens therefore represent a transfer of value from non-validators to validators. There absolutely is a counterparty (network participants), and there absolutely is a transfer of value (from non-validators). The fact that we may not be able to tell who the counterparty is is irrelevant.

Second, even if one accepts that there is no counterparty issuing the block rewards, that “fact” is simply irrelevant from a legal point of view. The definition of income under section 61 does not require that income be received from a counterparty. For federal income tax purposes, income is “any accession to wealth, clearly realized, under the taxpayer dominion and control.”⁹¹ The Glenshaw Glass standard of income does not require that income be received from a sentient being.

Note that a treasure trove is clearly taxable at the time of the find,⁹² even though it is received from no one. In Jarrett, the taxpayers try to distinguish block rewards from treasure trove by claiming that treasure trove, even if not received from anyone, has been “’previously owned’ by someone.”⁹³ This is a distinction without meaning. The definition of income does not require that the property received be previously owned. If a taxpayer receives newly issued stock, she must include the value of the stock in income. The fact no one owned the stock before is irrelevant.

A somewhat similar line of argument suggests that block rewards are not like any other types of income. For example, the Jarretts’ brief goes into great detail explaining why staking rewards are unlike interest or dividends,⁹⁴ or income from services,⁹⁵ for tax purposes. Again, from a legal perspective, it does not matter if block rewards are like other types of income. Any realized accession to wealth under the taxpayer’s control is income.

The summary of this subsection is straightforward: Newly created cryptocurrencies received as a component of block rewards are clearly taxable upon receipt at their FMV. There is no legal exception for inclusion of block rewards, and arguments against inclusion either ignore or misrepresent current law.

III. Taxation of Block Rewards: Policy

Although current law is clear, we can reasonably debate tax policy. In this section, I question if there is a good policy reason to exempt block rewards from taxation upon receipt. I argue that there is none. I address taxation of block rewards in the context of the three determinants of tax policy: equity, efficiency, and administrability.

A. Equity Considerations

An equitable (or fair) tax system is one that takes into consideration the individual circumstances of each taxpayer when determining their tax burdens.⁹⁶ The two basic determinants of equitable taxation are vertical equity and horizontal equity.⁹⁷ Vertical equity means that taxpayers’ tax burdens should correlate with their well-being⁹⁸ — affluent taxpayers should carry a higher overall tax burden than poor taxpayers. Horizontal equity questions “under what, if any, circumstances it is acceptable that that two equally well-off households bear a different tax burden.”⁹⁹

Vertical equity considerations require that validators be taxed on income that they receive, because it increases their ability to pay. Under horizontal equity considerations, one must make an argument that justifies different taxation for taxpayers who earn income in the form of block rewards than for taxpayers who earn income in any other form. For example, there may be a good policy reason to tax salaries but to exempt lost wages received as compensation for physical injury.¹⁰⁰ But I am unaware of any such argument in the context of block rewards. Validators do not experience unique difficulty compared with taxpayers who earn value in other taxable forms.

The only particular argument I am aware of in this context is that PoS rewards may be treated differently from PoW rewards because of the supposed ambiguity of the 2014 notice.¹⁰¹ As explained earlier, there is no legal merit to that argument.¹⁰² This conclusion is also supported by equity considerations: There is no good equitable argument to burden miners more than stakers. Why should $1,000 worth of staking rewards be taxed differently from $1,000 worth of mining rewards or $1,000 worth of a corporate employer’s stock? From a fairness point of view, this is a difficult normative argument to make. One must identify hardship that is worthy of relief and associated only with staking.

There is also an efficiency argument in favor of exempting staking rewards but not mining rewards. This argument relates to the fact that staking is more environmentally friendly than mining. I address this argument in the next subsection.

B. Efficiency Considerations

An efficient tax system is one that adequately funds government while minimizing distortions in economic behavior. If the government taxed income in the form of block rewards differently from any other income, it would be picking winners and losers. It would distort behavioral decision-making in favor of engaging in validation over other activities.

Sometimes governments pick winners and losers on purpose. When a societal interest is compelling enough, a government may subsidize an activity through the tax system to encourage that activity. For example, the government may offer credits for research and development activities to encourage that activity in the United States,¹⁰³ or offer particular incentives for the production of renewable energies in order to steer taxpayers away from polluting activities.¹⁰⁴

Cryptocurrency proponents frequently assert that government must exempt block rewards from taxation because not doing so puts the industry at risk. The disincentive, they argue, may hamper innovation in the cryptocurrency space, to the detriment of society.¹⁰⁵ This argument is questionable.

There is no evidence that the taxation of block rewards hampers innovative activity or even the mere adoption of cryptocurrency. The cryptocurrency industry has grown dramatically since its inception. A recent analysis suggests that the global market for cryptocurrency grew at an annualized rate of 10 percent from 2017 to 2019, and that the rate of growth will reach 11.1 percent (annualized) between 2021 and 2028.¹⁰⁶ It seems that despite the warnings, blockchain markets do just fine without government subsidies. It is difficult to justify a tax subsidy for an industry that seems to be doing very well under existing tax laws.

