Maximizing Returns: A Guide to Liquid Staking for U.S. Taxpayers (2024)

In the evolving landscape of decentralized finance (DeFi), staking has emerged as a cornerstone activity, attracting widespread participation. However, with the innovation in staking mechanisms, particularly in the context of liquid staking and restaking, comes the need for clarity around tax implications in the United States. This guide aims to demystify the tax treatment of liquid staking, using LiNEAR Protocol as a case study, and provide strategic insights for US taxpayers. Note: this guide does not serve as any financial, tax or legal advice. Please consult your advisors for a definitive understanding of your tax implications.

Staking involves pledging cryptocurrency assets to support a blockchain network and, in return, earning rewards. The Internal Revenue Service (IRS) categorizes these staking rewards as taxable income, calculated at their fair market value upon receipt. This taxation at the point of acquisition significantly impacts the net profitability of staking. For US taxpayers, the classification of foreign corporations, including those involved in smart contract protocols, is crucial. Most liquid staking protocols do not fall under the Passive Foreign Investment Companies (PFICs) classification due to active income generation. This distinction is important as PFICs are subject to stringent tax consequences in the US.

Staking involves locking up tokens in a manner that restricts their immediate liquidity. Examples include Near Protocol’s PoS staking or single-asset pools in various DeFi platforms. According to IRS Revenue Ruling 2023–14, rewards from staking are taxable upon receipt as ordinary income.

Contrastingly, liquid staking introduces an innovative approach, allowing participants to receive staking derivative tokens representing a share in a staked asset pool, providing liquidity and flexibility. Tokens from liquid staking, such as those issued by protocols like LiNEAR or Lido, offer a different tax treatment, potentially enhancing tax efficiency.

LiNEAR Protocol, a leading liquid staking solution in the NEAR ecosystem, exemplifies the potential of liquid staking. By staking $NEAR tokens, users receive $LiNEAR tokens, representing their stake, which can be utilized across various DeFi protocols. This enhances capital efficiency and introduces liquidity to staking. As the leading DeFi protocol with the highest Total Value Locked (TVL) in the NEAR ecosystem, it pioneered various innovative features, such as the Automatic Validator Selection Optimization Algorithm, offering the highest liquid staking yield at 8.67% to its users and improving the security of the NEAR network by delegating to 200+ activate validators. Furthermore, the introduction of $bLiNEAR for restaking purposes allows for additional financial activities like collateralized lending, illustrating the versatility of liquid staking solutions.

In traditional staking models, rewards are taxed as income at their fair market value upon receipt. Taking NEAR’s PoS staking as an example, taxes are incurred after receiving additional $NEAR tokens as staking rewards after each epoch, even if users have not unstaked or sold their tokens. This can result in a substantial tax burden, particularly if the cryptocurrency’s value experiences significant fluctuations. Let’s consider an example: Bob stakes $NEAR at $5, incurring taxes as $NEAR rises to $7, with additional $NEAR sent to Bob’s wallet after each epoch (approximately 12–15 hours). Subsequently, $NEAR drops to $2. Despite not selling any tokens, including those earned when $NEAR was at $7, Bob may face a substantial tax liability, potentially erasing most of his unrealized gains from staking. The only way for Bob to mitigate this is by constantly unstaking and then immediately selling his staking income. However, this approach presents significant operational challenges, not to mention paying significantly more transaction and gas fees.

With liquid staking, you stake your cryptocurrency and receive a liquid token in return. This exchange is typically not considered a taxable event by the IRS. For example, staking $NEAR tokens to receive $LiNEAR tokens doesn’t trigger immediate taxes. The actual tax event occurs when you sell or trade the liquid tokens received. If these tokens have appreciated in value since acquisition, you’ll owe capital gains tax on the profit. The tax rate depends on your holding period: assets held for more than a year qualify for lower long-term capital gains rates, while those held for a shorter period are taxed at higher short-term capital gains rates.

In Bob’s case, he only needs to pay taxes when selling or converting his $LiNEAR tokens. The additional earned tokens from staking are not taxed upon receipt but accumulate in $LiNEAR’s value. Consequently, Bob can avoid the substantial tax burden at $7 and the hurdle of constant selling of his staking income, providing a more tax-efficient approach.

