Ethereum’s evolution to proof of stake raises cutting-edge tax questions
Last month, the world’s second-largest cryptocurrency by market cap experienced a major evolution. Ethereum no longer relies on powerful, energy-guzzling miners (via a process called proof of work) to verify transactions on its decentralized network. Instead, Ethereum now uses a more energy-efficient mechanism called proof of stake after an event last month called the Merge. Users can participate, and earn rewards, by locking ETH on the new proof of stake network.
The Merge resulted in a “chain split” and the creation of a new coin called ETHW. Depending on where you held your coins at the time of the split, there may be tax implications. A few major exchanges disbursed ETHW to ETH holders last month, for example, which should be taxed as income equal to the value of the coins at the moment of receipt. Learn more about the Merge chain split and its tax implications here.
Before and after the Merge, however, different kinds of Ethereum staking techniques raise a myriad of cutting-edge tax considerations.
Here are a few key takeaways:
- Staking ETH comes with a key limitation: Staked ETH and compounding rewards cannot be unlocked for the next year or so (until another upgrade called Shanghai is completed).
- ETH staking rewards may potentially be taxed as income equal to the value of the coins at the moment of receipt. But without the ability to unlock funds, and given ETH’s price volatility, staking tax liabilities can be confusing. And without formal IRS guidance, a taxpayer may also be able to reasonably argue that taxable income should be deferred until funds are completely unlocked.
- To solve the obstacle of indefinitely inaccessible funds, users can alternatively participate in “liquid staking.” Via liquid staking pools, users can stake ETH and receive a freely transferable token in return – entitling holders to the locked ETH, and any accrued rewards, at an undetermined later date.
- Exchanging ETH for a liquid token (for example stETH via the popular Lido staking pool or cbETH on Coinbase) is likely a taxable event, although this is far from common knowledge.
Solo Staking and Staking-as-a-Service
Any ETH holder can help secure the Ethereum network and earn rewards in the process by staking. As the backbone of its decentralized and global network, however, the Ethereum Foundation refers to “solo home staking” as the gold standard of staking. With 32 ETH and an internet-connected computer running 24/7, anyone can solo stake directly on the network and earn rewards in the process.
If you don’t want to worry about running a dedicated computer 24/7 for staking, however, some users may also choose to participate in “staking-as-a-service” options. In this case, you can delegate your 32 ETH stake to a third party who operates the staking node while earning a portion of the rewards in the process.
In both solo staking and staking-as-a-service, the act of staking 32 ETH likely does not have tax implications in itself. However, any rewards earned would potentially be taxed as income equal to the value of the ETH rewards at the moment of receipt (similar to how proof of work mining rewards are taxed currently). There is an important disclaimer with ETH staking, however, as both the staked ETH and any rewards are locked indefinitely – until another upgrade called Shanghai occurs in the next year or so.
Given that both staking-as-a-service and solo stakers will not have “dominion and control” (as outlined in Rev. Rul. 2019-24 where the IRS previously issued guidance on the tax implications of blockchain hard forks) over any accrued rewards for the time being, taxpayers may be able to reasonably argue that income tax liabilities should be deferred until the moment ETH staking rewards can be unlocked. Hopefully, the IRS will issue formal guidance to clarify the matter.
Pooled and Liquid Staking
There are two key limitations with both solo and staking-as-a-service options. Firstly, the 32 ETH requirement (worth over $40K at the time of writing) may be restrictive for many individuals. Secondly, the indefinite timeline for being able to unlock your staked ETH and accrued rewards can be frustrating, especially given ETH’s day-to-day price volatility.
As a result of these obstacles, a variety of alternative solutions have emerged. One solution is so-called “pooled staking.” In this case, users can stake as little as 0.01 ETH as a “pool” in order to meet the 32 ETH staking requirements and earn proportional rewards. Many staking pools also enable “liquid staking” whereby you can receive a freely tradeable ERC-20 token that represents the value of your staked ETH.
When you deposit ETH into the popular Lido liquid staking pool, for example, you instantly receive another token called stETH in return. Whereas the staked ETH is locked indefinitely, your stETH is freely tradeable – and is supposed to represent the value of the initial staked ETH plus any accrued rewards that can be later redeemed at the moment the network unlocks.
Similar to Lido’s stETH, major centralized exchanges such as Coinbase offer liquid staking tokens to users who want to earn yields with minimal effort compared to other options. Via Coinbase’s cbETH, users who stake ETH can receive a liquid token called cbETH in return. Like Lido’s stETH, 1 cbETH is supposed to represent the value of 1 staked ETH plus all of its accrued rewards. (Although given the uncertain timeline for the ability to unlock staked ETH, cbETH and other liquid tokens frequently trade at a discounted value versus the value of 1 unstaked ETH today.)
The act of exchanging staked ETH for a liquid staked ETH token is likely a taxable event. In this case, the IRS would likely regard it as an exchange of one asset for a materially different one (ETH to an ERC-20 token). This is not commonly known, however, and there are likely many investors who will be clamoring for official clarification.
We hope that the IRS provides official guidance on the matter, as they once did after the high-profile Bitcoin/Bitcoin Cash hard fork of 2017.
