Phantom Income and the Taxation of New Cryptocurrency Tokens
Abraham Sutherland is an adjunct professor at the University of Virginia School of Law. He is an adviser to the Proof of Stake Alliance and a fellow at Coin Center. Together with Fenwick & West LLP and Consovoy McCarthy PLLC, he represents the plaintiffs in Jarrett.
In this article, Sutherland argues that cryptocurrency staking rewards shouldn’t be taxable when they are created, and he responds to counterarguments presented by the New York State Bar Association and others.
Copyright 2023 Abraham Sutherland.
All rights reserved.
Suppose Tesla Inc. decides to reward its shareholders by issuing each of them 10 percent more shares, or perhaps 400 percent more. Why shouldn’t those new shares be taxable income?
“Because of tax code section 305(a)” isn’t the answer I’m looking for. The reason they shouldn’t be income is that the value of the new shares is not the recipients’ economic gain; the recipients “merely receive more stock evidencing the same ownership interest.”1 Section 305(a) is a reason why the new shares are not income.2
That is-ought distinction is helpful for an important taxation puzzle in cryptocurrency, a new technology and form of property that challenges our tax intuitions. It helps to approach this issue in two parts: How should — and then how does — the Internal Revenue Code tax the so-called staking rewards that give an incentive to members of the public to validate transactions and add blocks of those transactions to cryptocurrency blockchains?
The answers are important for millions of taxpayers and the future of the technology.3 And several recent articles merit a response. A New York State Bar Association report provides a cogent overview of cryptocurrency technology and the problems it poses for taxation.4 But when it turns to its legal analysis and recommendations on staking rewards, the report’s omissions are notable, and its arguments fall short. The report hides the ball on why this question is so important in the first place. Then it makes two principal errors — one legal, one factual — to conclude that staking rewards are and should be immediately taxable income. I address those omissions and errors below. Also, responding to recent commentary, I address a secondary question: How should gains from the sale of cryptocurrency tokens be taxed?
Only Gains Should Be Taxed
Cryptocurrencies are not stock companies, but in this case the analogy to stock dividends or splits is helpful. Like stock splits, there’s both an “ought” and an “is” answer to the question of staking reward taxation. One reason staking rewards should not be included in gross income is that including them would be economically irrational and unfair.5 Including staking rewards in income demonstrably and systematically overstates taxpayer gains; thus, taxing them results in demonstrable and systematic overtaxation.
If the tax code demanded such a result, the law should be fixed. That shouldn’t be controversial. If old tax law clashes with new technology and economic activity, why should the old law win? The income tax taxes gains. It doesn’t immediately tax all gains, but we should all agree on this: If it’s not a gain, it shouldn’t be taxed. And if old law also makes compliance ridiculously complicated, a clear burden on taxpayers’ choice of technology and economic activity, what argument is there for keeping it?
Indeed, if it’s not a gain, maybe the law doesn’t permit it to be taxed. There’s nothing strange about directly taxing property itself; all the states do it. What’s notable is that the federal government doesn’t. It can’t, unless it jumps through formidable constitutional hoops, something it last did in 1861.6 This provides all the more reason to view with extreme skepticism any claim that existing law defines taxable income to include taxpayer wealth that is not that taxpayer’s gain.
That’s the “ought” part, and it’s more than enough reason for Congress to promptly pass legislation that confirms the “is” part. In August 2020 Josh Jarrett sought a ruling on the taxation of his tezos staking rewards.7 The IRS has declined to oblige, and Jarrett is still waiting.8 And today, two and a half years on, millions more Americans face the same question about this emerging technology. So much for the taxpayer’s right “to pay no more than the correct amount of tax” and to “challenge the position of the Internal Revenue Service and be heard.”9
Congress can and should act, but it’s important to see why taxing staking rewards only upon sale isn’t a change in tax principles. Under existing law, the reason staking rewards are not immediately taxable does not depend on administrative complexity and need not reach the fact of overtaxation. Staking rewards are not income because newly created property — property not received from another person as payment or compensation — is never taxable income.
This tax treatment of new property is not some obscure loophole. It’s ubiquitous and universal. New property comes into existence all the time, and it’s never income to its first owner. Under our system, the creation of wealth is not a taxable event — and neither is the creation of property, which is a form of wealth. This is true even for typical scenarios in which taxing new property as income would not lead to overtaxation.
The correct tax treatment of new property is the same now as it was before Glenshaw Glass Co. was decided in 1955. And academic theories of income have no bearing on this issue, except to sow confusion. The fact is that we have a realization-based income tax — and not a Haig-Simons-based income tax. But if we did tax Haig-Simons income, everything would also work out fine: The overtaxation would disappear. Assessing economic income based on changes in wealth over a period of time (as opposed to when gains or losses are realized) is indeed fair.
And staking rewards are indeed new property created by stakers. The simplest way to confirm that is to note that they are no one else’s expense. Computers and software don’t create property; people do, and income always comes from another person. If you’ve got some new wealth on your books, and no one else’s books could show a debit corresponding to your credit, it’s a safe bet that it’s not (yet) taxable income.
There’s another way to prove that reward tokens are created by stakers, but it requires some understanding of how cryptocurrency actually works. The central features of a public cryptocurrency — that it’s just software run by a decentralized group of people, and no bank or government is in the background pulling the strings — can indeed be tough to get one’s head around. It means there is no “issuer” of new tokens; it means that blocks of transactions and new tokens are in fact created not by some other person, by the decentralized community of all stakers, or by a software “protocol.” Rather, they are created by stakers whose independent efforts to add blocks to the blockchain make a public cryptocurrency what it is.