Restaking involves using your staked assets (or their derivatives) to engage in further staking activities. For example, in LiNEAR, you can restake your $NEAR tokens to receive another type of token (like $bLiNEAR), which represents a restaked position. Similar to liquid staking, converting your staking tokens into restaking tokens typically isn’t a taxable event. This means you can potentially increase your earnings without incurring immediate tax liabilities. The deferral of taxation until the sale or exchange of restaking tokens allows for compounded growth of investments. When you eventually sell or exchange the restaking tokens, the profits are subject to capital gains tax. As with liquid staking, holding these tokens for over a year may result in lower long-term capital gains taxes.

• Tax Deferral: enjoy the benefit of deferring taxes on your staked assets until you decide to sell or exchange the liquid or restaking tokens, avoiding short term price volatility of traditional staking and the immediate tax burdens associated with it.
• Lower Tax Rates with Long-Term Holding: hold onto your liquid or restaking tokens for over a year to potentially qualify for lower long-term capital gains tax rates, without the concerns of managing short term price volatility
• Flexibility and Liquidity: liquid staking offers the flexibility to use or trade your staked assets without the need to unstake, providing liquidity uncommon in traditional staking.

DeFi Protocols and U.S. Tax Exposure

It’s also crucial for developers and participants in these protocols to be aware that, for U.S. tax purposes, foreign corporations are only subject to U.S. corporate tax if they engage in a U.S. trade or business. This classification holds significant weight, especially considering the potential tax exposure for U.S. taxpayers investing in foreign corporations classified as Passive Foreign Investment Companies (PFICs). However, most smart contract protocols, particularly those involved in consensus-layer staking or active financial activities, do not typically fall under PFIC status due to their active nature of income generation. In addition, a US person can avoid paying any taxes on liquid staking protocol if the liquid staking is done by their foreign entity. They would only need to pay taxes on any capital gains from selling their foreign entity or distributing cash back to their personal accounts.

• Choose a Protocol: Start with a trusted liquid staking platform like LiNEAR.
• Understand the Tax Events: Recognize that acquiring liquid staking tokens (and restaking them) is not a taxable event. However, selling or trading them is.
• Keep Records: Document the value of your tokens at the time of acquisition and sale to accurately calculate potential capital gains.
• Consult Tax Professionals: Given the complexities of cryptocurrency taxation, seeking advice from a tax expert is advisable for personalized guidance.

The landscape of DeFi and staking continues to evolve, bringing new opportunities and complexities in tax implications. Understanding these nuances, as exemplified by protocols like LiNEAR, is crucial for effective tax planning and investment strategy formulation. US taxpayers should remain vigilant and consult with tax professionals to navigate this dynamic domain, ensuring compliance and optimizing tax liabilities.

Legal memo from Will:

Staking is one of the most participated activities in the world of decentralized finance (DeFi), and recent IRS guidelines have clarified the tax treatment of staking rewards in the United States. According to the IRS, staking rewards are taxable as income at the time of receipt, which means they are taxed based on their fair market value when you gain control over them. This is important to consider since the tax implications can significantly affect the net returns of your investments.

In practice, unless you hold highly appreciated cryptocurrency, opting for tokens that represent a proportionate share in a pool of assets may be more tax-efficient compared to direct receipt of streaming staking rewards. This is because swapping into these tokens might not trigger a taxable event until you sell or exchange them, whereas directly receiving staking rewards is a taxable event at the time of acquisition.

Illiquid Staking: Illiquid staking, involves locking up the staked tokens in a way that restricts their immediate use or trade. The tokens are directly provided to a validator, and the stoker earns rewards based on the agreed percentage. However, these tokens cannot be used or traded until they are unlocked or the staking period ends.

Examples:

l Traditional Staking on Ethereum: This involves locking ETH directly in the Ethereum 2.0 Beacon Chain contract. Once staked, the ETH becomes illiquid until the launch of future Ethereum upgrades that enable withdrawals.

l Staking in Single-Asset Pools: Many DeFi platforms offer single-asset staking pools where you can stake a specific cryptocurrency like BTC or DOT. In these pools, your assets are locked and you cannot use them until you decide to unstake, making them illiquid during the staking period.

l Staking in Newer or Smaller Blockchains: Staking in newer or less popular blockchains often involves locking tokens without the option of a liquid derivative. This is typical in networks that are still developing their ecosystems and do not have integrated liquid staking solutions.

