Digital asset upgrade does not result in income realization

A digital asset’s protocol upgrade from a proof-of-work to a proof-of-stake consensus mechanism did not cause a taxpayer to realize gain or loss or have an item of gross income, since there was no “accession to wealth,” the IRS Office of Chief Counsel advised in a Chief Counsel Advice memorandum (CCA).

Under the facts of the CCA, K is a blockchain that uses “distributed ledger technology” to record cryptocurrency transactions using its underlying protocol. The protocol is a set of rules that includes a “consensus mechanism” for adding new blocks of transactions to K, including those involving a cryptocurrency, C. Any participant who adds any new blocks to K receives a block reward in accordance with K’s underlying protocol.

The taxpayer buys 10 units of cryptocurrency C, storing the private keys in an “unhosted wallet,” i.e., not hosted by a third-party financial system (see Financial Crimes Enforcement Network, frequently asked questions on proposed rules (Dec. 18, 2020)). After the taxpayer purchases cryptocurrency C, K changes its consensus mechanism on who may validate transactions and add blocks to its blockchain from proof of work to proof of stake. The major difference between the two is that a proof-of-stake consensus mechanism uses a randomly selected validator to confirm transactions and add blocks, while the proof-of-work consensus mechanism uses a competitive validation methodology (Frankenfield, “What Does Proof-of-Stake (PoS) Mean in Crypto?” Investopedia (updated May 31, 2023)). The change in the consensus mechanism is referred to as a “protocol upgrade,” since K is now requiring that transactions be validated and that blocks added use only a proof-of-stake consensus mechanism. The protocol upgrade does not affect any transactions or blocks prior to the upgrade, and any new blocks added will be subject to the new proof-of- stake consensus mechanism.

Cryptocurrency C remains unchanged after the protocol, with the taxpayer continuing to hold 10 units of cryptocurrency C. The taxpayer does not receive any cash, services, or property (including additional shares of C) due to the protocol upgrade.

Therefore, the question becomes, does the taxpayer need to realize any income due to K’s protocol upgrade?

Sec. 6045(g)(3)(D) (added by the Infrastructure Investment and Jobs Act of 2021, P.L. 117-58) defines “digital assets” as digital representations of value that are “recorded on a cryptographically secured distributed ledger” or similar specified technology. These assets do not exist in physical form and to an extent include “convertible virtual currency and cryptocurrency” (Notice 2014-21; see also Rev. Rul. 2019-24). Notice 2014-21 provides that convertible virtual currency is property subject to the property disposition rules of the Internal Revenue Code.

Cryptocurrency is a type of virtual currency that utilizes cryptography to secure transactions that are recorded on a distributed ledger such as blockchain. Cryptocurrencies are often referred to as “coins” or “tokens.”

Regs. Sec. 1.1001-1(a) provides that gain or loss on property dispositions may be realized, and ultimately recognized, as an income or loss item if the property for which it is exchanged differs materially in kind or extent. Therefore, a realization event occurs only if the property received materially differs from the property transferred (Sec. 1001). Also, for the properties to be materially different under Sec. 1001, “they must embody legally distinct entitlements” (Cottage Savings Association, 499 U.S. 554 (1991)).

Sec. 61(a) provides that gross income includes “all income from whatever source derived” except as otherwise provided, including any gains or losses involving the sale or other disposition of property. This includes all gains or “undeniable accessions to wealth” realized over which a taxpayer has complete dominion (Glenshaw Glass Co., 348 U.S. 426 (1955)). According to Jacobson, 336 U.S. 28 (1949), income should be “described in sweeping terms and should be broadly construed in accordance with an obvious purpose to tax income comprehensively.”

The amount included in gross income is the difference between the consideration (i.e., fair market value) received for the property or services that the taxpayer had complete dominion over, reduced by the amount of consideration, if any, given up.

The realization of gross income can come in a variety of forms, such as cash, property, services, meals, accommodations, and stock (Regs. Sec. 1.61-1(a)).

According to the Chief Counsel’s Office, the protocol upgrade did not alter any past transactions or blocks previously validated and added to K. This included the taxpayer’s 10 units of cryptocurrency C. The protocol upgrade only affected the consensus mechanism by which future transactions are validated and blocks are added. Since cryptocurrency C remained unchanged by the protocol upgrade, the upgrade did not result in a realization event under Sec. 1001, since the taxpayer continued to own the same 10 units after the upgrade as before it.

Even if a realization event did occur, the protocol upgrade did not result in an accession to wealth for the taxpayer. The taxpayer’s 10 units in cryptocurrency C remained unchanged after the upgrade, creating no “separable economic benefits” in the form of “cash, services, or other property (including other cryptocurrencies).” Absent an accession to wealth, the protocol upgrade did not result in an income event for the taxpayer within the meaning of Sec. 61(a).

However, if the taxpayer received rewards in the form of additional units of cryptocurrency C when the consensus mechanism switched to a proof-of-stake validation methodology, then the taxpayer, if on the cash basis of accounting, may have had to include the rewards in gross income if the taxpayer maintained dominion and control over them (Rev. Rul. 2023-14).

That is not the case here, however. No reward or other consideration was received by the taxpayer when the protocol upgrade took effect. The taxpayer’s ownership in cryptocurrency C always remained the same.

■ CCA 202316008

— Matthew Geiszler, Ph.D., is a lecturer in accounting at the Brooks School of Public Policy; John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation in the SC Johnson College of Business; and Austin Arnold, CPA, is a lecturer in taxation and financial literacy in the Cornell Law School, all at Cornell University. To comment on this column, contact Paul Bonner, the JofA’s tax editor.