Proof-of-Stake or Proof-of-Work, That Is the Question

An analysis of the advantages and disadvantages of the blockchain protocols that are the basis of the entire industry.

Bitcoin (BTC) is the largest decentralized digital currency in the world, with an estimated market capitalization of around $169 billion. In the nearly 12 years since the publication of Satoshi Nakamoto’s famous white paper in 2008, Bitcoin has become the most well-known example of a cryptocurrency, and it is responsible for sparking the blockchain revolution.

More than half a million peer-to-peer transactions have been recorded on the Bitcoin blockchain, a public and verifiable distributed ledger. The network’s proof-of-work consensus algorithm confirms transactions and produces new blocks without needing a third party. Bitcoin is a revolutionary technology, but the network’s massive energy footprint is comparable to the entire country of Ireland’s electricity consumption.

Luckily, the blockchain ecosystem today is more diverse than ever: A growing number of blockchains are now based on proof-of-stake protocols, and they account for billions of United States dollars in value without a comparable environmental impact. Proof-of-stake blockchains have numerous advantages over proof-of-work: They are more scalable, less resource-intensive and they incentivize tokenholder participation in network security.

Despite the wave of PoS blockchain innovation and the fundamental economic and incentive differences of these networks, many still assume that all blockchains are created equal and that PoS blockchains should still be taxed and regulated in the U.S. in the same manner as Bitcoin and PoW blockchains. This regulatory environment inhibits proof-of-stake innovation, pushing groundbreaking projects away from the U.S.

In order to continue to drive the technological innovation and growth of this new financial ecosystem, tax laws need to be crafted with a deep understanding of the underlying technology and the incentives of these new networks to better reflect developments in blockchain technology that have come since Bitcoin’s introduction over a decade ago.

Tax guidance on proof-of-work is being applied to proof-of-stake

The only guidance on cryptocurrency taxation from the Internal Revenue Service is in Notice 2014-21 and Notice 2014-16 IRB 938. This guidance mentions that mining rewards are treated as ordinary income at the date of receipt of the mining rewards. The issue is that these guidelines were written in 2014, preceding most proof-of-stake blockchains in existence today.

Can taxation guidance drafted prior to the existence of PoS-based protocols adequately regulate the PoS industry? No. Proof-of-stake blockchains, and their economic incentives, are fundamentally different by design and should be regulated accordingly.

The 2014 IRS guidance should not be confused with statutes passed by Congress or authoritative interpretations of law and regulations issued by federal courts. Well-intentioned entrepreneurs and innovators who are interested in building networks based on PoS technology would benefit greatly from regulatory clarity. And it’s critical that regulators understand the technological distinctions.

How proof-of-work and proof-of-stake networks’ incentives differ

In proof-of-work protocols, power-intensive mathematical problems need to be solved in order to create the next block. The miner that solves the mathematical problem and creates the next block also creates the block reward in the form of newly generated tokens — think of this as “network inflation.” In essence, miners are incentivized to put in a tremendous amount of computational work to potentially get rewarded with brand-new tokens.

With proof-of-stake protocols, individuals “stake” — or show ownership of — the tokens by locking up a set amount of tokens for a set time period, and they are randomly selected to verify transactions on the protocol. Network participants are incentivized to maintain the integrity of transactions on the network by being rewarded with new tokens. This process is known as “forging” or “minting” in PoS protocols. The protocol has built-in mechanisms to penalize anyone who falsely or negligently verifies transactions by “slashing” this activity, meaning the individual loses a portion of their staked tokens.

Get taxed to break even

Proof-of-stake protocols have a built-in inflation mechanism that increases the supply of coins. New coins are distributed proportionally to those that have been staked. If everyone were to participate in staking, everyone’s “stake” would remain the same because the new supply is distributed pro rata. Anyone who does not stake is not helping secure the network and is effectively punished with token dilution. Staking, by design, encourages every owner of tokens to participate in the network. In proof-of-work protocols such as Bitcoin, not every tokenholder is also a miner — the great majority do not have the ability or resources to mine. But with PoS protocols, each holder of the token is incentivized to participate in the network or risk having their ownership diluted.

