What Happened
The biggest upgrade to the Ethereum network known as the “the merge” is tentatively scheduled to go live on September 14th, 2022. After the merge, the Ethereum network will switch from a proof-of-work (PoW) system to a proof-of-stake (PoS) system in the Beacon chain.
As we move closer and closer to the merge there are many questions circling around the taxability of each step. Here’s what you need to know.
Key Concepts
The Merge May Be Viewed As a “Soft Fork”
Although there is no merge-specific tax guidance, the merge looks akin to a “Soft fork” described in the IRS FAQ 30 published in 2019.
“A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and thus does not result in the creation of a new cryptocurrency. Because soft forks do not result in you receiving new cryptocurrency, you will be in the same position you were in prior to the soft fork, meaning that the soft fork will not result in any income to you.”
The merge will not result in two Ethereum chains (there could be spin-offs, which will be addressed later). After the merge, users will still hold the same ETH tokens (but PoS enabled) that they held prior to the merge. Therefore, the merge will not result in any taxable income.
For example, imagine Steve holds 1 ETH. When the merge goes through and Steve’s one ETH gets upgraded automatically to PoS-enabled ETH, he will not have any income to report under the Soft fork argument.
Tax Implications of Locking in Ether
You can earn ETH staking rewards prior to the merge by locking in your PoW-based ETH in a supported crypto exchange. Cryptocurrency exchanges use different labels to represent these staked ether. For example, “ETH2” and “ETH2.S” represent staked ether on Coinbase and Kraken, respectively.
Based on my firm’s research, converting ETH to “ETH2” or “ET2.S (in other words locking assets in)” is likely not a taxable event because a disposition event has not occurred. “ETH2” & “ETH2.S” are just labels used to represent the same original ether with PoS support; They are not different coins.
For example, let’s say Steve purchased one ETH for $100 (cost basis) a few years ago. In 2021, Steve stakes his ETH and converts it into ETH2 on Coinbase to start earning staking rewards. At the time of conversion, one ETH is worth $2,000. This transaction is not a taxable event. Steve’s ETH2 takes on the original holding period and the cost basis ($100).
Once the upgrade to the Ethereum 2.0 network is complete, ETH2-labeled coins will cease to exist. They will be replaced with just “ETH” coins which will be fully powered by PoS. This is likely another non-taxable event under the Soft fork tax rules explained earlier.
Tax Implications of Earning Staking Rewards
The IRS has not issued any staking specific tax guidance. The infamous ongoing court case, Joshua Jarrett, Jessica Jarrett (plaintiffs) v. US (defendant), is trying to get more clarity about this issue as well.
In the absence of staking-specific rules, the conservative approach is to recognize income at the time you receive staking rewards and you can exercise dominion and control over the asset (ability to sell, move or transfer the asset in simple terms).
Currently, you can stake ETH in many exchanges and earn rewards. However, these rewards are not accessible to you until a future date.
"Rewards will be reflected in your account, but will not be actually credited until the end of the lockup period. Unless otherwise stated, you will not be able to trade, transfer, or otherwise access your ETH staking rewards during the lockup period" (Coinbase User Agreement)
Let’s use an example to illustrate this. In 2021, Steve earned 6.0% interest on ETH2 and received 0.1 ETH2 as a staking reward. At the time he received the reward, 0.1 ETH2 was valued at $100. Although he sees this 0.1 ETH2 in his exchange wallet, he can neither move nor sell it. In this case, Steve doesn’t have any taxable income to report because he doesn’t have dominion and control over the 0.1 ETH2 yet.
Say, in 2022, the exchange gives Steve access to his 0.1 ETH2. At this time, 0.1 ETH2 is valued at $500. At this point, Steve has dominion and control so he should report $500 of ordinary income on her tax return.
On the other hand, certain platforms like Lido allow you to earn liquid ETH2 staking rewards. In such cases, it’s reasonable to think that you have taxable income at the time you receive those rewards in your wallet.
Possibility of an Ethereum Hard Fork
Some Ethereum miners have proposed a hard fork to retain the originality of the PoW chain. If this were to happen successfully, there will be two Ethereum chains (PoW chain & PoS chain), instead of a unified chain planned by the official merge. Under this scenario, the merge will likely be classified as a hard fork for tax purposes.
According to the IRS FAQ 22, “A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger. This may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger”.
“If a hard fork is followed by an airdrop and you receive new cryptocurrency, you will have taxable income in the taxable year you receive that cryptocurrency” (FAQ 23)
Therefore, the PoW-enabled coins you receive after the merge will be income for you (Q24).
Although it’s prudent to think about the potential tax implications of the merge, we have to wait until the merge happens to further evaluate the actual facts and circ*mstances surrounding the transactions to finalize tax positions.
Next Steps
- Closely monitor if there’s any Hard fork prior to the Merge
Further Reading
- The IRS Is Working On A New Tax Form To Capture Your Crypto Activity
- Large Crypto Losses May Not Become Instant Tax Write-0ffs, But Here’s What You Can Do
- IRS May Not Tax Passive Income From Holding Crypto Right Away
