Analysis: Reading the Tea Leaves - What Enforcement Actions Mean for the U.S. Taxation of Crypto

This article was written by Jason Schwartz. Jason Schwartz is a tax partner and co-head of the Digital Assets and Blockchain Practice at Fried, Frank, Harris, Shriver & Jacobson LLP.

"We need regulatory clarity" is a catchphrase among U.S. crypto policy wonks. Just a dose of sensible rulemaking, they say, could secure the nation’s technological primacy for another decade or two. But U.S. regulators have been pretty clear: crypto should be treated like stock.

Analogizing crypto to stock makes some sense. Both are financial instruments whose value depends on the success of an enterprise—a blockchain in the case of layer-one tokens; a liquidity pool in the case of LP tokens; a DeFi platform in the case of DAO governance tokens.

But taking the analogy too far could yield nonsensical results. Crypto tokens and the rails on which they’re built are software. You can’t coerce software into filing periodic registration statements or other disclosures. Even if you could, it’s often unclear what those registration statements would say. And although a team of developers might have had a heavy hand in the software’s initial development, they often lack the ability to upgrade it, or may leave future decisions to the user community, making them suboptimal compliance deputies.

A bevy of enforcement actions over the last year suggests that U.S. regulators don’t think those distinctions justify the application of a new set of rules to crypto. Instead, the message from regulators seems to be that if those distinctions make a project unworkable, developers should figure out how to eliminate them.

The IRS often defers to other agencies in characterizing assets. This article explores how non-tax regulators’ approach to digital assets might inform the IRS’s own views.

Taxation of Consensus-layer Staking Rewards

Background. The IRS hasn’t issued guidance on the taxation of consensus-layer staking rewards, but has said that mining rewards, including newly minted tokens, are taxed as ordinary income at their fair market value when received, which implies that they are payments for services.

There is little basis to distinguish the taxation of consensus-layer staking rewards from mining rewards, since both are paid by a blockchain protocol to validators. But in Jarrett v. United States, a home staker sued the IRS for a refund of the tax he paid on his newly minted block rewards, arguing that the rewards were self-created property instead of property received for services. If Jarrett is right, validators should receive newly minted block rewards without tax and with a zero basis, and should recognize capital gain (not ordinary income) when they later sell the rewards, unless they hold the rewards as inventory or otherwise in connection with a business.

The IRS initially contested Jarrett’s refund suit, then granted his refund and successfully sued to dismiss the case on mootness grounds. The IRS’s course of action suggests they are still trying to figure out the appropriate treatment of newly minted block rewards and didn’t want a court to figure it out for them.

SEC and LBRY. According to Jarrett’s lawyers, blockchains are open-source software and each new block is the proposing validator’s own creation out of that software. Everyone validating under the same consensus mechanism is, by definition, maintaining the same blockchain, but validators are free to collectively or individually deviate from, or fork, a blockchain’s consensus mechanism, giving rise to a new blockchain. (Whether that new blockchain has any value would depend on whether anyone is interested in submitting information to it.)

Under an alternative view, blockchains are finished products created and deployed by developers and merely maintained by validators. Supporters of the "finished products" view observe that the rules for most blockchains are developed by one or more parties acting in concert, and network effects discourage validators from trying to unilaterally change those rules. They contend that validating transactions is more like maintaining someone else’s machine in exchange for some of its output than like producing something oneself.

The Securities and Exchange Commission’s position in SEC v. LBRY, Inc. was more aligned with the finished products view.

Like many blockchains, LBRY is stewarded by a development company, LBRY, Inc. According to the SEC, LBRY, Inc. sold the blockchain’s native token as an unregistered security because the sales involved an investment of money in a common enterprise with the expectation of profit to be derived from the efforts of others. In other words, the blockchain’s tokens were similar to stock issued by LBRY, Inc. to fund further product development.

The SEC won on summary judgment in November 2022.