The tax treatment of illiquid staking rewards in the United States has been clarified through recent IRS guidance. According to Revenue Ruling 2023–14, these rewards are considered taxable income at the time they are received by the taxpayer. This means that the fair market value of the staking rewards, at the moment they come under the taxpayer’s control, is included in their gross income. In the case of illiquid staking, where the staked assets are typically locked in the staking contract and not immediately accessible or tradable, the rewards are still recognized as taxable income upon receipt. This approach ensures a consistent tax treatment for staking rewards, aligning with the broader principle of taxing income when it is realized or constructively received.

Furthermore, when these illiquid staking rewards are eventually sold, exchanged, or otherwise disposed of, they become subject to capital gains tax. The cost basis for calculating capital gains or losses is the market value of the rewards at the time they were included as income. This underscores the importance of keeping detailed records of the fair market value of staking rewards at the time of receipt. The tax implications do not end with the recognition of income; careful tracking is necessary to accurately report any capital gains or losses resulting from the disposition of these staking rewards. This two-fold tax consideration — income tax upon receipt and capital gains tax upon disposal — is crucial for taxpayers engaged in illiquid staking activities to understand and account for in their tax planning and reporting.

Liquid Staking: Liquid staking has emerged as an innovative concept in the cryptocurrency space, fundamentally revolving around the idea of holding tokens that represent a proportionate share in a pool of assets, essentially enabling users to maintain liquidity and engage in other transactions or investments without relinquishing their staked assets. By holding these tokens, users are entitled to a share of the staking rewards generated by the underlying assets, while simultaneously enjoying the flexibility and liquidity usually not afforded by traditional staking mechanisms.

Examples:

l Aave Lending: You deposit USDC into Aave, a decentralized lending protocol, in exchange for aTokens (like aUSDC). These aTokens represent your deposited USDC plus accrued interest over time, reflecting the earnings from lending activities within the protocol.

l Yearn Finance Vaults: You deposit assets like Ethereum or stablecoins into Yearn Finance’s vaults. In return, you receive yTokens (such as yETH or yUSDC) which signify your share in the vault. The value of these yTokens increases as the vault strategy earns yield through various DeFi strategies.

l Compound’s cTokens: Similar to Aave, when you supply assets like ETH to Compound, a popular DeFi lending platform, you receive cTokens (such as cETH). These cTokens represent your supplied assets plus the interest accrued from lending them out to borrowers within the platform.

The choice of opting for tokens that represent a proportionate share in a pool of assets, such as liquidity pool tokens or certain types of staking derivatives, can be more tax-efficient compared to directly receiving streaming staking rewards. When you swap your cryptocurrency for these pool-share tokens, you’re essentially participating in a form of asset exchange rather than realizing income. As a result, the initial acquisition of these tokens might not be a taxable event under current tax regulations. The tax implications are deferred until these tokens are sold or exchanged, at which point capital gains tax would apply.

The IRS has not issued any specific ruling that directly addresses the tax treatment of swapping cryptocurrencies for pool share tokens in the context of liquidity pools or staking derivatives. Nonetheless, it is important for taxpayers to understand the difference: while liquid staking still has potential tax implications as per the IRS’s treatment of cryptocurrency as property, it is not seen as “realizing income” in the traditional sense. Unlike direct staking rewards, which are taxed as income at their fair market value upon receipt, tokens representing a share in a pool may not immediately trigger a taxable event. This is because acquiring these tokens is often not considered a disposition event in itself.

By applying the IRS Notice 2014–21, it could be reasonably implied that swapping cryptocurrencies, including for pool share tokens, is likely considered a crypto-to-crypto exchange, which potentially become subject to capital gains tax thus, not a taxable event until when the crypto asset is eventually traded or disposed. This delay in taxation can be particularly advantageous for those looking to manage their tax liabilities more effectively, as it allows for potential growth in the value of the tokens without immediate tax consequences.