Some commentators have advocated the exemption of staking rewards and not mining rewards, because staking is more environmentally friendly.¹⁰⁷ That argument fails to explain why governments need to support staking in the first place. These arguments also fail to account for the fact that the market seems to transfer from mining to staking on its own, without any government subsidy. Staking seems to be growing in popularity, and one of the most valuable blockchain networks (in term of market cap) — ethereum — is in the process of moving from PoW to PoS, without any government intervention.¹⁰⁸

Even if one accepts the premise that staking is preferable to mining as an environmental policy, it is not clear that this is an argument for a tax subsidy as opposed to an argument for a carbon tax. The government could facilitate a transfer toward staking by taxing polluting crypto-mining facilities rather than exempting staking.

Moreover, taxpayers might already prefer staking over mining simply because PoS is cheaper. Staking does not require expensive computing power. Thus, the incentive for staking over mining, in the form of the price of entry, is already encouraging PoS rather than PoW. It is not clear why the government needs to add another price incentive over the one already offered by the market.

Further, the blockchain industry already benefits from all government subsidies allowed to innovators. When a blockchain start-up is engaged in R&D in the United States, it can claim a research credit or enjoy favorable rules allowing immediate expensing of specific investments. I am unaware of any unique reason to subsidize innovative blockchain start-ups more than other innovative start-ups, and if there were such a reason, it is solely Congress’s prerogative to create that incentive.

Even if one could show that current taxation of block rewards somehow impedes blockchain innovation, one must point to a government interest in helping cryptocurrencies succeed. There needs to be a showing that without a government subsidy, the blockchain industry may fail and that that would be a bad outcome. Cryptocurrencies are sometimes promoted as alternatives to government currencies. There are also strong indications that cryptocurrencies facilitate illicit transactions.¹⁰⁹ To argue for government subsidy for an instrument that is designed to deny government control of monetary policy and that may facilitate crime, one has to point to a significant benefit for society that outweighs those major detriments. To date, I am unaware of any serious normative argument that would justify government subsidy of block rewards.

C. Administrability Considerations

In the context of PoS, some commentators offer administrative justifications for exempting block rewards from taxation upon receipt. They make two arguments.

The first involves the supposed difficulty of calculating the actual value of accession to wealth because of inflationary concerns.¹¹⁰ They say it is therefore preferred to tax block rewards when the gains become fixed — at the time of sale. As I explained earlier,¹¹¹ this argument has no merit because under tax law, taxpayers include amounts received in income at FMV when received. As far as tax administration goes, the administrative dilution argument is a solution in search of a problem.

The second administrative argument against taxation concerns the fact that “stakers may be earning Staking Rewards very frequently and in very short time segments,” which presumably makes it impractical to tax those rewards every time the staker receives them.¹¹² As far as impracticality goes, this argument is factually incorrect. As shown nicely in Jarrett, the taxpayers were able to calculate the exact amount of tax they needed to pay on their staking rewards, pay it, and sue for a refund. They were able to clearly document in their brief when they received their staking rewards and what the value of the rewards was when received.¹¹³ Taxpayers do not sit in front of their computer with a pencil and notebook; the receipts are documented electronically. Market values are known.

Moreover, there are similar instances of taxpayers making gains multiple times a day. Day traders make multiple transactions a day, and there is no argument that they should be exempt from taxation because of a supposed administrative burden. Algorithm-based trading sometimes consists of thousands of transactions in mere minutes, but no one suggests (as far as I am aware) that algo-traders be exempt from calculating their gains when their transactions are executed. What justification is there to treat stakers differently from traders in securities?

There is no serious compliance burden in reporting block rewards when received — certainly none that is more burdensome than those for other transactions that are clearly taxable and for which no one seriously considers administrative relief.

IV. It Is Just Bad Tax Planning

One the most baffling aspects of the arguments against taxation of block rewards upon receipt is that it is very likely bad tax planning.

If one accepts the argument that validators create or mine their block rewards, then, upon sale, the entire appreciation would be subject to tax at ordinary rates. On the other hand, under the correct treatment (meaning taxation at receipt), only the value of the initial receipt is taxed at ordinary rates. Any future appreciation might enjoy preferred long-term capital gains rates. This would likely result in lower tax burdens. If one expects the value of block rewards to increase (as most validators probably do), it is in their interest to pay tax upon receipt.

