Legislative corridors in the United States are fueled with ambition and hopes to deliver a well-rounded framework for digital asset taxation. However, the path to unified and comprehensive legislation is laden with details and controversies. In July 2023, the Joint Committee on Taxation requested comments from interested parties on how current laws and regulations might be applied to digital assets. Various stakeholders from legal, economic, and technological domains are facing a pivotal moment as their insights and positioning will be put to the test.
In this post, we aim to provide some common-sense recommendations about what is possible. We focus on the practical intersections of policy, technology, and economics to present a refined blueprint for clear and equitable taxation. Issues around the taxation of digital assets have been around since the earliest days of cryptocurrency. The Internal Revenue Service (IRS) issued its first set of guidance in 2014 in response to growing questions about the taxation of cryptocurrency and has continued to issue guidance, most recently in 2023. Congress has also taken an interest in the space, with the Lummis-Gillibrand Responsible Financial Innovation Act, S. 2281, 118th Cong. (2023) proposed bill to regulate cryptocurrency having been introduced recently, although Congress has not yet been able to pass a comprehensive cryptocurrency bill.
While policymakers are taking action, it’s also no secret that the digital asset industry strongly advocates for a regulatory landscape that aligns with their interests. A testament to this is the failed cryptocurrency exchange FTX, which, prior to its downfall in 2022, briefly became one of the largest political donors in the United States. While industries inevitably harbor their self-interests, the onus is on Congress to sculpt regulations that transcend special interests and instead apply a consistent set of rules to digital assets that align with other financial products of an analogous nature.
Our recent comment letter submitted to the Joint Committee on Taxation accentuates the desirability of ingraining a uniform set of rules applicable to digital assets. We underscore the importance of prioritizing the intrinsic economic dimensions and the nature of transactions as the fulcrum for rule application and digital asset valuation. In our view, any prospective regulations should (1) harmonize the treatment of digital assets with conventional financial assets sharing synonymous attributes, (2) distinguish classes of digital assets, prescribing differentiated treatment based on their inherent economic structures, (3) mitigate the propensities for transactional configurations motivated by tax incentives, and (4) empower the IRS with the agility to adapt and regulate emergent classes of digital assets.
We begin by noting (and we agree with the digital asset industry) that there are inherent challenges in the taxation of digital assets. For example, the question of how traders, governments, businesses, charitable organizations, and others determine the value of a digital asset is central to many of the Internal Revenue Code (IRC) sections being examined. This seems like an easy question, as the value of digital assets such as Bitcoin or Ether is readily available and identifiable. Both are actively traded on dozens of centralized and decentralized exchanges and directly on the blockchain. However, focusing on the largest, most liquid, and highly traded digital assets masks the complexity of regulating the entire digital asset space. Digital assets encompass liquid, fungible digital assets and illiquid or non-fungible assets (Cong and Xiao 2021). A digital asset can represent anything from an entry on a ledger, a contract, a claim on another asset, art, or a seemingly endless array of assets, entities, and agreements. The laws governing digital assets must not treat digital assets as a single class of assets but account for the underlying characteristics of each individual digital asset (Grennan 2024).
Another concern is that digital assets have unique features that do not exist in traditional financial markets. These features represent challenges in fitting digital assets into traditional financial markets and tax rules. In traditional markets, it is nearly impossible for an individual to create a new publicly traded security. But in the digital asset space, a user can create and trade a new digital asset publicly within days or even hours. Additionally, the attributes of these newly created digital assets can be tailored to specific uses. This ability to create new tokens offers traders significant opportunities to structure transactions so they receive tax-favorable treatment without meaningful changes in the underlying economics. For instance, there are numerous provisions in the Code that prevent changes in tax consequences without a significant change in the underlying economics, such as IRC §§751, 1091, 7701(o).
We firmly reject that these challenges are so great as to make digital assets untaxable in the current system. In fact, we note that the wash sale rule, which disallows claiming losses on securities sold at a loss and repurchased within 30 days before or after the sale, creates significant complexity in the taxation of traditional stocks. The wash sale rule is designed to prevent taxpayers from artificially realizing losses to offset taxable gains while maintaining their investment position. For example, if an investor buys 100 shares of Coinbase’s stock for $150 per share and later sells those shares for $140, realizing a $1,000 loss, they cannot claim that loss if they repurchase Coinbase’s stock again within 30 days of the sale. Many individuals are unaware of the full complexity and scope of the wash sale rules.
