The miners’ work consists of solving a complicated mathematical problem, and, in return, they are rewarded with newly issued bitcoins. In contrast, in PoS structures, some of the holders of the cryptocurrency take on the obligation of validating transactions. To obtain the position of validator, a holder of the cryptocurrency puts up a bond (a "stake") of an amount of the cryptocurrency to back up its position. One validator is appointed to review and approve a block of the transaction, and other validators confirm the decision. Because this validating process requires specialized software and constant and secure connection to the Internet, a validator who is unwilling to make it’s efforts may delegate another validator to perform this task for it (a "delegator").
Notice 2014-21 provided the following answers to a few previously raised tax questions:
- A cryptocurrency like Bitcoin is property rather than currency under section 988.
- Miners have income when they are rewarded with bitcoins as a result of solving a mathematical problem.
- A miner can be engaged in a trade or business.
As to the issue of labeling cryptocurrencies, Shakow implies that the IRS' conclusion is reasonable. Because the only currencies in existence are issued by governments, the IRS was powerless to include Bitcoin as a currency, no matter how much it resembled a currency in practice.
As to the timing of income, Shakow agrees with the IRS and further provides a detailed theoretical analysis that Notice 2014-21 has neglected. He compares the tax analysis of the rewards that are received from the system through the creation of new cryptocurrency tokens with that of (1) found property, such as fish caught by a fisherman, and (2) created property, such as vases created by a glassblower. First, the tokens that the miners or validators receive from the system are not like found property because the tokens did not exist until they were created by the blockchain and were transferred to the successful validator. Second, the tokens are not like created property because the tokens are not the direct product of the validator's activities. The system creates the reward, and the validator's task is not to create the reward but to validate the block. Because the validator has accomplished its task, it is given a reward. That task and reward structure is a classic example of taxable compensation, and thus, the validators have income immediately when they receive the rewards, not when they dispose of their tokens (With this regard, Shakow criticizes Abraham Sutherland, who opposed the immediate taxation of the reward. Here is my review on Sutherland's work). Shakow's comparison between token rewards and found property and created property clarifies many issues underlying the token rewards, and I have become more sympathetic to the IRS’ position after reading Shakow’s analysis.
The third issue on trade or business deserves further consideration. Although Notice 2014-21 does not determine whether a minor or validator is engaged in a trade or business, Shakow concludes that minors in the PoW process and validators in the PoS process are engaged in a trade or business. A minor’s amount of regular activity, along with the substantial use of electricity and hardware, justifies this conclusion. Hence, expenses related to the process should be deductible, and the income should be ordinary income. However, is a delegator also engaged in a trade or business? If validating crypto transactions is a trade or business, delegators might be in partnership with the active validator under section 761(a). However, characterizing this relationship as a partnership would result in practical problems. Specifically, in order to comply with tax law, a partnership is required to file a tax return and furnish a Form K-1 to each of its partners, which requires partners—e.g., validators and delegators—reveal themselves to each other. That is inconsistent with the general anonymity that the blockchain structure provides, which may be inconceivable for the blockchain users.
Rev. Rul. 2019-24 deals with the effect of a “hard fork” on taxpayers holding a cryptocurrency. When the rules governing the operation of a blockchain change, it is possible that some persons will continue using the old protocol while others use the new one, so that two separate forms of the cryptocurrency can be spent thereafter. The IRS ruled that, as long as the hard fork results in the blockchain creating a new separate coin for those who held the currency before the hard fork (an "airdrop" of the new coin), the hard fork will result in the creation of additional income. Shakow correctly points out that the IRS uses the term "airdrop" in a broad sense to include all situations where the holder of the cryptocurrency at the time of the hard fork ends up with access to an additional item thereafter. When the Ethereum hard forks occurred, the old path, now referred to as the Ethereum Classic, became the continuation of the original Ethereum blockchain and is still having positive value. The much more valuable new Ethereum is considered the airdrop under Rev. Rul. 2019-24, and thus taxable income. However, Shakow explains that this position is contrary to the notion that stakeholders, who create a hard form to improve the blockchain protocol, expect that items on the new fork will be viewed as the continuation of the original crypto. Shakow seeks a legislative solution. He suggests that recipients of new crypto may be taxed on the value of items on the less valuable fork. Alternatively, holders could be permitted to allocate their basis between the two resulting cryptos, as is allowed in the stock situation in section 307. I tend to endorse the alternative solution for allocating the basis between the two resulting cryptos.
Finally, Shakow addresses the issues that the IRS has not yet decided. First, he points out it is not clear who is responsible for the actions in the blockchain world. What if the blockchain is causing no harm, but it is incurring legal obligations, such as a tax compliance obligation? The SEC took the position that the tokens reflecting investment in The DAO, a decentralized autonomous organization, were securities under the Howey test for purposes of the U.S. securities laws. Further, the SEC took the position that the entity which developed this DAO structure, Slock.it, is potentially responsible for legal obligations resulting from failing to register the tokens. (For a fuller description of The DAO, see Shakow's another work, The Tao of The DAO, reviewed by Ariel Jurow Kleiman here.) However, it is not clear that the SEC's position would remain valid if Slock.it had not been so intimately involved in The DAO's creation and marketing, in which case there is no person or entity that would be held responsible for the legal obligation of The DAO. Also, the IRS' responsibility vis-a-vis the operation of the blockchain is different than the SEC's. The IRS has to deal with the blockchain if it is to be considered a trade or business. Somebody should furnish Forms 1099 to all successful miners and validators who receive block reward income. Can we conclude that a blockchain like Bitcoin is an entity for tax purposes and is responsible for such tax compliance? Shakow thinks not, and leaves this as an open question.
Also, it is not clear where the blockchain system is located for tax law purposes. Once it is launched, the blockchain system is located on a large number of computers, and the system has no idea where the many computers holding a copy of the blockchain are located. This makes it difficult for any tax authority to assert its tax jurisdiction. In principle, an entity transferring an item of income to another is required to issue an information statement to the recipient and to file the form with the IRS. However, the IRS has neither indicated that the Bitcoin blockchain is not in compliance for failure to issue the appropriate forms to the miners who receive reward income, nor stated that the blockchain need not issue those forms because it is either not within the U.S. jurisdiction or not an entity. Shakow further explains the difficulty of identifying the location of economic activity in the context of cloud computing. I would like to add that the issue of crypto and blockchain being nowhere and everywhere relates to the unanswered question of whether the crypto owners should file FBAR or FATCA reports with the IRS.
Shakow has been writing a series of insightful papers on taxing cryptocurrencies, including this paper. I look forward to reading more, and hope that he shares his wisdom on the most challenging issue of the crypto economics, at least to me—the valuation of the crypto in various situations.