I have set out this explanation elsewhere in great detail. On September 22, 2019, at 11:33:55 a.m. GMT, for example, Jarrett created a valid new block and 16 new tokens on the tezos cryptocurrency blockchain.10 No one else created that block, and neither was it created by tezos. Claiming that block or those 16 tokens were created by tezos makes as much sense as saying the novel you just finished writing was created by Microsoft Word.11
How Cryptocurrency Works
A cryptocurrency blockchain is a ledger that records new transactions and tells us which accounts control what. New blocks of transactions are added to that blockchain by a diversity of people — new blocks must be created by a diversity of people, or it wouldn’t be a cryptocurrency.
We trust ledger systems run by a single entity — for example, account balances kept by a bank, or account balances and money supply managed by a central bank. But neither of those is a public cryptocurrency. It’s only a cryptocurrency if it’s designed to prevent any one person from tinkering with account balances or the currency supply.
Making sure that no single person can take control of such a network is a difficult problem. Bitcoin’s inventor solved it with software that recognizes the right to add a new block based on a person’s “work.” That work takes the form of computer calculations. The calculations themselves aren’t difficult or complicated. Computers just guess, repeatedly, until one finds a winning solution and proves it to the world by including it in a new block. But these calculations are expensive.
A MacBook with an M1 chip, for example, could manage about 5 million attempts per second. However, it takes about 145 sextillion guesses, on average, before some bitcoin miner chances upon a solution giving them the right to add the next block of transactions to the bitcoin blockchain. Each winning guess comes from pure luck, but if you do 5 percent of the calculations, over time you get to build 5 percent of the blocks. As long as no one person does too much of this work compared with all the other “miners,” no one person will be able to create enough blocks to gain control over the network.
Proof-of-stake cryptocurrencies such as tezos use a different method to allocate the opportunity to build onto the blockchain so that no one can take over the process. “Stakers” get the chance to add a new block of transactions based on their stake in the network. If you stake 5 percent of the staked tokens, over time you get to build 5 percent of the blocks. As long as no one controls too great a share of the staked tokens, no one will get to create too great a share of the new blocks. The network will remain decentralized and therefore secure.
That’s how a public cryptocurrency makes sure that no one person controls the network. That process is important to understand because it also explains why miners and stakers create blocks and why, for tax purposes, it is not coherent to say that tezos or bitcoin creates those blocks.
But there is a second challenge, which is making sure a diversity of people want to participate in validating transactions and adding blocks. If only one or two people bother to participate, it won’t work. So there’s an economic incentive.
When you successfully create a new block that gets added to the blockchain, you also create some new tokens. Depending on the cryptocurrency network, you might also receive transaction fees, debited from the accounts of network users who paid that fee to ensure that their transaction got included in your new block.12 But the new tokens are not received from another person. The miner’s or staker’s token ledger shows a credit, but there’s no corresponding ledger entry showing a debit. No one else gets to record an expense. They’re new. Following convention, I call these new tokens block rewards or staking rewards, even though a more accurate term is “created property” since these new tokens are created by the staker’s efforts and not paid to the staker by anyone.
The Economics of New Tokens
Consider a simple proof-of-stake cryptocurrency in which 10 people each hold 1,000 tokens. To make sure that holders are encouraged to stake — that is, to validate transactions and add blocks to the blockchain — block rewards increase the total number of tokens by 10 percent over the course of a year. So a year later, 11,000 tokens will be on the network.
If every holder stakes and acquires a proportionate share of these new tokens, each will end the year with 1,100 tokens. Everyone has 10 percent more tokens, but no one is better off from staking. Taxing each staker’s 100 new tokens as income would be wrong. It would be like taxing the new shares created in an 11-for-10 stock split.
There is indeed an economic incentive to help keep such a cryptocurrency network secure by staking, but it’s not the one suggested by bitcoin miners making a profit even after spending on specialized computer hardware and the electricity needed to run it. The incentive in this proof-of-stake example is to avoid losing out. If everyone stakes, no one gains.
This is a profoundly elegant, equitable, and cost-effective solution to a deep coordination problem. It allows everyone who holds tokens to participate in adding new blocks and keeping the network securely decentralized. It eliminates major costs — specialized computer hardware, electricity — as requirements for fairly distributing the right to create those new blocks. In its Platonic form — in which everyone participates — no one gains at all from the new tokens, which means no one loses, either.
But this model simply won’t work if it’s taxed incorrectly. If the government sees phantom income and taxes it, the value of the network will be siphoned off to the treasury even if no one has actual gains from staking.
Note that in this simple example, in which every token holder participates in staking, the token creation rate is irrelevant. Whether it is 10 percent or 50 percent, stakers’ actual gains are zero.
The token creation rate, however, does determine the amount of phantom income that, under the wrong policy, would be subject to genuine tax. Note what happens if new tokens are included in taxable income by comparing two simple hypothetical cryptocurrencies with 100 percent participation in staking. Crypto A and Crypto B are identical, except Crypto A’s token supply increases 10 percent over a year, while Crypto B’s supply increases 50 percent. Each network starts with 10,000 tokens, and over the course of a tax year the total value of each network’s tokens holds constant at $10,000.
