Analysis: The Latest DeFi Alpha Is Tax-Optimized Staking

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

Staking is a core DeFi activity, but there is no formal guidance on how staking rewards are taxed in the United States. Because tax can turn a good investment into a bad one, it pays to think about how to report staking transactions and whether they are all taxed alike.

In short, unless you are sitting on a pile of highly appreciated crypto, swapping into a token that represents a proportionate share of a changing pool of assets (e.g. wstETH or cTokens) is likely to be more tax-efficient than receiving streaming rewards (e.g. stETH or aTokens).

Definitions

Staking involves depositing your tokens into a smart contract in exchange for yield. Broadly, staking comes in two flavors: liquid and illiquid.

1. Liquid staking: Yield accrues inside a new ’liquid staking token’ that the smart contract issues to the depositor.

Examples:

• You deposit ETH into consensus-layer staking protocol Rocket Pool or Lido in exchange for rETH or wstETH. The rETH or wstETH entitles you to a proportionate share of the aggregate ETH deposited, plus rewards earned by the protocol through consensus-layer staking, minus socialized node operator fees and slashing penalties.

• You deposit DAI into lending protocol Compound in exchange for cDAI. The cDAI entitles you to a proportionate share of the aggregate DAI deposited, plus stability fees paid by borrowers.

• You deposit ETH and USDC into automated market maker Uniswap in exchange for LP tokens. Each LP token entitles you to a proportionate share of the aggregate ETH and USDC pooled in the price range within which you are providing liquidity, plus fees charged to traders.

2. Illiquid staking: Yield is credited periodically to your wallet or an online portal.

Examples:

• You run a consensus-layer validation node and deposit ETH into the Ethereum protocol in exchange for streamed validator rewards.

• You deposit SNX into Synthetix in exchange for streamed inflationary SNX rewards.

• You deposit LP tokens into a Curve gauge in exchange for streamed inflationary CRV rewards.

Under a variant of illiquid staking, the smart contract instantiates your deposit in the form of a ‘bailment token’. The bailment token differs from a liquid staking token in that it represents a one-to-one claim to the deposited token, not a claim to a proportionate share of a changing pool. The bailment token is transferable, arguably making ‘illiquid staking’ a misnomer, but I’m a tax lawyer, not a marketer.

Examples:

• You deposit DAI into Aave in exchange for aDAI, which represents the DAI you deposited and entitles you to streaming rewards equal to your share of stability fees.

• You deposit ETH into Lido in exchange for stETH, which represents the ETH you deposited and entitles you to streaming rewards equal to your share of consensus-layer staking rewards.

Analysis

In the absence of guidance, U.S. tax lawyers typically determine how a new type of product is treated by analogizing it to another type of product for which guidance exists.

1. Liquid Staking

Because liquid staking tokens represent interests in a joint venture for profit (albeit an automated one), their most straightforward comparison would be to equity in an entity. By default, entities that are not organized in the United States are treated as foreign, and foreign entities are treated as partnerships unless: (1) all members have limited liability under a statute; or (2) the equity is readily tradable and less than 90% of the entity’s income is ‘passive’.

Liquid stakers don’t have limited liability under a statute. However, most liquid staking tokens are readily tradable, and income earned by the protocols typically doesn’t fit the statutory definition of passive income. Accordingly, liquid staking tokens are probably best treated as equity in a foreign corporation.

Foreign corporations are subject to U.S. corporate tax only if they are ‘engaged in a U.S. trade or business’. One way for developers to mitigate the risk of the IRS asserting that a smart contract protocol is engaged in a U.S. trade or business is to ensure that the ultimate decision to deploy the smart contract is made and executed outside of the United States.

U.S. taxpayers can be subject to onerous consequences for investing in foreign corporations that are ‘passive foreign investment companies’, or PFICs. But the businesses of virtually all smart contract protocols — e.g. consensus-layer staking in the case of Rocket Pool or Lido, or active financial activities in the case of Compound or Uniswap — seem to keep them out of PFIC status.

