Why Pass-Through Taxation for Staking Rewards Is a Legal Fiction

The 2022 ruling that airdropped tokens are income upon receipt created a dangerous precedent. It treats staking rewards as a 'service payment' from the network, ignoring the fundamental property creation of PoS.

• Analogy Failure: Compares staking to mining, but PoS validators don't expend energy to 'discover' new coins; they are algorithmically allocated a property right.
• Taxable Event Fallacy: Creates a phantom income problem where tokens are taxed before they are liquid, creating a cash-flow crisis for validators.

Modern staking is a layered financial primitive, not a simple node operation. The 'pass-through' model collapses under Liquid Staking Tokens (LSTs) like Lido's stETH and Rocket Pool's rETH.

• Economic Disconnect: The staker holding an LST never receives the native token reward; the protocol does. Tax liability is severed from economic benefit.
• Delegation Complexity: With services like Coinbase Cloud or Figment, the entity performing the work (the node operator) is different from the entity deemed to receive the 'income' (the delegator).

The only coherent framework is to tax staking rewards as property created at the moment of sale or transfer, not receipt. This aligns with economic reality and existing law for other created property.

• First-Principles Basis: A validator's block reward is a newly created digital asset, akin to intellectual property or a manufactured good. Income is realized upon disposition.
• Precedent Exists: The IRS already uses this model for mining under Rev. Rul. 2019-24, creating a glaring inconsistency that undermines its own logic.

Building under flawed tax law forces unsustainable design. Protocols must either ignore regulatory risk or bake in crippling complexity to track unrealized gains for users.

• Innovation Tax: Projects like EigenLayer (restaking) and Cosmos (interchain security) create layered reward streams that are impossible to reconcile with annual pass-through accounting.
• Compliance Overhead: Forces protocol-level KYC/1099 reporting, destroying pseudonymity and pushing development offshore, akin to the OFAC-compliant vs. neutral MEV relay debate.

The IRS treats staking as a service (labor income), but it is fundamentally a capital allocation decision. Delegating ETH to a validator pool is economically identical to investing in a money market fund.

• Correct Analogy: Staking is capital providing security-as-a-service. The reward is a return on capital, not compensation for labor.
• Legal Mismatch: Applying ordinary income rates (up to 37%) to a capital return distorts investment and unfairly penalizes long-term network security providers.

Clarity will come from a new court case or act of Congress. The Token Taxonomy Act or a successor must explicitly define digital asset creation.

• Strategic Litigation: A case involving an LST holder or a delegator in a non-custodial pool (e.g., using StakeWise or Frax Ether) is needed to break the mining analogy.
• Industry Action: Consortiums like The Proof of Stake Alliance must fund legal challenges and lobby for the 'disposition' model to prevent a $10B+ unrealized tax liability from crippling the ecosystem.

The IRS applies the constructive receipt doctrine, arguing a staker has control over newly minted tokens. This ignores the technological reality of slashing and bonding periods.\n- Control is contingent: Tokens are not liquid or usable until after an unbonding period (e.g., 21 days on Ethereum).\n- Value is unrealized: The reward is a probabilistic future claim, not a present economic benefit, akin to an unvested stock option.

The seminal tax case Cesarini v. United States established that income requires complete dominion and control. Staking rewards fail this test at creation.\n- Precedent for delay: Finding cash in a piano was income because it was immediately spendable. Staking rewards are not.\n- True taxable event: Taxation should occur upon vesting or sale, aligning with the realization principle and matching cash flow for taxpayers.

The only court case on this issue rejected the IRS's position, creating a direct circuit split with the Revenue Ruling.\n- Tennessee Court Ruling: Found staking rewards are created property, not income, until sold.\n- Legal Fiction Exposed: The court highlighted the absurdity of taxing non-liquid, self-created assets, comparing it to taxing a homeowner for the imputed rental value of their own home.

The IRS treats staking rewards as income from a pass-through entity, like a partnership. This is a legal fiction that ignores the cryptographic reality of block production.

• False Equivalence: A validator is not a partnership; it's a deterministic state machine.
• Tax Event Mismatch: Creates phantom income at block proposal, not at token transfer or sale.
• Protocol Risk: Forces protocols to design for tax compliance, not optimal cryptoeconomics.

The only technically coherent model is to treat newly minted tokens as having a zero-cost basis at creation, with tax liability triggered upon disposition (sale, swap, use).

• Technical Truth: Aligns with how blockchains actually record value creation.
• Liquidity Focus: Tax is due when stakers realize fiat-equivalent value, solving the illiquidity problem.
• Protocol Design Freedom: Enables innovative reward mechanisms (e.g., restaking, liquid staking tokens) without creating tax landmines.

This ongoing case challenges the pass-through model, arguing staking rewards are newly created property, not income. A favorable ruling would be a seismic shift.

• Legal Attack Vector: Directly targets the core 'income' classification.
• VC Implication: Changes the risk calculus for any protocol with inflationary rewards (e.g., Ethereum, Solana, Cosmos).
• Strategic Playbook: Protocols must prepare legal arguments and model economics under both tax regimes.

Design with the assumption that pass-through taxation will fail. Build systems that are resilient to a cost-basis tax regime.

• LST-First Design: Liquid Staking Tokens (LSTs) like Lido's stETH naturally defer tax until sale.
• Reward Streaming: Implement continuous vesting or reward claims to avoid large, lump-sum 'income' events.
• Documentation Layer: Build transparent, on-chain reporting tools for cost-basis tracking, anticipating future regulatory demands.