Liquid staking offers several tax advantages that can be beneficial for investors. Firstly, the receipt of Liquid Staking Tokens (LSTs) in exchange for staking is not typically considered a taxable event. This differs significantly from illiquid staking, where rewards are immediately taxable as ordinary income upon receipt. The non-taxable nature of receiving LSTs allows investors to defer tax liabilities until the tokens are sold or exchanged, potentially benefiting from more favorable long-term capital gains tax rates if held for over a year.

Furthermore, liquid staking provides additional flexibility for tax planning. Investors can strategically decide when to trigger taxable events by selling or trading these LSTs based on their individual financial situations and tax brackets. This level of control is not available with illiquid staking, where the receipt of staking rewards automatically creates a taxable event.

It is also worth mentioning that for U.S. tax purposes, foreign corporations are only subject to U.S. corporate tax if they engage in a U.S. trade or business. This classification is crucial for developers and participants in these protocols. Ensuring that smart contract protocols, which the tokens represent, are not engaged in U.S. trade or business can mitigate tax exposure. This is significant as U.S. taxpayers face stringent tax consequences if they invest in foreign corporations classified as Passive Foreign Investment Companies (PFICs). However, most smart contract protocols, like those involved in consensus-layer staking or active financial activities, do not typically fall under PFIC status due to their active nature of income generation.

The tax treatment of swapping cryptocurrencies like ETH for these foreign corporate stocks in non-PFIC entities is particularly favorable. Such transactions trigger capital gains or losses at the point of exchange and exit but do not incur income tax during the holding period. This approach contrasts with direct income realization, as seen in traditional or illiquid staking, where staking rewards are immediately taxable as income. Liquid staking, therefore, presents a more tax-efficient strategy, deferring tax liabilities and potentially aligning with long-term capital gains if held for over a year.

Additionally, liquid staking can offer opportunities to participate in other DeFi activities without needing to unstake the original assets, thereby not triggering additional taxable events related to staking rewards. This can lead to more efficient capital utilization and potentially increased returns on investment, while still maintaining a favorable tax position.

Staking as custodial relationships

The tax implications discussed above apply mainly to decentralized protocols, however, these may not be directly applicable to staking services offered by centralized entities like exchanges or custodians.

In the United States, centralized platforms that manage crypto assets for investors often treat staked crypto as part of a custodial relationship. This is similar to traditional financial (TradFi) custodial transactions. For instance, when you keep stocks with a broker, you’re seen as the owner of those stocks, not as someone who has pledged them to the broker. This is true even if the broker mixes your stocks with those of other clients.

The tax treatment of staking in cryptocurrency, when viewed as a custodial relationship, presents a unique perspective in the realm of digital asset taxation. In custodial relationships, the ownership of the cryptocurrency is maintained by the staker, even when these assets are under the management of a centralized entity like a crypto exchange or custodian. The rewards or gains earned from such staking activities, under a custodial arrangement, are typically considered income for the asset owner. This means that any tokens or crypto rewards received from staking are subject to income tax as per the fair market value at the time of receipt. However, the staked assets themselves, under a custodial relationship, do not trigger a taxable event simply by virtue of being staked. Only the rewards generated from such staking are taxable. This approach provides clarity and simplicity in the tax treatment, aligning it with traditional custodial relationships in the financial sector, and ensuring that taxpayers can accurately report and manage their tax liabilities associated with staking in cryptocurrencies.

Finally, it’s important to understand that the choice of liquid staking does not eliminate tax liability but rather defers it. When these tokens are eventually sold or exchanged, they will be subject to capital gains tax based on the gain or loss from their original value at the time of swapping. Therefore, individuals considering this strategy should maintain accurate records of the value of their assets at the time of swapping into these tokens and monitor the changing tax landscape, as cryptocurrency tax regulations continue to evolve. Navigating these choices requires careful consideration of one’s specific financial situation and long-term investment strategy. Therefore, it’s crucial to consult with a tax professional for personalized advice, as the tax implications can vary based on individual circ*mstances and the specific nature of the crypto assets and transactions involved.