After much anticipation, on December 1, 2020, Ethereum began undergoing a major update called Ethereum 2.0. Ethereum, like many other cryptocurrencies, has long utilized a consensus mechanism known as proof of work.
After much anticipation, on December 1, 2020, Ethereum began undergoing a major update called Ethereum 2.0. The update aims to address the network’s scalability and security by switching from a proof of work consensus mechanism to proof of stake. The upgrade plans to enhance the speed, efficiency, and scalability to allow more transactions and reduce system bottlenecks.
The Ethereum 2.0 release will roll out in three phases. The first phase launched on December 1, 2020, with the other phases coming over the following years. The first phase transitioned Ethereum from a proof of work to proof of stake algorithm. The original Ethereum chain will continue to run so as to not break data continuity, which has created unique tax questions.
Ethereum, like many other cryptocurrencies, has long utilized a consensus mechanism known as proof of work. Proof of work blockchains require miners to use computer hardware processing power to solve complex mathematical puzzles to verify transactions. This process can be incredibly energy intensive and require extensive hardware to compute.
Proof of stake is viewed as superior because instead of mining, it allows validators to stake crypto as a means to verify transactions. Proof of stake algorithms remove the energy-intensive computer processing required to ensure consensus in verifying transactions. This upgrade should have the added benefit of being able to support increased transaction loads. Ethereum currently supports around 30 transactions per second, while Ethereum 2.0 is intended to scale up to 100,000 transactions per second.
The change in protocol to Ethereum 2.0 presents two tax questions:
Users with Ethereum will be able to convert to Ethereum 2.0 (at a 1:1 ratio) via a registration contract (which effectively burns the original ETH). The IRS addressed the tax implications of forks in Rev. Rul. 2019-24.
A hard fork occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger. A hard fork often results in a new distributed cryptocurrency, along with the legacy cryptocurrency continuing. When a taxpayer receives a new cryptocurrency and still owns the legacy cryptocurrency then the new cryptocurrency is considered an airdrop and is subject to ordinary income rules. The IRS reached this conclusion by citing Section 61(a)(3) which defines gross income to mean all income from whatever source derived including gains from dealings in property. Under Section 61, accessions to wealth are included in gross income.
In the case of converting Ethereum to Ethereum 2.0, the taxpayer will not continue to own the legacy cryptocurrency. Accordingly, the economics of this transaction are more akin to an upgrade to the existing protocol, rather than creating a new currency that results in an accession of wealth. The original token (ETH) should be tied to the value of (ETH2) because they can be exchanged for each other at a 1:1 ratio. It therefore appears that an upgrade from ETH to ETH2 falls outside of the definition of a hard fork and does not result in an accession of wealth. It is therefore reasonable to conclude that converting ETH to ETH2 is not a taxable event, and a user will maintain their original cost basis prior to the conversion.
With Ethereum 2.0’s transition to a proof of stake protocol there will be a transition from mining to staking. The IRS has direct guidance on the tax implications of mining, finding that a taxpayer who mines virtual currency recognizes ordinary income at the time of receipt. The existing guidance on mining conforms with Section 61 finding that all accessions to wealth, from whatever source derived, are included in gross income.
Similar to mining, staking results in an accession to wealth that is analogous to receiving interest on property. Accordingly, the most logical interpretation is to find that staking results in ordinary income at the time the asset is received for the fair market value of the asset.
Many exchanges provide users with a 1099-MISC if the user receives over $600 in income. This tax form will make it easy for users to know how much income they have generated on an exchange through staking activity. TaxBit Enterprise works with cryptocurrency exchanges to comply with their 1099 obligations to provide users with the necessary forms to complete their taxes.
The transition to Ethereum 2.0 should have many advantages that will allow further scalability and mass adoption. It appears that merely exchanging Ethereum to Ethereum 2.0 (at a 1:1 ratio) is not a taxable event. However, it is important to be aware that staking Ethereum 2.0 will carry ordinary income reporting obligations, as staking rewards would clearly be considered an ascension of wealth pursuant to Section 61 of the Internal Revenue Code.
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