Observations. The taxation of newly minted block rewards wasn’t at issue in LBRY, but the SEC (and the court) viewed the LBRY blockchain and its native token as a product of LBRY, Inc.’s efforts. That view seems at odds with Jarrett’s argument that blockchains are, effectively, communal property.

It could be that many blockchains start off as someone else’s product, then progressively decentralize until they are communal property. Consistent with that theory, shortly after the court ruled in LBRY, The Web 3 Foundation self-servingly announced that the native currency of the Polkadot blockchain, which it stewards, had "morphed" from a security into software. But there is no legal precedent under which something that starts out as a security becomes a non-security…or under which payments that start out as compensation become self-created property.

Treating staking rewards as compensation would leave open the question of how foreigners are treated when they delegate staking to a U.S. person. Foreigners who perform services within the United States, including through a U.S. agent, are subject to U.S. income or withholding tax. It’s unclear how to determine where staking services are actually performed, but, at the very least, it would seem prudent for delegated stakers to set up their nodes offshore if they want to serve foreigners.

Taxation of Liquidity Pools

Background. Ethereum’s great technological leap forward from Bitcoin is that it enables smart contracts. Smart contracts are software stored on a blockchain that auto-execute on the occurrence of specified preconditions.

Decentralized finance relies on smart contracts to disintermediate financial transactions. Commonly in DeFi, market participants pool liquidity into a smart contract in exchange for LP tokens. (LP stands for liquidity provider.) The smart contract uses the contributed liquidity to conduct an automated financial business, like market-making or overcollateralized lending, and accrues fees. The LP tokens entitle holders to a share of the business, including fees, which either accrue inside the LP tokens or are streamed to the holders.

As I’ve previously written, U.S. tax law often deems entities to exist, even in the absence of any legal form, and automated liquidity pools look a lot like corporations. Consistent with corporate stock treatment, most tax prep software treats LP tokens as indivisible property that gives rise to gain or loss when sold, instead of trying to look through them and calculate a holder’s tax liability based on the transactions that happen underneath the hood.

But treating liquidity pools exactly like corporations would raise serious practical issues. U.S. corporations, and foreign corporations that are in a U.S. business, have to file U.S. tax returns and pay U.S. corporate tax, and could have U.S. withholding and information reporting obligations. Surely liquidity pools—which are only software, after all—don’t need to file tax returns, pay and withhold taxes, and deliver 1099s to customers. Do they?

OFAC and Tornado Cash. In August 2022, the U.S. Department of the Treasury’s Office of Foreign Assets Control designated privacy-enhancing software protocol Tornado Cash as a specially designated national, which immediately rendered any assets in the protocol untouchable by U.S. people.

Tornado Cash is a set of non-upgradable smart contracts that use cryptography to obfuscate the relationship between a sending and a receiving address. In brief, when a user sends assets to Tornado Cash, they get a mathematical proof establishing their entitlement to those assets. They can then use that mathematical proof to withdraw the same assets from Tornado Cash into another crypto wallet. The greater the volume of transactions that go through Tornado Cash between deposit and withdrawal, the more difficult it would be for a blockchain sleuth to associate a withdrawn amount with a deposited amount.

OFAC derives its putative authority to sanction Tornado Cash from International Emergency Economic Powers Act and Executive Order 13694, which generally authorize it to illegalize the use of any property in which a foreign person has an interest if that person poses a threat to national security. The executive order defines persons as individuals, partnerships, associations, trusts, joint ventures, corporations, groups, subgroups, or other organizations.

Observations. The tax treatment of liquidity pools isn’t within OFAC’s purview, but OFAC and the IRS both sit within the U.S. Treasury Department. If the IRS, like OFAC, views liquidity pools as persons, it could impose tax payment and reporting obligations that they weren’t programmed to comply with.

We might get our first opportunity to glimpse the IRS’s approach to automated liquidity pools when it proposes regulations on the reporting requirements applicable to crypto brokers. Congress defined crypto brokers broadly to include "any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person." The tax code defines person similarly to EO 13694. If automated liquidity pools are persons, the proposed regulations could require DeFi protocols to deliver 1099s to users. Obviously, that requirement would be inconsistent with how DeFi works, and it’s unclear how the IRS would enforce it.

