Funds that Stake: U.S. Tax Considerations for Investors in Proof of Stake Networks
Proof of Stake (PoS) and the token rewards that arise from staking raise a host of new questions that the U.S. Treasury Department and the IRS and have yet to definitively answer.
- Does the receipt of staking rewards give rise to ordinary income or capital gains for investors? Or neither?
- Are staking rewards taxed differently than mining rewards?
- What are the implications for U.S. based Hedge/VC funds with Foreign LPs?
- What are the effects on LP’s in the different types of venture fund structures that exist?
- And more…
To start getting clarity on these questions and as part of our ongoing Figment Prime investor education service we hosted a call with Brian Hamano at Gibson Dunn – one of the top legal advisors for cryptocurrency taxation and regulation issues – and a number of funds that hold staking based tokens.
Is the Receipt of Staking Rewards Taxable?
Aside from a notice in 2014 and warning letters the IRS began sending to taxpayers in July 2019 to encourage voluntary compliance (Letter 6173, Letter 6174, and Letter 6174-A), the industry still awaits IRS crypto tax guidance. This leaves significant gray area around newer blockchain related developments in general such as DeFi and specifically staking.
In the absence of guidance, there are rational arguments in the current environment to justify a range of approaches to staking rewards: treat staking rewards as income when received or, on the most aggressive end, treat staking rewards as not giving rise to income upon receipt and only recognize capital gains when the staking rewards sold. The practical consequences of those options are self explanatory and would require taxpayers to set aside the liquid funds to pay the income taxes on the receipt and/or sale of the staking rewards.
Unrelated Business Taxable Income (UBTI)
VC funds have expressed concerns about staking rewards creating a UBTI issue. Generally speaking, UBTI is income of a tax-exempt organization that is not related to the organization’s tax-exempt purpose.
Although certain types of passive income that are similar to staking rewards (e.g., dividends and interest) generally are not treated as UBTI, the absence of IRS guidance leaves open the issue of how staking activities and staking rewards would be treated for purposes of the UBTI rules. VC funds that engage in (or that hire SaaS providers to engage in) staking activities could cause tax-exempt investors to have UBTI. VC funds can structure around the issue, however, through the use of alternative investment vehicles (so-called “AIVs”) and vehicles that are classified as corporations for U.S. tax purposes (“blocker corporations”).
Concerns of Foreign LPs
Non-U.S. persons are generally required to file U.S. tax returns, and are subject to U.S. federal income tax on a net basis, with respect to any income that is (or is treated as) “effectively connected” with a trade or business in the United States. The absence of IRS guidance also leaves open the issue of how staking activities and staking rewards would be treated for purposes of the “effectively connected income” rules. VC funds that engage in (or that hire SaaS providers to engage in) staking activities could cause foreign LPs to have effectively connected income. However, the same structuring techniques mentioned above for UBTI-sensitive investors can be used to structure around the “effectively connected income” issue for foreign LPs.
Structural Solutions: Benefits for UBTI-Sensitive and Foreign LPs
The use of AIVs and blocker corporations can provide significant benefits to UBTI-sensitive and foreign LPs. For UBTI-sensitive investors, these structural protections can help to ensure that the investors do not recognize UBTI. For foreign LPs, these structural protections can help the LPs avoid U.S. tax return filing and other reporting obligations in their personal capacities and potentially subjecting their other income to U.S. tax.
However, there are downsides to using AIVs and blocker corporations, such as U.S. tax return filing and other reporting obligations for those entities and potential corporate income tax leakage.
As decentralized finance mechanisms/opportunities continue to improve and mature and investment grows, we expect to see more sophisticated tax exempt investors negotiating for these types of structural protections and covenants in fund partnership agreements (which are similar to those provided in a traditional private equity fund).
Staking rewards should be considered well within the primary business of any investment group, as staking is the only way to avoid network dilution and is integral to investment in that token. This position would be further reinforced by contracting with a third party staking provider to assist with the staking of PoS assets.
If you have any additional staking related questions or needs, please do not hesitate to reach out to Figment Networks: firstname.lastname@example.org
If you have additional crypto tax questions, please do hesitate to reach out to Brian Hamano: email@example.com.
THIS DISCUSSION IS FOR GENERAL INFORMATION ONLY. ANY DISCUSSION OF U.S. FEDERAL INCOME TAX ISSUES IS NOT INTENDED TO BE, AND SHOULD NOT BE CONSTRUED TO BE, LEGAL OR TAX ADVICE TO ANY PARTICULAR TAXPAYER. EACH TAXPAYER IS STRONGLY URGED TO CONSULT HIS, HER OR ITS OWN TAX ADVISOR REGARDING THE TAX CONSEQUENCES OF STAKING AND INVESTING IN POS TOKENS.
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