Staking Income and Block Rewards
Staking Income and Block Rewards
As new proof of stake networks come on-line, new focus is being brought to the question of how block rewards and staking income should be taxed. Ideally, of course, tax exempt and foreign recipients of staking income and block rewards would have no obligation to pay US tax, but alas, that may not be the case. While it may be that the concerns described below are over-blown (or more likely, that it will be many years before the IRS is sophisticated enough about crypto currency to pursue these arguments), I’m always interested in evaluating what the risks are and how they might be hedged.
I have yet to see any definitive guidance on staking income or block rewards other than the 2014 IRS Notice that focused on mining rewards. Nevertheless, I think it’s a safe bet that the IRS will seek to treat any increase in the number of tokens you own as income as soon as those tokens are credited to your private key. (While I know some very thoughtful people putting together arguments why block rewards should not be taxed until they are sold, I doubt those arguments will provide an instant win.)
As a result, the following will assume that block rewards and staking income are taxable when credited to your account, and explore the nature of that income and the impact that determination may have on intermediaries like venture funds and trading platforms.
Basic US Tax Rules
To begin, a short primer on US taxation.
- US Citizens and Residents are taxed on their worldwide income. It is important to determine when the income is subject to tax (which we are assuming is as soon as the IRS can justify) and what its character is (capital gain versus ordinary). Generally, I would assume all block rewards and staking income are ordinary (unless it is ultimately determined that they are not taxable until the tokens are sold). Whether either type of income is also “Passive” income that can be offset by “Passive Activity Losses” (“PALs”) from other sources is a different question.
- Tax exempt participants are only subject to tax on “Unrelated Business Taxable Income” (“UBTI”). Their goal is to limit their income to passive investment income which is not UBTI. Non-resident foreign participants are taxed on “US Source Income” which is either passive (so called “FDAP”) or which is “ECI”:
- income that is “Fixed or Determinable Annual or Periodical” (“FDAP”), such as interest, rents, royalties, premiums, remunerations, or my favorite, “emoluments,” is taxed by requiring the US payor (the “withholding agent”) to withhold 30% (or lower treaty rate) from any payments; and
- income that is “effectively connected” with the “conduct of a trade or business” in the United states (“effectively connected income” or “ECI”) is subject to regular personal or corporate income tax. If such income is earned through a partnership or LLC, the partnership or LLC is supposed to withhold from income allocated to foreign partners at the highest applicable marginal rate of tax.
The US imposes tax by withholding because it doesn’t have the authority to make a non-resident alien individual or entity file a return or pay tax unless that foreign person has a physical presence in the US – so it puts the obligation to pay tax on the withholding agent. If a withholding agent fails to withhold tax as required, the withholding agent will be personally liable for the tax.
Which leaves us with the following questions:
- Are block rewards or validating income active business income?
- Are block rewards or validating income FDAP? and
- Are the particular block rewards or validating income in question US source?
The amount of block rewards earned by a validator is a function of the per validation fee on the block chain and the number of blocks validated by the validator. That latter variable is itself a function of (a) the number of transactions completed on the block chain, (b) the number of tokens the validator has standing behind his or her validation activities (his or her stake), and (c) the number of other validators and their stake. The first and the third of those are entirely outside the control of the validator or anyone providing him or her with a stake (more about staking later).
Block rewards look a lot like a fee for a service (of validating the blocks), which would ordinarily be treated as active business income (there is an argument that block rewards are more like a royalty for the use of software and computing power, but let’s leave that aside for the moment). In that case, the focus needs to be on source. Income from services are “sourced” where the services are performed. So a validator located inside the US would likely have US source income, and one located outside the US would likely have foreign source income. And since a validator with a physical presence in the US is likely already subject to US tax on its income in general, the discovery that his or her block reward is also taxable in the US would not be a surprise. (If the Block reward is a royalty, then the income is more likely FDAP and sourced in the location where the benefit of the software is being realized – and it’s hard to know (a) what does that mean (where the last contributor to the block is located? Where the last transaction of tokens reflected in the block occurred? etc.) and (b) to determine the information necessary to determine the source.)
Treatment of Staking Income
While there are certain issues in determining the taxation of Block Rewards, there are many more issues related to staking income.
Generally, staking involves one participant in a network providing a validator with additional tokens (a “stake”) which allow the validator to earn more block rewards, some of which income is shared with the participant providing the stake. The reason that a validator with a larger stake can earn more block rewards is in part because that means the validator has a relatively greater interest in the integrity of the ledger. However, it is also there because a validator who does his or her job incorrectly (e.g., signs or endorses more than one block at the same “height”) compromising the blockchain is subject to a penalty in the form of forfeiting tokens.