Looking at Crypto A at the end of the year, the IRS will observe 1,000 new tokens that “created” $955 in gross income.13 And looking at Crypto B, the IRS will see 5,000 new tokens totaling $4,167 in gross income.14 In other words, 9.5 percent and 42 percent of the networks’ values, respectively, will be deemed “income” and subject to very real tax, even though neither network increased in value and no one gained from staking. The mistake is in ignoring the dilutive effect of the new tokens on the value of all tokens.
Of course, we don’t have to assume that the total value of a network’s tokens holds constant at $10,000 — it just makes the math easier. But the one assumption you cannot make is that the token creation rate actually determines the network’s growth in value.
Some people are, in fact, confused by this. It’s easy to think that new tokens equal a gain — “Each one is valuable, and I didn’t have it before!” — and from there to assume that a higher percentage of new tokens means a greater gain. And some people might actually think that 10 percent new tokens means a 10 percent gain (so that the Crypto A network would end the year worth $11,000) and 50 percent new tokens entails a 50 percent gain (so that Crypto B ends up worth $15,000). That’s crazy — what about Crypto C, with 500 percent new tokens? But at least one tax commentator thinks that dilution is a myth.15
Such confusion is truly unfortunate. Perhaps we should teach more math and finance in schools or tighten our accredited investor rules to protect the public from themselves. But people who actually own and stake these tokens should quickly appreciate what really matters, which is how much their stake is worth over time — not simply how many tokens they have, or the dollar value of a single token at the moment it springs into existence.
But what if policymakers — or their tax advisers — succumb to such a blunder? That would indeed be a national embarrassment with serious consequences for taxpayers.
The Economics of Real-World Staking
The phantom-income problem persists in the real world, where the staking rate is less than 100 percent and token values fluctuate in relation to the U.S. dollar used to denominate, and pay, taxes.16 To the casual observer, those and other variables may obscure the irrationality of taxing new tokens as though they are gains. But they do not change the underlying reality.
In 2019 the staking rate on the tezos network averaged about 75 percent. In his petition to the IRS to clarify the agency’s position on the tax treatment of his staking rewards, Jarrett included a detailed analysis of his 2019 staking activity. That analysis was also published as an article in Tax Notes.17 In short, the IRS saw $9,404 of taxable income from Jarrett’s 8,876 new tokens. Over that year, the total number of tezos tokens, called tez, increased by 5.06 percent. Jarrett, meanwhile, saw staking increase his tokens at a rate of 5.74 percent.18 His actual economic gain from staking, using the most rigorous method we could think of under the assumption that a staker’s “receipt” of block rewards is a realization event, was just $1,458.19 That’s a lot of phantom income subject to real tax.
This overtaxation is not a minor quirk affecting occasional edge cases. It’s not comparable to the return of invested capital in a dividend that is taxed as ordinary income. Nor can it be compared to the especially unfortunate but singular plight of Charles W. Phellis, who invested his capital only to promptly receive 90 percent of his investment back in a dividend taxed as ordinary income. “The possibility of occasional instances of apparent hardship in the incidence of the tax may be conceded,” the Supreme Court apologized in deciding against that taxpayer.20 With staking, the overtaxation would be neither occasional nor merely “apparent” but persistent and punitive.
Day in and day out, stakers would “receive” staking rewards whose market value overstates the taxpayers’ gains from staking. Taxing Jarrett and millions of others like him on that phantom income is simply wrong. It would be an unprecedented flaw in our income tax. This policy would hamstring an elegant and equitable cryptocurrency model by imposing an economically illiterate punishment for democratizing participation and equalizing gains. The fairer staking gets economically, the worse the tax punishment: As participation in staking approaches 100 percent, actual economic gains from staking approach zero — and therefore the ratio of phantom income to stakers’ genuine economic gain climbs without bound.
How do advocates of taxing staking rewards on “receipt” address this inconvenient and irrefutable reality? To its credit, the NYSBA report does not deny it.21 But it acknowledges dilution only in passing. The report fails to reveal the magnitude of the problem and makes little effort to justify such unfair tax treatment.
Instead, the report pits its preferred policy — taxation on “receipt” — against a straw man: “We believe it would be difficult to craft rules that appropriately isolate the dilutive component of staking rewards and treat it differently than the component that reflects an accretion to wealth.”22 That is correct — the point of “Dilution and True Economic Gain”23 was to demonstrate exactly that. But on what grounds is it the government’s prerogative to tax phantom income in the first place?24 If it’s not a gain, it should not be taxed.
In any case, it’s a false choice. The alternative to taxing reward tokens on “receipt” is to tax them the way all forms of new property are and always have been taxed — at the time of their sale or exchange.
The Creation of Property Is Not a Taxable Event
Leaving aside the gross unfairness of systematically taxing phantom income, advocates of taxing newly created tokens as income must establish that existing law demands such taxation. Two errors — one legal, one factual — run through these arguments. First, there is the claim that taxpayer-created property is indeed immediately taxable income, unless perhaps some tax code provision, Treasury regulation, or allowance from the IRS graciously defers that taxation until the property’s sale. This is squarely false, but the mistake is illuminating.25
The NYSBA report argues that taxing newly created tokens as income would be “appropriate” as long as they “are not affirmatively treated as manufactured property or self-other created property [sic] subject to specific tax rules that defer recognition of income until the property is sold.”26 The report is wrong to suggest that those specific tax rules actually defer the recognition of income. But to be fair to the NYSBA, a very close reading of this section reveals that it does not actually claim that new property is taxable before sale, only that, in this case, taxing it would indeed be “appropriate.”
