Here’s the latest article by Adam Bergman from Forbes.com –
Cryptocurrency mining is the process by which transactions are verified and added to the block chain. Anyone with access to the internet and suitable hardware can participate in mining. In general, the most common way to mine cryptocurrencies is called Proof of Work (“PoW”). In the PoW system, the process involves compiling recent transactions into blocks and trying to solve a computationally difficult mathematical solution. The miner who solves the mathematical solution gets to place the next block on the blockchain and claim the rewards, which are typically newly released crypto coins.
Recently, a new cryptocurrency validation process has emerged called Proof of Stake (“PoS”). PoS is increasing in popularity and being adopted by several cryptocurrencies. There is still a question whether PoS shall be classified as mining or something else, since there are no block rewards.
In the PoS system, each validator owns some stake in the network. Unlike the Proof of Work system, in which the user validates transactions and creates new blocks by performing a certain amount of computational work, a Proof of Stake system requires the user to show ownership of a certain number of cryptocurrency units. The creator of a new block is chosen in a pseudo-random way, depending on the user’s wealth, also defined as “stake”. In the Proof of Stake system, blocks are said to be “forged” or “minted”, not mined. Users who validate transactions and create new blocks in this system are referred to as forgers.
In essence, the idea behind PoS is that the more coins a miner possesses, the higher chances he or she has to find blocks on the blockchain. Whereas, in a PoW system, you know a chain is valid because lots of work is behind it, while in the PoS system you trust the chain with the highest collateral. In other words, the PoS system works much like an escrow account. If one validates a fraudulent transaction, he would lose his holdings, as well as his rights to participate as a forger in the future. Once the forger puts their stake up, he can partake in the forging process, and because he has staked his own money, he is, in principle, now incentivized to validate the right transactions. In the PoS system there is no block reward, so, the miners take the transaction fees. Unlike the PoW system, where anyone can be a miner, with the PoS system, forgers are always those who own the coins minted.
The PoS system is gaining popularity because it does not require high energy costs and costly hardware to collaborate to the network; consensus can be reached based solely on the amount of coins each forger has.
When it comes to the taxation of cryptocurrency mining using the PoW system, IRS Notice 2014-21 is pretty clear. The Notice holds that when a taxpayer successfully“mines”virtual currency, the fair market value of the virtual currency, as of the date of receipt, is includible in gross income. In addition, the Notice holds that if a taxpayer’s “mining”of virtual currency constitutes a trade or business, and the “mining” activity is not undertaken by the taxpayer as an employee, the net earnings from self-employment (generally, gross income derived from carrying on a trade or business less allowable deductions) resulting from those activities constitute self-employment income and are subject to the self-employment tax.
Therefore, it is clear that the IRS will treat PoW mining activities as ordinary income and not the more favorable capital gains tax treatment. But what about transaction fees generated by the PoS system?
The question comes down to whether the IRS will treat the PoS system as mining activities or something else. Some cryptocurrency experts label the PoS system as a validation system that generates transaction fees simply by holding a cryptocurrency, much like a stock dividend, while others consider it as a quasi-mining activity. For example, the DASH cryptocurrency allows its holders to earn dividends in the form of DASH by running a master node, assuming one has a minimum of 1000 Dash units. Whereas, the cryptocurrency NEO essentially offers its holders Gas tokens which comes into being initially as a dividend (provided they are held in private wallets and not on a public exchange).
Unfortunately, there is no direct IRS guidance on whether transaction fees or tokens generated in a PoS system will be treated as ordinary income, such as mining activities. However, the consensus seems to consider the “forging” activities of the PoS system to have the same core validation role as miners in the PoW system, although, the PoS system does not have a block reward.
Accordingly, it appears that many PoS forgers are treating the transaction fees and tokens received by way of forging as ordinary income, like mining activities under the PoW system.
The PoS system is relatively new, but catching on fast. There is even talk that Ethereum, the second largest cryptocurrency based on market capitalization, will be moving from PoW to PoS.
Cryptocurrency investments are uncertain and highly volatile. Any investor interested in mining cryptocurrencies should do their diligence and proceed with caution.