The tax consequences of swapping ETH for foreign corporate stock in a non-PFIC that doesn’t pay dividends are that you have capital gain or loss on entry and exit, but do not have income inclusions during your holding period.

The IRS’s paltry crypto guidance to date supports the above analysis. Under that guidance, crypto is property for U.S. tax purposes. Property includes stock. As a general rule, an exchange of property for materially different property triggers capital gain or loss.

2. Illiquid Staking

The most straightforward real-world analog for illiquid staking is a pledge of fungible property as collateral.

Normally, pledging fungible property as collateral is not taxable to the pledgor if they can reacquire identical property within a reasonable time after demand. That rule is codified for securities, and it seems sensible to apply it to other fungible property like crypto. An exchange of property for identical property generally is not taxable, even if the exchange is deferred.

Significant staking lockups could put pressure on the analysis. Proposed regulations for securities loans would require reacquisition within 5 days after demand. On the other hand, it is hard to see a better comparison, and treating illiquid staking as a taxable event would require staking rewards to be treated as part basis recapture, part gain, which would be very difficult to administer.

The issuance of a bailment token in connection with an illiquid staking transaction shouldn’t change the tax treatment. A bailment token simply makes the staker’s position more readily assignable, but doesn’t otherwise change the transaction economics.

Assuming illiquid staking does not trigger gain or loss, stakers likely are taxed at ordinary rates on the fair market value of their staking rewards, determined at the time of receipt. That’s how income from securities loans is taxed as well.

The IRS’s crypto guidance supports the above analysis. Under that guidance, crypto miners, who are analogous to illiquid stakers, must include their mining rewards in income as they receive them. At least one taxpayer, in Jarrett v. United States, has argued that consensus-layer inflationary staking rewards should instead be treated like crops or other self-created property and taxed only on sale. Although the IRS issued a refund to Jarrett, the IRS didn’t concede its position. More recently, the New York State Bar Association’s Tax Section issued a report supporting current taxation of staking rewards at ordinary rates.

3. Delegated Staking

The above analysis makes sense for decentralized protocols, but might not apply equally to staking services offered by centralized exchanges or other custodians.

U.S. crypto custodians appear to treat their illiquid staking arrangements as custodial relationships, not pledges. That treatment is sensible by analogy to TradFi custodial transactions. Taxpayers who custody stock with a broker generally are treated as owning that stock, not as pledging it to the broker, even if the broker commingles stock of multiple clients. Similarly, investors in American depository receipts, or ADRs, are treated as owning the shares referenced by those ADRs, not as pledging them to the issuing bank.

While I’m not aware of crypto custodians issuing liquid staking tokens, it seems reasonable to expect custodians not to treat a client’s conversion of an illiquid staking position into a liquid staking token as a taxable event, because the conversion would be merely a formalistic change. In that case, the custodian would continue to report staking rewards as ordinary income to the client on an IRS Form 1099. However, the client’s treatment on withdrawing those liquid staking tokens into self-custody and swapping out of them would raise a number of tax characterization and information reporting questions for the buyer. We’ll cross that tax quagmire when we come to it.

Parting Thoughts

It’s hard to apply our current tax rules, which assume the existence of financial intermediaries, to a decentralized world. Finding a sensible and consistent reporting position for even basic DeFi transactions like staking often requires developers and investors to make an unacceptable choice: divert resources to expensive tax lawyers or close their eyes and hope for the best. Pension plans and other institutions that require a high degree of certainty on tax treatment are often sidelined entirely, further limiting capital inflows to innovators.

Crypto isn’t going anywhere. Modern finance needs a modern tax system, and policymakers should start thinking creatively about what that might look like. One straightforward option might be to let all U.S. taxpayers ‘mark to market’ their crypto holdings and pay tax only on appreciation measured at the end of the year (and receive a deduction for economic losses). A mark to market election currently exists for professional securities and commodities traders, but not for investors, and the threshold for trader status is high. Failure to adopt common-sense rules that give crypto natives greater tax clarity could put the financial and technological primacy of the United States at risk.