Consider the Jarretts’ case as an example. The Jarretts’ contested taxable income was $9,407.¹¹⁴ It resulted in a tax liability of $3,293.¹¹⁵ This implies that the Jarretts were in the 35 percent tax bracket in 2019.¹¹⁶

Let’s assume a hypothetical world in which the Jarretts’ position is the law, and that they did not pay any tax upon receipt of the block rewards in 2019. Instead, assume they have sold all the contested stock of 8,876 tokens¹¹⁷ two years later, on December 31, 2021. Only at that point would a tax liability arise, according to the Jarretts. That day, tezos — the token that is the subject of the case — closed at a price of $4.58. A hypothetical sale would have generated taxable income of approximately $40,652.¹¹⁸ At a 35 percent rate, the Jarretts’ resulting tax liability would be approximately $14,228. Assuming a 5 percent discount rate, the present value of that tax on December 31, 2019, would have been $12,905.¹¹⁹

Let’s compare this with the other (correct) alternative, in which the Jarretts did pay the tax upon receipt of the token in 2019. Their payment of $3,293 in tax on the tokens would generate a basis in the tokens equal to their full value,¹²⁰ or $9,407. Upon a hypothetical sale of those tokens, their taxable gain would be $31,245.¹²¹ This time, however, the gain would be subject to a capital gains rate of 23.8 percent.¹²² This would generate a tax liability of $7,436.¹²³ Discounted to the 2019 present value at 5 percent, the tax would be $6,745. In present value terms for the end for 2019, this means that the total tax paid by the Jarretts under this alternative would be $10,038,¹²⁴ or $2,867 less than if their position in court is accepted.¹²⁵

A summary of the calculation is in the table below.

		Calculation	Jarretts’ Original Position (taxation upon receipt)	Jarretts’ Current Position (taxation only upon sale)
Income upon receipt of rewards on 12/31/2019	A	From complaint	$9,407	$0
Tax liability on 12/31/2019	B	From complaint	$3,293	$0
Basis in reward tokens on 12/31/2019	C	= A	$9,407	$0
Amount realized at sale on 12/31/2021 (8,876 tokens for $4.58 each)	D	= 8,876 * $4.58	$40,652	$40,652
Taxable gain on 12/31/2021	E	= D - C	$31,245	$40,652
Total taxable income to date	F	= E + A	$40,652	$40,652
Tax rate applied on 12/31/2021	G	Implied from complaint	23.8%	35%
Tax liability on 12/31/2021	H	= E * G	$7,436	$14,228
Total taxes paid (absolute)	I	= H + B	$10,729	$14,228
12/31/2019 taxes PV (5% discount, 2 years)	J	B + PV(H)	$10,038	$12,905
Excess PV tax if Jarretts’ position is accepted	K			$2,867

It is difficult to understand the validator community’s incentive in pushing for no taxation upon receipt of block rewards. It defies financial logic, and it goes against the logic of code sections specifically designed to ensure that taxpayers enjoy the benefit of current taxation in specific circumstances. For example, section 83(b) allows taxpayers to include in income, on a current basis, receipt of property that otherwise would not have constituted income. The very purpose of this section is to enable taxpayers to enjoy capital gain rates on the appreciation. One of the functions of section 83(b) is to give service providers an incentive to accept payment for services in restricted property by offering a possible tax benefit.

Analogizing the economics of block rewards to section 83(b) shows how financially irrational the position of the validator community is. One of the arguments made by the community is that current taxation of block rewards will dissuade people from participating in the validation process.¹²⁶ This turns the entire logic of section 83(b) on its head. If validators’ argument is applied to section 83(b), section 83(b) is not a tax incentive but rather a tax disincentive.

Of course, there may be other tax considerations at play. For example, validators may never sell their block rewards. They can hold them until death, at which point their heirs would enjoy a stepped-up basis, effectively eliminating taxation on the entire appreciation.¹²⁷ Another alternative is that validators may liquidate their block rewards in a way that skirts antiabuse rules that Congress has yet to apply to cryptocurrencies (despite signaling that it intends to do so).¹²⁸ In those cases, block rewards would never be taxed. If this is the validators’ intention, it significantly undermines any argument that they care about the principles of correct or fair taxation. It suggests that what they are really after is no taxation (ever) of block rewards, and that the movement to exempt block rewards upon receipt is just a step in that direction. If that is the case, it adds another policy reason to tax block rewards upon receipt: If the government does not tax them at receipt, it will never tax them.

V. Conclusion

Validators who earn block rewards sometimes argue that there is some ambiguity in the law whether block rewards should be taxed upon receipt. There is no such ambiguity. Block rewards are clearly taxable upon receipt under current law.

In the alternative, some commentators have said that block rewards (or, at a minimum, staking rewards) should — as a matter of tax policy — be exempt from taxation upon receipt. They argue that tax should be deferred until block rewards are sold. Those arguments are unconvincing. Exempting block rewards from taxation when received is inequitable and behaviorally distortive. Proponents of nontaxation have failed to point to any government interest that may justify this inequitable and distortive policy. Moreover, validation activity seems to be gaining traction without government intervention. What possible interest does the government have in subsidizing activity that is flourishing without subsidy?

Finally, nontaxation of block rewards until sale is bad tax planning. It would result in the entire appreciation being subject to tax at high ordinary rates rather than capital gain rates. There is no rational reason for validators to pursue that treatment, unless the argument is about something else — that is, that validators plan to avoid taxation even when they sell their block rewards. Validators who argue against current taxation of block rewards are either very bad tax planners or not completely open about their motives.

Block rewards are taxable upon receipt and should remain taxable upon receipt.