Professor Omri Marian is clearer in his claim: “Stakers who make the manufacturer analogy fail to identify a specific exception for the inclusion of staking rewards in income.”27 Unlike the NYSBA, Marian leaves no interpretive wiggle room in his view on the creation of new property. He goes on to say that even if stakers “manufacture” tokens, they wouldn’t get the benefit of the “deferral” that appears in the regulations unless they are in the “trade or business” of manufacturing.
Scattered provisions in the code, regulations, and IRS pronouncements confirm that various types of new property are not taxed until sold. But those provisions do not establish exceptions. Rather, they acknowledge the fundamental point that the Internal Revenue Code taxes income, in the course of explaining other rules, such as what costs are deductible upon sale and which are costs of goods sold.28 And sure, if a rogue IRS agent tried to come after you for unpaid taxes on new but unsold property, you could save time shutting him down by pointing to those provisions. I have no idea how IRS agency guidance, or even Treasury regulations, could supersede section 61’s mandate to tax new property (if it existed).29 But in any case, those provisions do not establish exceptions to a general rule that new property is income. To the contrary, new property is never income at the time of its creation.30
For example, when you finish “manufacturing” a chair in your home workshop, its fair market value is not your taxable income. I choose this example because Marian claims that it is your income, on the grounds that you’re not in the business of manufacturing and thus can’t capture the deferral of recognition he says resides in Treasury regulations.31 I actually don’t know if every imaginable classification of “property” can be matched to some comment (in the code, regulations, or IRS guidance) confirming that it isn’t taxed until sold. But the idea that such an exclusion is required is wrong.
When the last coat of varnish dries on your new chair, perhaps Marian thinks it might escape taxation as “imputed income,” a category of economic gain that everyone agrees is not subject to the income tax. But he misrepresents the point made in Jarrett’s IRS petition and mischaracterizes imputed income and its place in our realization-based tax system.32
If you eat an apple you’ve grown instead of selling it, or keep and use a chair you’ve made instead of selling it, that’s untaxed imputed income. This can indeed be a vexing problem for taxation, depending on one’s commitment to the view that no accretion to wealth should ever go untaxed. But that’s not our problem because Jarrett’s new tokens are not imputed income, and he doesn’t claim they are. To the contrary, his brief pointed out that imputed income has nothing to do with our question except to further demonstrate that creating new property is not a taxable event. Marian suggests imputed income arises from property that taxpayers “create for their own use or consumption,”33 but the motivation to create property doesn’t matter.34 And more importantly, the “loophole” doesn’t arise until the taxpayer consumes the property instead of selling it — which was Jarrett’s point in mentioning imputed income:
If imputed income from self-created property were included in gross income, it is nonetheless clear that such income would be realized at the time of the property’s consumption, not the time of its creation.35
In other words, if picking an apple from your own tree were a taxable event, you’d never get the chance to escape taxation by eating it yourself.
Crops, livestock, minerals, and widgets are intuitive examples of new property, but this categorization is irrelevant to the threshold determination of what counts as income. Anything can be income if it’s received as payment from someone else. But that thing is never income in the hands of its creator.
Some celebrities can reliably sell their autographs — does the star who signs a stack of headshots have reportable income even before she hits the convention circuit? The rest of us can use our digital signatures to create tokens on cryptocurrency networks. Besides bitcoins and tez — which are difficult to make, hence their value — these include one-of-a-kind or “non-fungible” tokens. Do we have to determine what kind of property an autograph or a particular NFT is before determining whether that act of creation is a taxable event? Does it depend on how difficult it is to assign an FMV to one’s new wealth? Do we need to determine when the act of creation is complete, establishing the moment of its dollar valuation?
The answer is no on all counts. Neither the IRS nor any court would say otherwise, but understanding Marian’s position is illuminating. The attempt to include new property in taxable income arises from confusion over two conceptions of income — not mistaking one for the other, but mixing them up and selectively applying pieces of each. The example of staking rewards shows why that doesn’t work and certainly is not mandated under existing law.
The first sense of income is the income we actually tax: realized income. Realization is event-based: Income happens whenever it happens, but it still has to come in, so creating valuable stuff doesn’t count, and neither does an increase in something’s value. Normally, the same applies to losses — they must be realized — except for specific exceptions, like depreciation, that are accounted for in the tax code to keep things fair for taxpayers.36
The second, Haig-Simons or economic income, is broader and captures changes in wealth that under our actual law are not taxable. I think it’s confusing to call it income for purposes of the tax law, but that ship has sailed in many circles. Economic income is time-based: To tax it, you need to measure your wealth at the beginning and end of a period — say, a tax year. The change, after accounting for consumption, is your income (or loss). There are exceptional circumstances when income is determined in this manner, such as by making a mark-to-market election under section 475, but our tax law does not typically work that way.
Here’s the important part, though: The creation of property isn’t a taxable event under either system. Under Haig-Simons, you wait until the end of the period to assess your new wealth. Consider the hypothetical Crypto A discussed above, in which each of 10 stakers ends the year with 10 percent more tokens. If your goal is to tax all economic gain, there’s no need to put an FMV on each of these tokens as they accumulate minute by minute, block by block. What matters is their value at the end of the year. At the end of the year, each staker will hold $1,000 worth of tokens — 100 reward tokens and the 1,000 initial tokens, each worth $0.909. With everyone staking, each staker’s Haig-Simons income is zero, which is what it should be.
