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TAX CLINIC

until the taxpayer sells or disposes of which allows it to maintain all transac- and after the time it takes for a person
them in some other manner. In early tions publicly and transparently with a to validate the block (the lockup period
February, the U.S. Department of Justice full audit log, eliminating the need for a is subjective and variable based on the
instructed the IRS to issue a refund to middleman to facilitate transactions or blockchain). This process is enforced
the taxpayer and moved to dismiss the value exchange (i.e., banks and other fi- to ensure the validator is not acting
case. The Jarretts declined the refund nancial institutions), thus reducing costs, maliciously. Proof-of-stake consensus
and are seeking a declaratory judgment increasing efficiency, and improving mechanisms also can have built-in
to cover future tax years. The case is transparency for transfers of value. “slashing” rules, where staked tokens can
still pending. A cryptoasset transaction can be be permanently taken away if the valida-
In order to fully understand this validated through numerous differ- tor is violating any of the protocol’s rules
argument, it is essential to understand ent consensus mechanisms, the most governing consensus.
a few fundamental elements of how popular of which are proof-of-work and Through the actions of the validators,
staking rewards work and the law as it proof-of-stake consensus mechanisms. the blockchain creates staking rewards,
relates to created property. The proof-of-work validation process an allotment of newly minted tokens as
involves “miners” who compete in the part of the blockchain’s built-in inflation.
Proof of stake and staking task of solving a cryptographic puzzle in This staking reward comes from the
rewards order to earn the right to propose a new blockchain protocol itself and not from
The proof-of-stake consensus algorithm block in the blockchain and receive the any third party. Validators retain these
is a blockchain consensus mechanism transaction fees and newly minted rewards for their participation in the
developed to facilitate and validate cryptoasset (collectively “mining re- validation process.
transactions in digital assets on a block- wards”) in exchange for their efforts.
chain, such as the Tezos blockchain at Proof-of-work mining generally requires Current guidance: Notice
issue in the Jarrett case. specialized computer equipment and 2014-21
As a reminder, a blockchain is a significant energy consumption. Currently, there is limited guidance from
cryptographically secured digital ledger In a proof-of-stake consensus the IRS and Treasury specifically ap-
for publicly recording transactions in blockchain there is no energy-intensive plicable to the taxation of digital assets.
digital assets. Numerous individual cryptographic puzzle to solve. Rather, The IRS first addressed digital assets in
nodes maintain this electronic ledger by “validators” are chosen based on their 2014 with Notice 2014-21. The notice,
connecting to one another over a net- proportional ownership amounts, in which addresses virtual currency and
work and by running the same protocol a random number lottery process, to convertible virtual currency, clarifies that
software. Transactions on a blockchain propose a new block of transactions. digital assets are considered property and
can include the transfer of digital as- For every block on a proof-of-stake not currency for federal tax purposes.
sets, such as tokens, and users generally blockchain, one validator is chosen to Additionally, Question 8 of the notice
interact with the blockchain through create the block, which is then proposed states that a taxpayer who mines virtual
user-level software or hardware-based to the other validators for their ap- currency would need to include the fair
tools called wallets. Digital tokens proval. If there is a consensus among the market value of the mining rewards in
typically serve as a representation of validators that the transactions in the gross income as of the date of receipt of
value for online transactions, such as an newly proposed block do not violate any such rewards.
online money transfer or subscribing to of the protocol’s rules, then the block Based on the notice, the mining re-
a service. is appended to the blockchain and the wards would likely be taxed at ordinary
Rules governing a blockchain process starts over. income rates and not at capital gains
network, referred to as a consensus Under the proof-of-stake consensus rates since miners are receiving com-
mechanism, are built into the protocol mechanism, validators must have an pensation in exchange for providing a
software, and a blockchain is only up- economic stake in the blockchain’s un- service and the rewards would likely not
dated when there is consensus among derlying digital asset to participate in the be seen as a capital asset in the hands of
the nodes that transactions and data process. Validators are required to place the miner. The notice does not include
being submitted comply with the built- their own tokens (which generally need specific guidance relating to proof-of-
in consensus rules and are validated to meet a certain staking threshold to stake transactions and staking rewards
accordingly. The appeal of blockchain is qualify) into a smart contract where they because proof of stake had barely begun
that it is a decentralized trustless veri- are held for a period of time (otherwise to emerge at that time. Subsequent
fication system based on cryptography, referred to as a lockup period) during cryptoasset guidance has been quite

20 April 2022 The Tax Adviser