The broad reach of the wash sale rule has created a system where the IRS generally expects taxpayers to engage in reasonable practices while not pursuing enforcement actions against issues that may technically be violations but are not willful and have an unreasonably high cost of compliance. For traditional securities, brokerage firms handle much of the complexity in tracking and reporting wash sales. We believe that just as the traditional financial system has overcome complex reporting requirements, the digital asset industry also would have little issue dealing with complex reporting requirements. As the digital asset space matures, crypto exchanges and trading platforms will likely develop systems to track and report wash sales, easing the burden on individual taxpayers.
The ability to structure transactions is a key feature of and challenge to regulating digital assets. We argue that the taxation of digital assets should conform not only to the taxation of current financial assets but also be internally and logically consistent, allowing digital asset users to predict the tax treatment of digital asset transactions. This would give the digital asset space much-needed certainty, allowing for greater investment in new technology. One of our key concerns in the digital asset space is the taxation of validation rewards. This area highlights the differences between a measured approach to integrating digital assets into the financial and tax system and the preferred digital asset industry position of minimization of regulation and taxes.
In our comment letter, we highlight the taxation of validation rewards (specifically, staking rewards) as an area where the interests of the digital asset industry and efficient tax administration may clash. Under the most basic tenets of income tax policy, validation rewards should be taxed when the rewards come under the validators’ dominion and control. This policy is not only in line with basic income tax concepts but also the view of the IRS, multiple scholars (see, e.g., Omri Marian, Henry Ordower, and Amanda Parsons), professional organizations, and policy experts. The most basic concept underlying income tax policy is that taxpayers pay tax based on their “ability to pay.” When validators receive a validation award, they are better off financially, so their ability to pay increases. All else being equal, if taxpayer A receives $1,000 worth of validation rewards and taxpayer B receives $1,000 worth of Apple Inc. stock, they should both be subjected to the same tax burden on the $1,000 they received. The form of their earnings should not matter, as they are both equally well off. Treating validation rewards differently will permit such rewards a preferential treatment over all other forms of earnings.
Commenters writing comment letters for the digital asset industry have offered several contradictory arguments for the deferral of taxation on staking rewards. For example, one argument for the deferral is the “inflation” argument. Under this argument, validation rewards should not be taxed because the process used to create rewards is intrinsically inflationary. It adds new tokens to the ecosystem, which deflates the value of all other token holders. The value of tokens cannot be determined until they are sold, and they should not be taxed until they are sold. However, a separate argument for the deferral is the “capital shift” argument. Under the capital shift theory, there can be no taxation since there is no one who is paying a validation reward, and no one has a matching expense for the validation reward (because new tokens are created, not transferred from others). In our letter, we discuss why each of these arguments does not stand up to scrutiny by themselves. However, even if each argument could stand up by themselves, they are contradictory. If the value of validation rewards is uncertain because the process is inflationary, then we know exactly where the value of the validator’s rewards comes from. It would be an economic loss for the non-validating digital asset holders who suffer inflation costs but do not receive the validation rewards. Thus, if the inflation argument is correct, the capital shift argument must be wrong.
Finally, while various sections of the tax code are viewed as distinct, each section relating to a separate and specific transactions, we note that if Congress were to accede to all of the digital asset industry demands, some digital assets may never be taxed, even while granting significant benefits to their owners. We walk through how various parts of the Internal Revenue Code interact and could create situations where significant amounts of value generated by digital assets remain untaxed. We begin with a taxpayer who engages in staking for Ethereum, one of the most popular and liquid digital assets. Continuing with the scenario, the taxpayer purchases 1,000 ETH for $2,000 each to stake the ETH. The taxpayer ultimately receives 100 ETH tokens as validation rewards, which would not be taxed under the digital asset industry position until sale. At $2,000 per ETH, this represents $200,000 of value, a 10% return on the original investment.
Digital asset proponents argue for applying the $200 per transaction de minimis safe harbor rule (IRC Section 988(e)). This rule, which currently applies to foreign currency exchange transactions, would exempt the gain from digital assets from tax if each transaction is under $200. Our example taxpayer buys $10,000 on groceries, coffee, and other services in transactions, which are structured to each fall under the $200 threshold. Under the digital asset industry’s preferred application of tax law, they would pay no tax on these conversions of ETH to goods and services.
