The staking and mining of digital assets were among the issues discussed by two speakers at the Foundation for Accounting Education’s Taxation of Financial Instruments Conference on Jan. 9. The session was titled  “Taxation in a World of Digital Assets."

Andrea S. Kramer, a  regulatory, tax, commercial, and governance lawyer at ASKramer Law, framed the presentation by providing the newest definition of “digital assets” by the IRS: “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary [of the Treasury].”

“What I think is interesting is that they give us all of this guidance, none of it that's of precedential value, [and] none of it that we can actually rely on,” she commented. “And so here in their definition of digital assets, what they added, which I thought was of particular interest, is they make it clear to us that they're including stablecoins in the digital asset definition.”

That led Iqbal Khan, tax director at Forvis Khan, to raise some questions about this particular form of digital asset. Investopedia defines stablecoins as  cryptocurrencies whose value is pegged, or tied, to that of another currency, commodity, or financial instrument.

“We have so many questions about [stablecoins],” Khan said. “Is it truly debt? Is it equity, is it property or is currency? We don't have a real guidance on it but, from what it seems like, it could be debt because that's the closest to security.” 

Kramer pointed out the tax consequences of digital assets, such as that transactions involving a digital asset are generally required to be reported on a tax return. Taxable income, gain or loss may also result from a number of transactions that are listed on the IRS website. She then discussed what she found to be one of the key aspects of the guidance to be issued recently, a ruling on the taxation of staking income. (A week after the conference, the IRS announced that businesses do not have to report the receipt of digital assets in the same way as they must report the receipt of cash until Treasury and the IRS issue regulations.)

On July 31, 2023, the IRS issued a ruling, holding that when "a cash-method taxpayer stakes cryptocurrency native to a proof-of-stake blockchain and receives additional units of cryptocurrency as rewards when validation occurs, the fair market value of the validation rewards received [which is determined as of the date and time the taxpayer gains dominion and control over the validation rewards] is included in the taxpayer's gross income in the taxable year in which the taxpayer gains dominion and control over the validation rewards."

That led to an extended discussion of staking versus mining, but not before Kramer noted “another thing that's got us all confused": how the various agencies define these assets. For example, the Securities and Exchange Commission (SEC) calls them digital assets or tokens or coins, while the Commodity Futures Trading Commission (CFTC) uses the same terms as the IRS does—virtual currency or digital assets.

“When the IRS started coming out with information about digital assets, it was talking about convertible virtual currencies. That was the universe that they were looking at, and then Congress did its reporting rules and it used the word digital assets,” Kramer said. “And so now the IRS is sort of twisting back and forth between virtual currency, digital assets and some of their recent stuff. They're talking about cryptocurrency, and [now there are] popular terms for cryptocurrency—coins and tokens."

“Level one securities or tokens are Bitcoin or Ethereum because that is the first level of native tokens that we have,” explained Khan. “But then when you roll up the native protocol and build a utility or a functionality on top of that and you can create tokens for that, [then] that will be your level two tokens, which are used for completely different functionality. But now you have a protocol on which you could operate and leverage. It could be like an Ethereum protocol, or it could be a Bitcoin protocol, or any other protocol which is out there.”

Khan then returned to mining, “a term where you are actually creating Bitcoin or … a proof of work concept,” he said. “What you do is that you are solving complex algorithms and complex problems to validate a transaction in a block. And, as you create a new block, there's a new crypto or token created, which is passed on, and that has additional functions. That's mining in the world of Bitcoin protocol.”

Now, he said, the result is a “proof of stake” in the Ethereum protocol, in which the miner must “put on” his native token, in this case Ethereum, to participate in the validation process.

“The validation process is picking up validators at random and making sure they can validate the transactions, and [the] people who are able to do that get rewards, and these are called staking rewards,” he said. “And when it comes to mining, you typically recognize income the day you receive the mining income at its fair market value.”

Staking happens directly, he said, as validators are able to take the step.

Coinbase defines the term delegation as the process "whereby a holder of a network’s tokens can earn block rewards by adding their asset to the staked tokens on someone else’s node."

“This term delegation becomes very, very important because if you're self-staking, which means that it is a service you're providing and that income could be U.S. trade or business income [or] service income.”

Kramer then brought up non-fungible tokens (NFTs), asking, “Are these digital tokens? They're unlike something that you can exchange one for another.”

Khan answered with an anecdote about a client who came to his firm, asking how he could treat an NFT that he was writing based on a monkey’s artwork. Khan said that he had no idea what to tell the client.

“But in this example, ... maybe [the client] thought, ... because it's a painting or something like that, it could be collectible, and you could get the 28 percent [tax] rate on that,” he said. “But it also gives us an idea of how the IRS is looking at these different digital assets, as they have known that there are many derivatives which are coming out of the protocols, and each protocol has a different nuance and a different tax consequence. So, we will have to look through—at least from their perspectives—to see what will be the final ... recognition process.”