Once again, we generally don’t tax Haig-Simons income. Whether doing so would be constitutional, practically feasible, and something Congress should consider are questions for another day. The point is that while it would work in principle, you can’t mix and match. Realization or Haig-Simons — it’s one or the other. The problem arises from mixing the Haig-Simons expanded notion of income — that is, all new wealth is subject to tax, even if it hasn’t “come in” — with a novel application of “realization” that captures new tokens as they roll off the assembly line but not changes in the value of all tokens.
Given the law we have, if you’re motivated to tax a broader segment of gains, “realization” is the only tool at your disposal. So the famous Glenshaw Glass Co. element — that income be “clearly realized” — gets some creative glosses. For example, the NYSBA report asserts that with staking rewards, “the amount is clearly realized.”37 Presumably, that refers to the fact that you can find out how many new tokens you have and determine their FMV on the dates “received” by checking price charts on the internet.38 Of course, given dilution, the taxpayer’s economic gain is not expressed in the FMV of those new tokens — a fact acknowledged elsewhere in the NYSBA’s own report. And as shown by the Jarrett analysis — and as acknowledged in the NYSBA’s report — the amount of gain is not at all clear. In any case, realization does not mean that you, or the IRS, will one day “realize” that you’re “clearly” richer than before.
Stakers Create New Blocks and Tokens
Next, the NYSBA errs on a factual question. Its report argues that stakers do not create tokens; rather, “staking rewards are generated by a software protocol.”39 The affirmative argument that stakers create blocks and tokens is presented above and elsewhere.40 But the NYSBA’s and others’ arguments are revealing on their own terms. Computer software, and tools of any description, don’t do anything for tax purposes. Only people do. Machines aren’t people, whether natural or legal, and they don’t employ or pay people. The NYSBA offers a peculiar hypothetical to argue that taxpayers can nevertheless “receive” income from a software protocol:
Suppose a machine existed that could create valuable assets (for example, diamonds) but required periodic maintenance, and that the machine automatically issued the assets to any person who successfully performed the maintenance. We believe that the maintenance reward would be currently includable in income, and that the analogy — however far-fetched it may currently be as a technological matter — is simply an illustration of how blockchain protocols operate.41
The NYSBA’s hypothetical is peculiar because there is nothing far-fetched about it, technologically or legally. Diamond-making machines are available for $200,000 on alibaba.com, but the example could just as well mention any machine, or any tool, used to create valuable property. Making a diamond is never a taxable event. Supposing you used such a machine and got to take a diamond home, it is indeed conceivable that the diamond is your taxable income. But the hypothetical is conspicuously silent on the threshold question that can end the analysis: Whose machine is it? Unless it is someone else’s machine, the diamond is definitely not your taxable income.42 Bitcoin and tezos are not someone else’s machines.
Offering a similar argument, Marian makes explicit the false premise that the NYSBA carefully omitted from its hypothetical: “At best, validators pull the lever of a coin-manufacturing machine in a factory where they work.”43 (Emphasis added.) The first part of Marian’s metaphor is excellent — viewing validators like Jarrett as pulling the lever of a coin-making machine is correct and helpful. The coins that pop out are not (yet) anyone’s income because creating property is never a taxable event. But then we reach the italicized part, which sounds weird because it is weird — and wrong. Jarrett is not a worker in a factory. Of course, if Jarrett has employees who pull the lever for him and he pays them in tez, those tez are indeed the employees’ income because anything an employee receives as payment from his employer can be income.44
Taxation of New Tokens on Sale or Exchange
Like any other property you can think of, new cryptocurrency tokens are not income to their first owner. But like all other property, gains from the sale or exchange of those tokens will be taxed. How those gains are taxed is a separate question. Whether gains are ordinary or capital in nature turns on whether the things sold are capital assets. “The term capital assets includes all classes of property not specifically excluded by section 1221.”45
So are staking rewards excluded by section 1221? It depends; whether something is a capital asset is not a feature of the asset itself but instead depends on the taxpayer and how the taxpayer uses that asset. Using Jarrett as an example, we look down the list of specific exclusions in section 1221. Jarrett’s tokens are not his “stock in trade” and are not held by him “primarily for sale to customers,” so section 1221(a)(1) does not exclude them. Nor do any of the remaining exclusions apply. For Jarrett, then, reward tokens are capital assets. End of analysis.
This merits some elaboration because a non-lawyer seeking guidance in the pages of Tax Notes might come across contrary advice, delivered with such confidence that the casual reader might overlook the lack of argument. Two recent articles assert that if reward tokens “are not considered income until the taxpayer sells or exchanges them, the entire appreciation will be taxed at the higher ordinary income rate.”46 Amanda Parsons does not mince words: “Any law student will tell you that the tax treatment sought in Jarrett is not desirable.”47
I would hope that any law student would tell you that the first step is to consult the Internal Revenue Code. Neither Marian nor Parsons appears to have done that. Neither provides any support whatsoever for the assertion that reward token sales necessarily result in ordinary income. In Parsons’s case, it’s an assertion that launches an entire article. Neither of them so much as mentions section 1221.