Next, our sample taxpayer would like to make a large purchase. Since the threshold for IRC section 988(e) is relatively low, they must use a different rule. Under the industry-preferred reading of IRC section 1259, taking out a loan secured by digital assets would not be considered a constructive sale and would not create any taxable income or gain. This allows our taxpayer to take out a $50,000 loan against his ETH balance, use the cash for a large purchase such as a car or downpayment on a house, and not pay any tax. They would have to continue to pay some nominal interest rate, but this would be less than the tax, and the loan could stay outstanding indefinitely.
The taxpayer may then want to make a charitable donation of ETH. Under IRC section 171(f), the taxpayer can donate to a donor-advised fund (DAF). Although this donation does create taxable income, it also creates a tax deduction. Our taxpayer will recognize $50,000 of taxable long-term capital gain (taxed at 15% preferential rates, $7,500 of additional tax) but will simultaneously receive a charitable contribution deduction of the FMV of the digital assets. Assuming a 25% tax rate on ordinary income, the net effect on the taxpayer will actually result in the taxpayer saving $5,000 in taxes ($7,500 in additional capital gains tax plus $12,500 in tax savings by offsetting ordinary income with the charitable contribution deduction).
A donation to a DAF is also special in that the donor retains some control over the donated assets and can direct them to be invested before going to an actual charity (Grennan 2022). This means that the taxpayer can use the donated ETH to invest in other digital asset projects that they or their friends may have a financial interest in, using the donor-advised fund as a form of venture capital. If these investments are risky, actual charities may end up receiving nothing if the value of the investments drops to 0. They may also choose for the DAF to hold the digital assets rather than sell them so that the market price of the digital assets is not reduced by selling pressure from large donations.
Given the high volatility of digital assets, the market value of ETH may decrease. If the market value of ETH temporarily decreases due to a flash crash or other shock, the taxpayer may be able to sell their original ETH (the 1,000 ETH that were purchased for $2m) and immediately buy back the ETH. These transactions may be only seconds apart. If the value of ETH drops 10%, and the IRC section 1091 wash sale rules do not apply, then the taxpayer would recognize a $200,000 capital loss, deductible against other capital gain income on their tax return – saving potentially $30,000 in taxes even while the taxpayer holds the exact same amount of ETH.
Finally, our taxpayer dies and bequeaths his digital assets to his heirs. His heirs get a step-up in basis to the FMV of the digital assets but pay no tax on the inheritance as long as the total value remains under $12.9 million ($25.8 million for married taxpayers). Even though, in our example, the price of ETH stayed the same, this step-up results in the elimination of $200,000 of capital gain income on the originally purchased 1,000 ETH and the elimination of $140,000 of staking income that was not yet taxed. The heirs can then sell the digital assets for cash while recognizing no gain. They will have to repay the loan that was taken out, but ultimately, they end up with a significant increase in wealth. If the taxpayer were taxed, as we propose, the taxpayer would have paid $37,500 in tax after accounting for the charitable contributions. Instead, if the digital assets are taxed as the digital asset industry proposes, the taxpayer would benefit from $35,000 in tax savings, even while receiving a $90,000 increase in wealth and $60,000 of purchases.
Our comment letter presents common sense suggestions for the taxation of digital assets. We strongly believe that the regulation of digital assets should be examined as a whole, not as individual separate items. Any policy changes should be consistent with current taxation principles and coherent across various topics. As we note, some arguments for certain tax treatments of digital assets are contradictory and selectively applied only when they are beneficial. When implementing changes to the taxation of digital assets, the interconnectedness of rules and provisions in the code should be considered. We hope that Congress will create rules that acknowledge the diversity in digital assets but do not encourage the creation of new digital assets to circumvent rules or avoid tax.
Jillian Grennan is an Associate Professor at the Haas School of Business of the University of California, Berkeley.
Omri Marian is a Professor of Law at the University of California, Irvine School of Law.
Tyler Menzer is a Ph.D. student in Accounting at the University of Iowa, Tippie College of Business, and will be starting as an Assistant Professor of Accounting at Texas Christian University in Fall.
Matthew E. Foreman is a Partner at Falcon, Rappaport, and Berman.
This post was adapted from their comment letter in response to the Wyden, Crapo Solicitation for Policy Input on Taxation of Digital Assets.
Figure 1. The Road to Tax-Free Digital Assets
