A shift in US tax policy could open up Proof of Stake possibilities, University of Virginia law professor says

A big sticking point of the debate between proof of work (PoW) and proof of stake (PoS) comes down to the inevitable: taxes. A recent report from University of Virginia law professor Abe Sutherland contends staked rewards shouldn’t be taxed as income but rather as created property, which would incentivize more miners to use staking networks, saving energy and promoting innovation. 

With PoW protocols, miners compete to discover the correct "nonce," the random integer which enables the creation of a block and the payout of a block reward. The most powerful computer usually wins, with winning probablistic to the percentage of total computational power. This means if one controls 20% of hashpower, they can expect to win about 20% of the competitions over the long run. For this reason, PoW protocols can require enormous amounts of energy, and also create an ecosystem where areas with cheap electricity have an advantage. Industry sources say sticking to PoW fails to incentivize mining activity to remain in the U.S., and instead deflects much of it to places like China, Mongolia and others where low electricity costs and cold environments save on cooling costs for mining farms. 

PoW takes higher electricity costs to perform the transactions and cool overheating machines. In a world where energy use dominates non-crypto native fears around mining, PoS represents an opportunity for efficiency. Instead of a direct race to the finish, PoS sees validators “stake” tokens, where frequency of block production is proportional to the percent of total stake, meaning if one controls 20% of staked tokens, one can expect to produce 20% of blocks and earn the ensuing rewards over the long term. Those who stake more tokens have a higher chance of being selected to create the next block in a lottery-like system, receiving a payout according to the size of their stake. 

With this understanding, Sutherland asserts the IRS’ 2014 guidance didn’t fully capture the complexity of the situation of crypto rewards. As of now, the IRS views these rewards as income, meaning they’re taxed as they come, but Sutherland contends they should be viewed as created property. In this case, the gains only get taxed once they’re sold. Sutherland said this is how many commodities are viewed.

“Any other commodity whether it’s oil from the Earth or anything mined from the Earth or farmed or raised, or just created through any investment of time and resources, that’s created property or even manufactured property,” he said. “When something rolls off the assembly line, that’s not income.”

These commodities are taxed once they’re finally sold, and Sutherland said the same should hold for cryptocurrency tokens. While cryptocurrencies can have a both/and quality, the Commodity Futures Trading Commission (CFTC) designated bitcoin as a commodity in 2015, with Ethereum to follow in 2019.

So why did the IRS view it this way? Sutherland said this approach made more sense in 2014, when Bitcoin was still being explored and understood by users and regulators. 

“Because of the specialization of Bitcoin mining, the implications of that approach to taxation are much, much less severe than they are with proof of stake,” he said.

With PoS, where many validators are involved, Sutherland said tax policy applies more broadly, since all token holders are capable of receiving reward tokens.

Overtaxation can also become an issue, considering the value of the tokens can fluctuate, according Stephen Turanchik, a tax lawyer with Paul Hastings LLP and head of the AICPA digital asset working group.

“I think our argument is that if you tax it at its purported fair market value, you’re overtaxing it on the day these tokens are received,” he said.

By taxing when the token is disposed of, the holder is taxed on the value at which they actually saw a tangible gain. If they use the token to buy a car, they’re taxed on the value of the car, rather than what the token was worth when they received it. 

The idea has gained attention from those interested in the growth of staking, including the Proof of Stake Alliance. The proposal itself has been published in the journal Tax Notes, as well. A change in treatment could come from the IRS itself, updating its 2014 guidance, or an act of Congress.