If the participation rate — i.e., the amount of tokenholders who stake — is low, then those who receive staking rewards will enjoy outsized returns, not just their pro rata share of the network inflation.

As a tokenholder, not participating in a PoS network results in a financial loss. In some networks, individuals need to stake coins just to break even against inflation. Nevertheless, in applying the 2014 IRS guidance, staking rewards are considered ordinary income. In PoW protocols, network security is completely separate from token ownership. In PoS protocols, individuals work to maintain the same level of the network.

Excess taxation and volatility

The 2014 guidance to proof-of-stake networks introduced several taxation issues for network participants as they earn rewards. These issues concern taxation as it relates to the timing of taxable events, network inflation and network participation rates.

Timing of taxation: In volatile cryptocurrency markets, coin values can fluctuate widely. Taxes on staking rewards are calculated at the moment token rewards are received under current IRS guidance. By the time a network participant pays taxes, the value of the coin could have dropped significantly. The coins aren’t worth what they were when they were received, yet they are taxed based on the value when they were received, leaving the network participant with a huge tax burden.

Network inflation: In order for a network participant to earn staking rewards, they need to bond those tokens to the network. If all tokenholders, bond their tokens to participate in securing the network, the token rewards are distributed evenly based on the network inflation rate. For example, if John stakes 100 tokens and the network inflation rate is 10%, assuming there is 100% staking participation, John would earn 10 new tokens when rewards are issued by the network. In this scenario, staking effectively enables John to recapture the dilution of his pro rata share of the network. But under current IRS guidance, John is required to pay taxes on the total dollar value of these tokens at the time the rewards are received, even if his pro rata share of the network did not increase.

Network participation: While PoS network participation is extremely high — both Cosmos and Tezos have participation rates over 70% — in reality networks rarely see 100% of tokenholders participating in staking. For example, if Alice owns 100 tokens in the same network, and Alice does not participate in staking, the 10 tokens Alice would have earned for securing the network — given the same 10% network inflation rate — will be redistributed to all those tokenholders who chose to stake, including some to John who will now earn slightly more than 10 tokens for staking. Under current IRS guidance, John is taxed on the dollar value of all of these rewards — the 10 tokens corresponding to the network inflation rate plus his portion of the tokens Alice would have earned — even though the majority of these rewards only cover the recapturing of the dilution of his pro rata share of the network.

The current IRS guidance, as applied to PoS networks, creates an excessive tax burden for network participants. Applying 2014 Bitcoin mining guidance would strongly discourage network participation in the U.S. today. If left unaddressed, this could eventually drive innovators to leave the U.S. for countries with more forward-thinking tax regulations.

A new path forward: Created property

Abraham Sutherland, an adjunct professor at the University of Virginia School of Law, recently published a research paper in Tax Notes that argued staking rewards should be treated as “created property.” This is a new application of a decades-old concept of taxpayer-created or taxpayer-discovered property such as crops, minerals, livestock, artworks and even widgets off an assembly line. In these examples, the property logically isn’t taxed at creation but when it is sold. Taxing staking rewards as created property will ensure that tokenholders are not on the receiving end of excessive tax bills.

Tax laws can foster U.S. innovation

Tax laws, when tailored to promising new technologies, can actually foster innovation. In 1998, Congress passed the Internet Tax Freedom Act, which bars federal, state and local governments from taxing internet access and from imposing discriminatory internet-only taxes such as bit taxes, bandwidth taxes and email taxes. The ITFA also bars multiple taxes on electronic commerce — a huge stimulus to growing the internet economy in the U.S.

More than 30 years later, the U.S. is now a well-established leader of the global movement in internet innovation with Google, Facebook, Microsoft, Netflix and Amazon growing into some of the most valuable publicly traded companies in the world. The U.S. is still benefiting to this day from the regulatory foresight that ensured the internet had the opportunity to grow here.

From a policy perspective, U.S. regulators play an important role in carefully considering tax laws so that they provide an environment that cultivates these protocols. Like the early days of the internet, we are still in the beginning stages of blockchain. It’s not too late to enable innovation and businesses to prosper in the U.S.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.