Perhaps they believe that taxpayer-created property is always excluded under section 1221, and that this proposition is so patently obvious that no citation is needed. One needn’t understand much about capital assets to confirm that’s wrong. Just reading the first few paragraphs of section 1221 is sufficient. In particular, section 1221(a)(3) excludes copyrights from the definition of capital assets if they are held by “a taxpayer whose personal efforts created such property.”48
Copyrights were not always singled out for this special exclusion from capital asset status. In 1948 General Eisenhower sold his World War II memoirs.49 At the time, no exclusion applied — notably, Crusade in Europe was not his “inventory” as Eisenhower was not a professional writer — and he was taxed on the sale of a capital asset. Congress didn’t like that and in 1950 added the exclusion of certain taxpayer-created property now found in section 1221(a)(3).50 The exclusion covers “a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property,”51 such as “a theatrical production, a radio program, a newspaper cartoon strip, or any other property eligible for copyright protection (whether under statute or common law).”52 The reasoning is that even if they are amateurs, when artists, writers, and musicians realize a gain from the sale of their creative works, that gain is properly viewed as a substitute for the ordinary income that typically results from personal efforts. Just five years ago, Congress added other forms of intellectual property to that exclusion, namely “a patent, invention, model or design (whether or not patented), [or] a secret formula or process.”53 If taxpayer-created property were always excluded, those provisions would be unnecessary and have no effect. And of course, tezos tokens are not copyrights, patents, or any similar form of property excluded by 1221(a)(3).
What about the rest of section 1221’s exclusions? Marian and Parsons rely on the assumption that tezos tokens Jarrett acquired by purchase are, in his hands, capital assets. This is a question of fact and, on this point, they are correct. Most relevantly, Jarrett’s tez are not his “inventory” or “for sale to customers in the ordinary course of his trade or business,” which would exclude them under the principal exclusion, section 1221(a)(1). As with most individuals holding cryptocurrency tokens, in Jarrett’s hands they are indeed capital assets. But — with the exception of 1221(a)(3), which, as just seen, does not apply — how a taxpayer acquires an asset is irrelevant to its status as a capital asset.54 Jarrett holds his newly created tokens for the same reasons and uses that he holds tokens he purchased or acquired by any other means.
Marian’s and Parsons’s own arguments help explain how capital asset classification works. Suppose that they are correct that newly created tokens would always yield ordinary income when sold. Would that make taxation at sale or exchange obviously undesirable, which is the entire point of Parsons’s article?
Not at all. Under Marian and Parsons’s preferred policy — taxation on “receipt” — taxpayers have no control over their realization of income. Taxpayers must account for the exact timing of new tokens and then keep track of each new token’s tax basis according to its FMV on the date “received,” presumably by reference to public, published price information, which in reality might not reflect a dollar liquidation price actually available to the taxpayer. With riskier or more volatile assets, any failure to carefully maintain the dollar liquidity to pay tax through ongoing sales of the new tokens opens the taxpayer to considerable risk. This fact is intimately appreciated today by thousands of American taxpayers wondering how their paper “income” from a largely passive investment in a staked token could exceed those tokens’ current market value. And taxation on “receipt” would have complex secondary consequences beyond the scope of this article.
Marian’s and Parsons’s arguments simply assume that tokens will increase in value so that taxpayers are primarily concerned to capture long-term capital gain tax rates on future appreciation. That’s an extraordinary and unreasonable assumption, but let’s suppose that token prices will always go up.55 If Marian and Parsons were right about that, taxpayers could simply sell their new tokens — as they are acquired, or at any time of their choosing — and then buy them right back, this time as capital assets. If that sounds weird, it’s because the tax law doesn’t require such shenanigans. As ridiculously complicated as it is, our tax code is usually rational, and indeed whether property is inventory in a taxpayer’s hands doesn’t depend on how the taxpayer got that property.
So the law is clear: Reward tokens can be capital assets, and in Jarrett’s case they indeed are. But maybe the law is wrong! If the sale of an asset should give rise to ordinary income, section 1221(a) stands ready to exclude it. Should Congress amend it to specifically exclude cryptocurrency reward tokens, to close a “loophole” just like it did in 1950 with copyrights and most recently in 2017 with several other forms of IP?56 Should stakers be classified with those who perform “literary, theatrical, musical, artistic, or other creative or productive work which affirmatively contributes to the creation of the property”?57
Clearly not. Broadly speaking, section 1221(a) exclusions ensure that gains that should be taxed at ordinary rates don’t masquerade as capital gains. Unlike copyrights, patents, and other creative works, cryptocurrency tokens are fungible. Assuming that tezos tokens are not a taxpayer’s inventory or otherwise excluded under section 1221(a) and so under current law are in fact capital assets in that taxpayer’s hands, what grounds could there be for classifying new tokens differently from purchased ones?58 The taxpayer who buys some tokens and later sells them all will have a gain or loss depending on the change in the investment’s value.
Staking doesn’t change that logic, at least for a typical taxpayer like Jarrett, for whom the sale of tokens is not a substitute for ordinary income. The taxpayer who buys 100 tokens, stakes them to avoid dilution, and later sells 105 tokens should not fare differently. Economically, there is no meaningful distinction between gain (or loss) that arises from the change in value of one’s tokens and gain (or loss) from the change in value of one’s tokens plus the value of new tokens acquired through staking.
Indeed, excluding new tokens from capital assets would have unreasonable consequences based solely on the cryptocurrency’s token creation rate, which of course is arbitrary as far as the token’s economics are concerned. As shown above, if new tokens are incorrectly taxed on “receipt,” the token creation rate determines the amount of phantom income that will be subject to real taxation. Similarly, if reward tokens are (correctly) taxed only upon sale but are not capital assets (while purchased tokens are capital assets), the token creation rate determines the rate at which one’s holdings of capital assets are converted into ordinary assets. This lack of symmetry has perverse consequences and is best observed by again comparing the two hypothetical cryptocurrencies introduced earlier, Crypto A and Crypto B, each with 10,000 tokens held equally by 10 stakers. Once again, for simplicity we assume that the total value of each network holds constant at $10,000.
