Proof of Work to Proof of Stake: Examining the Tax Implications of Cryptocurrency Consensus Changes

The Internal Revenue Service has determined that units of cryptocurrency which transition from a proof of work consensus mechanism to a proof of stake consensus mechanism are not considered a sale, exchange, or other type of income recognition event according to IRC §61.
Taxpayers who hold any form of cryptocurrency should consult with their tax professionals and be aware of all tax implications in order to avoid unintentional tax evasion or other complications. The attorneys at Silver Law, PLC are dedicated to remaining up to date on this relatively new and expanding area of tax law so they can continue to provide their clients with the best legal advice.
Taxpayers who hold cryptocurrency or participate in verification transactions may be wondering how the new conclusions from the IRS affect the tax liability.

What is Proof of Work vs. Proof of Stake?

Proof of work and proof of stake are methods that are used to verify cryptocurrency transactions. They share similarities in that they are both mechanisms in which a network of holders agree on new blocks of transactions being added to a cryptocurrency digital ledger, which is called a blockchain. Both methods provide a way to verify transactions without the involvement of a central authority. However, each method reaches this goal in a different way.

Proof of Work (PoW)

This computational method is essentially a competition to determine which new block will have the most computational work performed on its behalf. This method is commonly used by Bitcoin. All of the miners on the network will compete to solve a cryptographic puzzle through computational power. The winner adds the transactions to the blockchain, earning cryptocurrency for their work. The network determines the difficulty of the puzzle and ensures that new blocks are added consistently so that the network remains stable. For some investors, proof of work verification methods are controversial because of their utilization of electricity. However, they are significantly more secure than proof of stake and many applaud the decentralized approach to mining.

Proof of Stake (PoS)

This verification method requires participants to stake collateral on transactions in a voting process. Each validator stakes cryptocurrency on a transaction based on which block they want to add to the chain. Blockchains may set different limits or requirements for the amount of collateral that is required to stake on the transaction. In compensation for their vote on a legitimate transaction, the validators are randomly selected based on how much they have staked in the network and are paid over time through newly created cryptocurrency. This energy-efficient method of cryptocurrency validation is faster and offers a less expensive alternative to the high cost of computational power that is needed for proof of work transactions, but has been criticized for being centralized. Other investors dislike proof of stake because the validators with the most currency to stake are typically the ones who are rewarded. Additionally, proof of stake is a newer approach that has not been fully tested for success.
The IRS has been investigating the growing and changing field of cryptocurrency and determining whether a change in protocol from proof of work or proof of stake is an effective exchange of digital assets and therefore a taxable transaction or source of income.

IRS Analysis of Proof of Work vs Proof of Stake Transactions

In response to the popular change in cryptocurrency protocols, the IRS has been examining proof of work and proof of stake verifications in order to determine whether either protocol represents taxable loss/gain transactions or an effective source of income that is subject to taxation.
In a publication from the Office of Chief Counsel dated March 27, 2023, the IRS examined two questions:

• Does an individual taxpayer (“T”), who holds 10 units of C, a cryptocurrency native to a distributed ledger that undergoes a protocol upgrade (as defined below) that changes the consensus mechanism by which transactions are validated, realize gain or loss on those units under section 1001 of the Internal Revenue Code (“Code”) as a result of the protocol upgrade?
• Does T have an item of gross income under section 61(a) of the Code as a result of the protocol upgrade?

For both questions, the IRS concluded that the answer is no. Regarding the first question, the memorandum states:

The protocol upgrade affects the consensus mechanism by which future transactions are validated and blocks are added to K after Date 2. The protocol upgrade does not alter past transactions or blocks previously validated and added to K, including T’s 10 units of C. Furthermore, the existing units of C remain unchanged by the protocol change and there is not an exchange of the units of C under section 1001. Accordingly, T continues to own the same 10 units of C before and after the upgrade and the protocol upgrade does not result in a realization event from which T realized gain or loss on T’s existing 10 units of C.

In answer to the second question, the IRS concluded:

Similarly, T derives no accession to wealth from the upgrade. T’s 10 units of C remain unchanged after the upgrade, and T does not derive any separable economic benefits, in the form of cash, services, or other property (including other cryptocurrencies) from it. In the absence of an accession of wealth to T, the protocol upgrade does not result in T having an income inclusion within the meaning of section 61(a).

For taxpayers who hold cryptocurrency and participate in proof of work or proof of stake verifications, this means that a change in protocol does not create a sale or exchange of the digital asset. Further, no income is created with a change in protocol.

Obtain Legal Advice Regarding the Tax Implications of your Cryptocurrency Holdings with Arizona’s Highest Rated Tax Attorneys

If you hold cryptocurrency, you likely know that taxation implications can be complicated, but you don’t have to find all the answers on your own! Schedule your consultation with Silver Law, PLC, Arizona’s leading tax attorney firm. We are dedicated to remaining up to date on the latest IRS conclusions in the ever-changing field of cryptocurrency and tax law so that we can continue to provide trusted legal advice for all of our clients who are invested in mining, stake holding, and other cryptocurrency transactions. As Arizona’s trusted tax attorneys, we are ready to provide experienced guidance, representation, and advice for every aspect of taxation. Contact our office today for your confidential consultation.

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