Digital Asset Platforms' Reward Freezing Discourse Outlined in Senior Legal Advisor's Guidance
Digital Asset Platforms' Reward Freezing Discourse Outlined in Senior Legal Advisor's Guidance
The Internal Revenue Service (IRS) has produced an Office of Chief Counsel Advice memorandum pertaining to the inclusion of digital asset rewards in taxable income, specifically when these rewards are frozen in a digital asset account later on. The crux of the situation revolves around the year of taxation for such rewards when the account is eventually frozen.
The particulars of the case are described in the memorandum. The taxpayer received rewards, primarily from staking activities, which were then deposited into their account at a Digital Asset Platform (the "Platform"). For clarity, when it comes to staking, one typically earns rewards (often in the form of additional digital currency) by allowing the blockchain to use their digital asset. This resembles depositing and locking funds in a bank account, with the bank then paying interest in return.
The IRS points out that under the agreement, the rewards were consistently deposited into the taxpayer's account (following any applicable lockup or waiting period). Once credited, the taxpayer was able to sell, exchange, or transfer the rewards. The agreement also specified that once the rewards were deposited, they belonged to the taxpayer.
In the same year the staking rewards were deposited, the Platform froze the account and filed for bankruptcy (Chapter 11). Consequently, the taxpayer was unable to sell, exchange, or transfer any digital assets in their account, including the staking rewards, from the date the account was frozen until the end of the year (December 31).
The problem at hand, then, was determining the proper year of inclusion for the staking rewards, given that the account was frozen.
In aid of its analysis, the IRS began by providing an explanation of digital assets, including the definition of a digital asset under § 6045(g)(3)(D). It also noted that, in accordance with prior administrative materials, convertible virtual currency is treated as property, and the relevant property tax principles are applied to such currencies (see IRS Notice 2014-21).
Under § 61(a), gross income comprises all income derived from any source. The Supreme Court has explained that items of income are "undoubtedly accessions to wealth, unquestionably realized, and over which the taxpayer has complete dominion." (Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955)). The memorandum elaborates that "the receipt of property constitutes gross income in the amount of its fair market value at the date and time at which it is reduced to undisputed possession."
In addressing the issue of staking prior to, the IRS has opined that "the fair market value of the validation rewards received is included in the taxpayer’s gross income in the taxable year in which the taxpayer gains dominion and control over the validation rewards." (Rev. Rul. 2023-14)
The subsequent issue, then, presented in this memorandum is the potential impact of the account freeze on income inclusion.
Under § 451(a), a cash-method taxpayer includes an item of income for the taxable year it is actually or constructively received. Constructive receipt occurs when an item 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." (Treas. Reg. § 1.451-2(a))
In this case, the IRS concluded that the taxpayer was in actual receipt of digital currency representing rewards when the digital currency was credited to the account. As a result, the memorandum concludes that the proper year of inclusion is the year of receipt, "notwithstanding subsequent events such as the account being frozen." Consequently, the rewards (including the staking rewards) must be included in gross income according to their fair market value at the date and time the rewards were credited to the taxpayer's account, even when the account was frozen as of the close of the year.
It is noteworthy that, if rewards were accrued but not yet credited before the account was frozen, then those rewards would not be considered taxable income. This is because the taxpayer would not have had sufficient dominion and control over the rewards (i.e., they could not have sold or transferred the rewards before the account freeze).
The memorandum is labeled as Chief Counsel Advice (CCA) 202444009 (released Nov. 1, 2024). You can access it here.
It is crucial to bear in mind that Chief Counsel Advice memoranda cannot be used or cited as precedent. The information provided in this summary and some constituents — such as facts, issues, citations, or analysis — may have been omitted or edited; if you require guidance in this area, please consult a tax attorney.
The memorandum also discusses the implications of the account freeze on the taxpayer's ability to sell, exchange, or transfer the digital assets, including the staking rewards. Despite the account freeze, the IRS maintains that the rewards must be included in the taxpayer's gross income according to their fair market value at the date and time the rewards were credited to the account, as the taxpayer was considered to be in actual receipt of the digital currency.