Prepare for the ETH2 staking reward tax bill
Published: February 21, 2023
Overview
Taxpayers should prepare for the Shanghai upgrade by setting aside fiat money to pay the tax man on their accrued ETH2 staking rewards. Tax advisors should discuss ETH2 staking rewards with their clients before any ETH price fluctuations make it hard to come up with the fiat money to pay the tax bill.
Crash course: what is the Shanghai upgrade?
Blockchain protocols operate a trust-less network that relies, in part, on value creation in order to incentivize participation in validating new blocks of information on the blockchain. Two well known types of validation participation are proof of work (PoW) and proof of stake (PoS). The Ethereum protocol started as PoW and then it was decided to move to PoS. In order to facilitate that transition, a second blockchain had to be created and a plan executed to merge the two once development was complete.
The second blockchain, called the Beacon Chain, went live in December 2020. A new token named ETH2 was named to distinguish it from the original ETH. Holders of ETH could now participate in PoS by locking up their ETH on the Beacon Chain, only to be unlocked once “The Merge” transpired. Participation in staking of ETH on the Beacon Chain started to earn holders rewards in ETH2.
The Merge successfully transpired in September 2022. Though ETH vs ETH2 no longer exists, the taxonomy is still used when distinguishing between the ways that new ETH was earned (through PoW or PoS). The Merge did not include the ability to un-stake ETH. https://ethereum.org/en/upgrades/merge/
The ability to un-stake ETH will be activated with the Shanghai upgrade. Un-staking is also called withdrawing. The Shanghai upgrade is tentatively slated for February/March 2023.
There are a few different ways that ETH holders can stake their ETH, including operating their own node from home and/or holding their ETH on a centralized crypto exchange that offers staking-as-a-service like Coinbase, Binance, and more. https://ethereum.org/en/staking/
Why is the Shanghai upgrade significant for taxes?
Though the tax treatment of ETH2 staking rewards varies from country to country, in the US there is a widely held interpretation amongst tax advisors that ETH2 staking rewards were not taxable in past years (2020, 2021, and 2022) as the taxpayer did not have dominion and control over the income (i.e. ETH2 assets). This was because the taxpayer, whether they operated an at-home node or used a centralized exchange offering staking-as-a-service, did not have the ability to withdraw (un-stake) their ETH or ETH2 staking rewards. With the Shanghai upgrade, taxpayers will obtain dominion and control over their ETH2 and a taxable event will be triggered, regardless if the taxpayer actually unstakes their ETH2 or not.
By way of example, let’s assume US Taxpayer A staked 32 ETH back in December 2020 when ETH prices were around $400 USD, locking up value at that time of about $12,800 USD. Assuming they earned an average of 5% each year, they might have around 35 ETH now (rounding for simplicity) which is 3 total ETH rewards. Assuming no other purchases or sales of crypto, they paid $0 of taxes in 2020, 2021, and 2022 related to this income. If this week (in February 2023) they gained dominion and control thereby triggering the taxable event, they will have taxable income of 3 x ~ $1,700 USD = $5,100 USD. Assuming the taxpayer is in the 24% tax bracket, they need to come up with $1,224 USD to pay the US federal tax bill for 2023 (ignoring state taxes). This tax would be due even if Taxpayer A has not withdrawn (un-staked) their ETH or the ETH2 rewards.
Alternatively, if the price of ETH jumps back up to $4,000 USD just before dominion and control is obtained, Taxpayer A could be looking at 3 x $4,000 USD = $12,000 USD of taxable income and a $2,880 USD US federal tax bill.
Final considerations
For Tax Advisors
Ask your clients if they have been staking ETH prior to 2023 and help them to track down their accrued rewards records to calculate their estimated tax bill.
If you have taken a position for your clients in prior years that their ETH2 rewards were taxable in the years accrued, be aware that the Taxpayer will likely receive a Form 1099-MISC for any staking-as-a-service rewards earned on the major centralized exchanges. These exchanges will not amend/reverse the Form 1099 due to a differing view of the Taxpayer or their tax advisor. Be prepared to pickup the Form 1099 in the tax return and then adjust it back out as a deduction.
The question of “on what date does the Taxpayer have dominion and control with ETH2?” remains unsettled. As such, centralized exchanges may take one view while tax advisors may take different views. For example, is it the date of the Shanghai upgrade going live? Is there a different date for dominion and control when held on a centralized exchange (“CEX”)? On that last point, in my view: likely yes it’s different on a CEX since the Taxpayer is at the mercy of the CEX and not the protocol itself (though the CEX is at the mercy of the protocol). This view is also generally confirmed in US Revenue Ruling 2019-24. As mentioned in the previous bullet, if you take a different position as to the date that the Taxpayer gains dominion and control over their ETH2 then you will need to pickup the Form 1099 as reported by the centralized exchange and then adjust it up or down through a separate line item depending on if the ETH2 price was higher or lower on the date you determine is appropriate.
For Taxpayers
Plan to set aside fiat cash for the tax bill, which might mean withdrawing and selling some ETH immediately to mitigate price fluctuations. In a worst case scenario, if the price of ETH drops far enough then you may have a hard time coming up with the funds to pay the tax bill. This happened to a number of taxpayers that sold ETH in January 2018 at a ~ $1,300 USD price and then went to pay the tax bill in February 2019 when the price of ETH was down to ~ $118 USD. Many of them are still paying off their tax bills today through payment plans.
If you did your own taxes in past years and picked up your ETH2 rewards into income (thereby already paying your taxes) then you should consider talking to a tax advisor well versed in crypto to determine your next steps. If you used a staking-as-a-service provider like a centralized exchange then you will likely receive a Form 1099-MISC for 2023 (in early 2024) reporting these multi-year accrued ETH2 rewards. Ignoring the Form 1099 will result in IRS notices for under reporting your income in 2023.
In general, you cannot strategically plan the taxation event of ETH2. I have seen it incorrectly claimed on the internet that you can plan to slowly withdraw (un-stake) your ETH2 rewards so as to have them be taxable in specific time periods of your choosing. This is not correct for US taxpayers, just like you can’t delay paying taxes on your wages by waiting until January to deposit your paper paycheck. The moment of taxation is when you have dominion and control of your ETH2, regardless of when you make your own personal decision to claim it (un-stake/withdraw).
How can Dune Consultants help?
Contact us today to discuss questions about Form 1099 and 1042-S reporting at info@duneconsultants.com. Or you can jump in the calendar for an introduction call.
