Frozen digital asset rewards constitute gross income

According to the IRS Chief Counsel’s office, regardless of subsequent events such as the freezing of a cash-basis taxpayer’s account, staking and other digital asset rewards that a taxpayer has dominion and control over are included in gross income in the year of receipt.

Facts: The taxpayer discussed in a Chief Counsel Advice memorandum (CCA) is an individual who uses the cash method of accounting to compute taxable income. In year 1, the taxpayer had an investment account at Platform X that contained digital assets, including cryptocurrency. Platform X uses a proof-of-stake consensus mechanism to update the blockchain. A proof-of-stake consensus mechanism allows individuals who hold cryptocurrency to participate in the validation process by staking their holdings themselves or indirectly through a digital asset platform, referred to as a cryptocurrency exchange (Rev. Rul. 2023-14). The user agreement between Platform X and the taxpayer specified that rewards, including those from staking, were periodically distributed to the taxpayer’s account, following any applicable lockup or waiting period. Once the rewards were credited to the taxpayer’s account, the user agreement specified that the rewards were the taxpayer’s property and that the taxpayer was free to sell, exchange, or transfer them.

During year 1, the taxpayer’s account was credited and received cryptocurrency as rewards from staking and other activities. Later that year, Platform X filed a Chapter 11 bankruptcy petition and froze customers’ accounts through the end of the calendar year. Due to the account being frozen, the taxpayer was unable to sell, exchange, or transfer any assets in the account, including credited rewards, from the date the account was frozen through the end of year 1.

Discussion: The CCA explains that Sec. 61(a) provides that gross income means all income from whatever source derived. Glenshaw Glass Co., 348 U.S. 426 (1955), clarifies the meaning of “income” as “instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Regs. Sec. 1.61-1(a) specifies that “gross income includes income realized in any form, whether in money, property, or services.” In the case of the receipt of property, the fair market value (FMV) of the property received will constitute gross income at the date and time it is reduced to undisputed possession (Koons, 315 F.2d 542 (9th Cir. 1963); Rooney, 88 T.C. 523 (1987); Regs. Sec. 1.61-2(d)(1)).

Sec. 451(a) provides that the amount of any item of income is included in taxpayers’ gross income for the tax year in which they receive it unless, under the method of accounting used in computing taxable income, the amount is to be “properly accounted for as of a different period.” Therefore, cash-method taxpayers must include any items of income in the tax year in which those items are actually or constructively received (Regs. Sec. 1.451-1(a)). Regs. Sec. 1.451-2(a) further clarifies that income, “although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.”

Applying these general concepts to digital assets, Rev. Rul. 2023-14 provides that if a cash-method taxpayer stakes cryptocurrency native to a proof-of-stake blockchain or through a cryptocurrency exchange and receives additional units of cryptocurrency as rewards when validation occurs, the FMV of the validation rewards received is included in the taxpayer’s gross income in the tax year in which the taxpayer gains dominion and control over the validation rewards.

Conclusion: The Chief Counsel’s office advised that the facts in the taxpayer’s case established that the taxpayer had dominion and control over the rewards in year 1. Thus, the validation awards were includible in the taxpayer’s gross income in year 1, even though the taxpayer’s account was subsequently frozen.

The Chief Counsel’s office noted, however, that any rewards that accrued but were not credited to the taxpayer’s account before the account was frozen would not be includible in income in year 1 because the taxpayer could not sell, exchange, or transfer those rewards prior to the account’s being frozen. In this instance, the rewards would not be actually or constructively received, and the taxpayer would not have dominion and control over them in year 1.

The CCA also addressed the effect of Sec. 451(i)(4), which defines a “frozen deposit” for purposes of interest credited by a qualified financial institution and might be thought to provide relief from having to include a frozen deposit in income. The CCA states, however, “Although this memorandum refers to frozen accounts and assets, [Sec.] 451(i) is not applicable because Platform X does not provide interest on deposits and is not a qualified financial institution as defined by [Secs.] 451(i)(5) and 165(l).”

CCA 202444009

— Matthew Geiszler, Ph.D., is a lecturer in accounting in the Brooks School of Public Policy, and 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, both at Cornell University. To comment on this column, contact Paul Bonner, the JofA’s tax editor.