Nizan Geslevich Packin (CUNY; Google Scholar) & Sean Stein Smith (CUNY; Google Scholar), ESG, Crypto, and What Does the IRS Got to Do With It?, 6 Stan. J. Blockchain L. & Pol'y ___ (2023):
Regulation almost always lags behind innovation, and this is also the situation with many FinTech-based products and services, and particularly those offered by crypto industry players. The crypto sector is a new and innovative one, which has proven to be not only based on highly technical concepts, but also by high levels of volatility and financial risk. In attempting to understand how to address many of the issues it raises in legal fields ranging from to financial regulation such as tax requirements to environmental law, and specifically matters that relate to climate change and energy wasting, regulators often find themselves trying to implement existing legal frameworks rather than creating new, clear rules. Much has been written about the SEC’s regime of regulation by enforcement of the crypto industry, and the impact of this type of rulemaking on society, businesses and persons. However, other financial regulators adopting a similar style of rulemaking—such as the IRS—have gotten much less attention for the impact of their regulatory actions. One such notable example, which is relevant in the Environmental, Social and Governance (ESG) awareness era, relates to the unintended consequences of the IRS’ regulation by enforcement, given the impact that such new rules have on the transition to greener energy.
This happens in the crypto industry in connection with proof-of-stake (PoS) consensus mechanisms—one of the two prominent transaction validation mechanisms. The PoS mechanism includes staking rewards – reward tokens that are earned/generated from securing a PoS blockchain – that validators, also known as stakers, get when they validate transactions. The IRS has not been clear as to whether staking rewards should be treated as income or property, a key classification for accounting purposes. It asserted that cryptocurrencies are considered property for income taxation purposes, which means that every transaction results in a gain or loss equating to the difference between the price of the crypto asset at purchase and the price of the sale. Thus, under most scenarios, crypto assets will be considered capital assets taxed at capital gains and losses rates.
In the case of the PoS mechanism’s staking rewards, the rationale behind deciding whether to classify the rewards as income versus property is partly based on when a person realizes income from their activity/sale. Can we argue that a person realizes income when she bakes a cake, or mines gold from a mine, or does that actually happen only when she sells it? This issue, which might seem minor, has recently become the subject of a lawsuit that one validator brought against the IRS, arguing that staking rewards should be taxed at the time they are sold, rather than created as the IRS has argued. Analyzing this issue, this Article argues that having legal clarity is important and that regulation by enforcement is less equitable. Additionally, this Article argues that proper lawmaking is especially needed in this PoS-based staking situation, given the importance of incentivizing persons to use PoS mechanisms due to environmental considerations, and the implications of financial regulation’s nudges on the behavior of persons and the promotion of ESG-based goals. Indeed, this clarity is needed because current legal ad hoc structures do not have the capacity to keep pace with the negative impact on the environment and the energy consumption issues that the crypto sector causes. It is clear, therefore, that we need additional behavioral incentives for the law to rely on to support and facilitate the objectives of greener environment goals’ promotion. Finally, this Article agrees with validators’ claims in connection with the IRS’ classification of staking as it relates to taxation policies that arguably go back more than 100 years, and which focuses on the time of sale rather than creation of value.