The proposed regulations are currently sitting at the Office of Information and Regulatory Affairs, which reviews regulations before they are unveiled to the public. Stay tuned.

Taxation of Protocol DAO Tokenholders

Background. Even when a significant amount of their smart contract logic is non-upgradeable by design, most DeFi protocols vest some control in holders of governance tokens, collectively called a decentralized autonomous organization. The DAO’s powers might include setting the protocol’s fees, overcollateralization requirements, and liquidation thresholds, approving new tokens or products, and allocating funds for research and development.

As I’ve previously written, protocol DAO governance tokens, like LP tokens, look a lot like corporate stock under U.S. tax principles. And like liquidity pools, most protocol DAOs don’t pay any taxes or do any tax reporting. If a protocol DAO were deemed to be a U.S. corporation, a partnership, or a foreign corporation that is in a U.S. business, it could have tax payment, filing, and information reporting obligations. At first blush, it might seem that DAOs can avoid liability for failing to comply with those obligations by remaining unwrapped so that there is no entity for the IRS to go after. But the Commodity Futures Trading Commission’s position in CFTC v. Ooki DAO casts doubt on that theory.

CFTC and Ooki DAO. In September 2022, the CFTC filed a civil enforcement action in the U.S. District Court for the Northern District of California charging Ooki DAO for, among other things, illegally offering leveraged and margined retail commodity transactions in digital assets in violation of the Commodity Exchange Act. Ooki DAO stewards a DeFi platform that uses smart contracts to enable noncustodial trading, lending, and exposure to leveraged positions.

The CFTC’s complaint asserts that Ooki DAO is an unincorporated association comprised of holders who have voted their tokens to govern the protocol. As a result, according to the complaint, each person who voted their tokens is jointly and severally liable under common law for the DAO’s debts.

Observations. The CFTC’s position in Ooki raises the possibility that, even if a DAO is a corporation for U.S. tax purposes (which presumes an opaque identity), the government could impose liability on its voting members under common law.

Because it’s built on open-source technology and lives on the internet, the crypto ecosystem is highly participatory. Developers, users, and trolls (often the same people at different times of day) pile into Discord servers and other chat applications to share ideas, debate, and out-meme each other. Voting is common but not necessarily legally binding; because most votes aren’t self-executing, one or more delegates typically need to be appointed to carry out a community’s wishes. Sometimes there is a mechanism for the community to remove and replace those delegates, but sometimes not.

Given the haphazard nature of protocol governance, it’s unfortunate that the CFTC’s Ooki complaint offers no clear roadmap for determining when a group of people comprise an unincorporated association. Are ETH holders who participate in the Ethereum Foundation’s weekly all core devs calls members of an unincorporated association? What about a subset of protocol builders—a so-called sub-DAO or pod—who agree to brainstorm around a particular idea and report their conclusions to a larger group? Absent further guidance, it would be reasonable to assume that any participation in a protocol DAO’s governance could make you liable for its taxes.

Wrapping a DAO in a legal entity might mitigate the risk that holders of its governance tokens are liable for its taxes, but could also increase the risk that the DAO is subject to tax in the first place, and obviously adds legal compliance costs.

Parting Thoughts

There’s no sugarcoating it: the current non-tax U.S. regulatory landscape is bleak for crypto. And because the IRS tends to defer to other agencies in characterizing assets, future U.S. tax guidance might further test the nerves of digital assets evangelists.

To be fair to the IRS (and the SEC, OFAC, and CFTC), it’s Congress’s job to pass laws that address new technologies, and it’s regulators’ job to interpret those laws. But it’s hard to imagine our current Congress unifying to support any industry, let alone one whose promise still requires significant technological prowess and imagination to grok.

That leaves only one reliable avenue for U.S. crypto developers: keep building, until crypto’s use cases become so obvious that even a divided legislature won’t have a choice but to act.

In the meantime, maybe keep a low profile.

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