Cryptocurrency is a virtual currency that uses cryptography to secure transactions recorded on a digital ledger. Units of cryptocurrency are known as coins or tokens. FOS’s estate planning newsletter has described the role of cryptocurrency in estate planning. https://foslaw.com/wp-content/uploads/2021/10/Fall-2021-EP-Newsletter.pdf
With market declines, cryptocurrency seemed to fall out of favor with many investors.
The IRS, however, treats the receipt of cryptocurrency as taxable income for federal tax purposes and has recently formalized its position on what qualifies as cryptocurrency-related income.
In recent Revenue Ruling 2023-14, the IRS clarified that if a taxpayer “stakes” cryptocurrency and receives additional cryptocurrency units as a result, the receipt of the additional cryptocurrency is taxable income.
The Revenue Ruling’s impact is best described through a primer on how cryptocurrency is created.
A blockchain, synonymous with a digital ledger, records cryptocurrency transactions.
These records, which are stored in multiple network locations (“nodes”), validate the blockchain’s integrity and ensure new record entries are authentic, which then create a new “block” on the chain.
Cryptocurrency holders can qualify themselves to participate in the validation process by “staking” their holdings. Multiple validators are digitally selected to perform the validation.
Holders may earn rewards —additional cryptocurrency units — when a validation occurs and may be penalized if a validation is unsuccessful.
According to the IRS, if a validator stakes cryptocurrency, the taxpayer gains dominion and control over the earned cryptocurrency reward when the validation occurs.
Revenue Ruling 2023-14 concludes that the fair market value of the reward at validation is gross income.
While cryptocurrency values may remain depressed for some time, holders and validators should stay abreast on the IRS’s position on the taxability of income associated with it to avoid future penalties and interest for failure to report income.