Crypto A’s supply increases by 10 percent, so at the end of the year, each staker would hold 1,000 capital asset tokens worth $909, plus 100 ordinary tokens worth $91. Selling them all would result in $91 of capital loss plus $91 of ordinary income. Meanwhile, Crypto B, which is economically identical except for its 50 percent token creation rate, would leave each staker with 1,500 tokens, each worth $0.67. Selling them would yield a $333 capital loss along with $333 in ordinary income. As a rule, any loss would accrue as a capital loss, which can only be set against capital gains. Meanwhile, new tokens would always result in ordinary income. Fortunately, the tax code today does not enforce such a silly result, and nothing in the logic of tax policy recommends amending the code to embrace it.59
Newly created property is never taxable income. Only taxpayer gains should be taxed. It would be doubly tragic if the first-ever breach of the first principle guaranteed the violation of the second principle as well. Staking rewards are not and should not be taxable income. Like all other new property, they will be taxed fairly when sold or exchanged.
1 IRS FAQ, “Do I need to pay taxes on the additional stock that I received as the result of a stock split?”
2 But not the only reason. Eisner v. Macomber, 252 U.S. 189 (1920).
3 See also “Brief in Support of Taxpayer Joshua Jarrett’s 1040-X Amended Return and Claim for Refund” (July 31, 2020) (Jarrett brief); Mattia Landoni and Abraham Sutherland, “Dilution and True Economic Gain From Cryptocurrency Block Rewards,” Tax Notes Federal, Aug. 17, 2020, p. 1189 (Dilution); Sutherland, “Cryptocurrency Economics and the Taxation of Block Rewards,” Tax Notes Federal, Nov. 4, 2019, p. 749; Sutherland, “Cryptocurrency Economics and the Taxation of Block Rewards, Part 2,” Tax Notes Federal, Nov. 11, 2019, p. 953 (Cryptocurrency Economics); and Sutherland, “Tax Treatment of Block Rewards: A Primer,” Proof of Stake Alliance, Dec. 18, 2020.
4 New York State Bar Association Tax Section, “Cryptocurrency and Other Fungible Digital Assets,” No. 1461, at 41-50 (Apr. 18, 2022) (NYSBA report).
5 A second important reason, which deserves more attention than I can give it here, is the complexity of compliance. For the argument that staking rewards should be taxed at sale to avoid this “astronomical administrative burden,” as well as for environmental reasons, see Reuven S. Avi-Yonah and Mohanad Salaimi, “A New Framework for Taxing Cryptocurrencies,” U. of Mich. Public Law Research Paper No. 22-014, at 31-32 (Mar. 31, 2022).
6 U.S. Const. Art. I, section 9, cl. 4; Act of Aug. 5, 1861, ch. 45, 12 Stat. 292 (direct tax on real estate); National Federation of Independent Business v. Sebelius, 567 U.S. 519, 571 (2012).
7 Following the rules, Jarrett first paid the disputed tax and then filed a petition with the IRS. See Jarrett brief, supra note 3. The IRS ignored the petition, requiring Jarrett to bring suit. Jarrett v. United States, No. 3:21-cv-00419 (M.D. Tenn. 2021). Seven months after that, the government unilaterally mailed him a refund check but refused to confirm that Jarrett was right on the law or that he would be treated the same in subsequent tax years. Jarrett rejected the check.
8 Jarrett v. United States, No. 22-6023 (6th Cir.) (appealing dismissal).
10 Jarrett brief, supra note 3, at 17.
11 See David L. Forst and Sean P. McElroy, “The Creation of Property Through Staking,” Tax Notes Federal, June 27, 2022, p. 2033.
12 Required to discourage spam transactions given the limited number of transactions that fit in a block, accounting for these micropayments can present a separate challenge for maintaining an administrable income tax.
13 See Sutherland, “Cryptocurrency Economics,” supra note 3, at 763-764 for the models and math behind these calculations. In short, the first new token will be worth $1 at the time of its creation, and the 1,000th new token will be worth $0.909.
14 Id.; the first new token will be worth $1, and the 5,000th new token will be worth $0.667.
15 “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 the inflationary effect, but the owners’ interest has not been diluted.” Omri Marian, “Law, Policy, and the Taxation of Block Rewards,” Tax Notes Federal, June 6, 2022, p. 1493, at 1500.
16 The economics of new tokens are presented in greater depth in Sutherland, “Cryptocurrency Economics,” supra note 3, at 760-771; and Landoni and Sutherland, “Dilution,” supra note 3.
17 Landoni and Sutherland, “Dilution,” supra note 3. A shorter version of the article with less math was also published by Coin Center.
18 Id. at 1221 n.17.
19 Id. at 1224, Table 6 (market value method). For a simpler model that uses the cryptocurrency’s staking rate to indicate the portion of staking rewards’ fair market value that is phantom income, see Sutherland, “Cryptocurrency Economics,” supra note 3, at 766-771.
20 United States v. Phellis, 257 U.S. 156, 171 (1921).
21 “We acknowledged the potential merit of this [dilution] argument in the Prior Report.” NYSBA report, supra note 4, at 48, referencing NYSBA Tax Section, “Report on the Taxation of Cryptocurrency,” No. 1433, at 40 (Jan. 26, 2020). As already noted, Marian thinks dilution doesn’t exist. See supra note 14. Professor Ordower argues that cryptocurrency volatility negates the dilutive effect of new tokens. Henry Ordower, “Block Rewards, Carried Interests, and Other Valuation Quandaries,” Tax Notes Federal, June 6, 2022, p. 1551, at 1553.