So what is the role of a participant who stakes a validator? That participant might be seen as:
A preferred shareholder in a partnership with the validator who gets preferred return of capital, and a limited / preferred share of profit from the validator’s active business of validating blocks (“Preferred Holder”);
A lender to the validator where the validator is paying interest on a loan, which interest is contingent on the amount of block rewards received by the validator (“Debt Holder”);
A provider of a surety bond who receives a premium for providing the economic back stop against the validator’s errors (“Surety Issuer”) – personally I find this interpretation the most compelling;
A principal doing the validating itself, using the services of the nominal validator, to which it is paying a fee equal to the excess of the related block rewards over the amount of staking income received by the participant (“Principal”).
If the participant is a Preferred Holder, staking income is bad for both foreign and tax exempt parties. They would be deemed to be engaged in the business that the validator is pursuing, making that income UBTI for the tax exempt participant and making it ECI for a foreign investor if the validator is operating in the US. Moreover, the validator (or more technically the deemed partnership between the validator and the foreign participant) would then have an obligation to withhold tax from the staking income paid to the foreign participant (and if it didn’t would be personally liable for that tax). Not a good result.
If the participant is a Debt Holder, the tax exempt participants are all fine, but the foreign participants are in trouble. Ordinarily, US source interest (which is FDAP) paid to a foreign debt holder is exempt from withholding tax, but this would be contingent interest and so would not be exempt. Again, if the validator is a US person, he or she would have to withhold tax at a rate of 30% (or a lower rate if a tax treaty applies) of the staking income. Better, but still not a good result.
If the participant is a Surety Issuer, then the staking income is now a “premium”, which is generally FDAP. That income might also be UBTI for a tax exempt participant (it’s unclear to me whether issuing a surety bond is an active business for this purpose). More important, however, if the participant is foreign, the validator is again required to withhold tax from the staking income if the risk being guaranteed is a US risk (e.g., if that’s where the validator runs his or her validations). Again, there may be tax treaties that protect foreign participants, but qualifying for those treaty exemptions requires an IRS Form W-8 and other documentation that is rarely provided by staking participants.
Finally, if we mangle the relationships to characterize the party staking the validator as a principal who is doing the validation and paying the validator a fee, both tax exempt and foreign participants will be deemed to be engaged in the business of validating the blockchain. That would generally be bad for the tax exempt participants regardless of where it is located, but maybe not so bad for the foreign participant or the validator. The foreign participant may be able to argue that if it is engaged in business, it must be a business located outside the United States (and so not subject to US tax). In addition, the validator would be able to argue that it is not paying anything to the foreign participant (either profit or FDAP) and so is not subject to an obligation to withhold. That said, even if we could modify the contractual relationship between stakers and validators to support this approach, there is no guarantee that, given the historic characterization of the relationship between the two, the IRS wouldn’t successfully challenge the approach and impose one of the first three interpretations (presumably the one with the worst results for the parties involved).
What can be Done?
Given the extra-national nature of blockchain, participants and validators could position that staking income is not US source, and so none of the issues discussed above are applicable. I think that would be a very difficult thing to prove if you were ever put to the test, but it may be enough to minimize penalties. However, if you can’t get comfortable that all staking income is foreign source, here are some other things you might consider:
If you are a validator located in the US, you may want to consider only accepting stakes from domestic participants. (If you are not in the US, I don’t think you care.) If you want to take stakes from non-US participants, you could require them to transact through a US partnership. That doesn’t change their exposure to tax, but it means that the withholding agent is their partnership, not the validator.
If you are a foreign participant, you may want to look for validators who operate outside the United States whose payments wouldn’t be US source anyway.
If you are a tax exempt participant or a fund, you might consider forming a special purpose corporation (an “SPC”) and lend tokens to it – so it is staking the validator. Then the income of the SPC will be subject to tax, but only after deduction of the interest on the token loan. You would then earn interest income which would not be contingent. For a tax exempt participant that would make it clear that all income is interest income (and none is UBTI). For a foreign investor in the fund (assuming it owned less than 10% of the fund), the interest payment from the SPC would be exempt from withholding (because it’s not contingent), and only the net income of the SPC would be subject to US tax. Unfortunately, the 2017 Tax Cuts and Jobs act limited the amount of deductible interest to 30% (now 50%) of a corporation’s income, so a significant amount of the staking income would be taxed twice.
If you are a platform and don’t want to be a withholding agent, I think you need to rely on the argument that you do not have control, receipt, custody or disposal of the staking income. As far as I know, platforms are reporting that income on IRS Form 1099-k as a transaction across a third party network. Whether that is a bullet proof solution or subject to challenge is an open question.
I mentioned above that some people are arguing that block rewards and staking income are more like stock dividends and shouldn’t be taxed until the new tokens are sold. If that’s the case, nearly all the above concerns go away. At this point, there is no way to know if the IRS will challenge that characterization, but there certainly have been no IRS pronouncements that support it either. Moreover, even if this argument works (and I’m not sure it does), it should only apply to the extent your block reward or validating income is equal to the growth of the network in total (e.g., if the network grows by 2% and you earn 4 tokens from staking 100 tokens, you would have 2 tokens worth of “inflationary” growth and 2 tokens of income).