22 NYSBA report, supra note 4, at 48.
23 Supra note 3.
24 Plus, the NYSBA’s sudden concern for administrative simplicity rings hollow. Taxing new tokens on “receipt” introduces enormous compliance burdens of its own.
25 The second, factual error is the claim that stakers do not create new blocks and tokens, addressed above and revisited below.
26 NYSBA report, supra note 4, at 47.
27 Marian, supra note 15, at 1498.
28 See Jarrett brief, supra note 3, at 25-26.
29 “Subregulatory guidance is not intended to affect taxpayer rights or obligations independent from underlying statutes or regulations. Unlike statutes and regulations, subregulatory guidance does not have the force and effect of law.” Treasury, “Policy Statement on the Tax Regulatory Process,” at Section III (Mar. 5, 2019).
30 For the reasons that taxpayers and the IRS alike have not been misinterpreting “all income from whatever source derived” for the past 100 years, see Jarrett brief, supra note 3, at 21-30.
31 Marian, supra note 15, at 1498.
32 Id. at 1498-1499.
33 Id. at 1499.
34 And property need not be created by the taxpayer to give rise to untaxed imputed income. The textbook example of imputed income is the rental value of an owner-occupied home. If you build a house yourself, finishing the construction isn’t a taxable event, and regardless of how you acquired the home, the imputed income from living in it rent-free wouldn’t accrue until you actually live in it rent-free.
35 Jarrett brief, supra note 3, at 26-27.
36 See Landoni and Sutherland, “Dilution,” supra note 3, at 1213-1214.
37 NYSBA report, supra note 4, at 47.
38 Even this claim is not true. Like the rancher whose new calves can’t be tallied until spring roundup — which doesn’t matter for taxation because their birth is never a taxable event — with some cryptocurrencies, new tokens cannot be dated. See Jarrett brief, supra note 3, at 31-34 (discussion of staking on the cosmos blockchain).
39 NYSBA report, supra note 4, at 47.
40 See supra notes 6, 7.
41 NYSBA report, supra note 4, at 47.
42 Even if it is someone else’s machine, the diamond likely is not your income. Renting, borrowing, or otherwise using someone else’s productive tool typically does not render its produce your taxable income. Since a cryptocurrency is not someone else’s machine, we need not explore the fringes of such scenarios here.
43 Marian, supra note 15, at 1499.
44 In a similar vein, Marian writes that “validators create their reward tokens just as much as Ford assembly line workers create Ford F-150s.” Id. Not quite. Tezos validators do indeed create their reward tokens just as much as Ford Motor Co. creates Ford F-150s, and neither the tez nor the trucks are income to their creators. Once again, anything Ford or Jarrett employees receive as payment from Ford or Jarrett would be taxable income.
45 Reg. section 1.1221-1(a).
46 Amanda Parsons, “May I Pay More? Lessons From Jarrett for Blockchain Tax Policy,” Tax Notes Federal, Sept. 26, 2022, p. 2063, at 2063-2064. And Marian, supra note 15, Section IV, “It Is Just Bad Tax Planning,” at 1505: “If one accepts the argument that validators create or mine their block rewards, the entire appreciation would be subject to tax at ordinary rates.”
47 Parsons, supra note 46, at 2063.
49 It should go without saying that Eisenhower did not have taxable income when he finished writing the book, because creating property is never a taxable event.
50 “Eisenhower Taxes on Memoirs Cited,” The New York Times, Sept. 28, 1952.
52 Reg. section 1.1221-1(c)(1).
53 P.L. 115-97, Dec. 22, 2017, 131 Stat. 2054, 2133. Congress didn’t include patents in its 1950 law, and then in 1954 it enacted section 1235 to give professional inventors the same tax treatment as amateur inventors. Section 1235 remains on the books; for the status of patents in light of the 2017 addition of patents to the section 1221(a)(3) exclusion, see Matthew Scaliti, Nick Gruidl, and Joseph Wiener, “Post-Tax Reform: Obtaining Capital Gain Treatment on Sale of Patents,” RSM (Dec. 11, 2019).
54 The method of acquisition does, of course, inform the asset’s tax basis, used for the calculation of taxable gain at the time of the asset’s sale or exchange.
55 Note also that the anticipated appreciation of such a cryptocurrency network would have to exceed the breakeven point determined by that network’s token creation rate.
56 To be fair to President Eisenhower, it’s not obvious that creators in the American arts and sciences should always have their writings and discoveries taxed at ordinary rates. See Rodney P. Mock and Jeffrey Tolin, “I Should Have Been a Rockstar: Deconstructing Section 1221(a)(3),” 65 Tax Law. (2011).
57 Reg. section 1.1221-1(c)(3).
58 A distinct question, on which I offer no opinion here, is whether cryptocurrency tokens should be taxed similarly to foreign currency.
59 Minor issues persist under today’s law because of (1) the holding period generally applicable to capital assets to qualify for preferential long-term tax rates, and (2) questions regarding new and old tokens’ tax basis, given taxpayer discretion over which assets are sold. Practically speaking, such consequences should be acceptable.
|Subject Areas / Tax Topics|
Tax Notes Federal, Jan. 30, 2023, p. 669
178 Tax Notes Federal 669 (Jan. 30, 2023)
University of Virginia School of Law
|Tax Analysts Document Number|