SECTION 2. BACKGROUND –

DIGITAL ASSETS AND STAKING

.01 Digital assets are digital representations of value recorded on a cryptographically secured distributed ledger or similar technology within the meaning of section 6045(g)(3)(D) of the Internal Revenue Code (Code) (digital assets). ¹ Digital assets generally are treated as property for Federal income tax purposes and Federal income tax principles apply to digital asset transactions. ² This revenue procedure addresses only digital assets for which transactions are carried out on a permissionless network that uses a proofof-stake consensus mechanism to validate those transactions.

.02 The operation of each digital asset blockchain network is governed by software that programmatically enforces certain network rules and technical requirements, as well as distributions of rewards (protocol). For a digital asset transaction to be recognized by the blockchain network, the transaction must be added to the network’s decentralized digital ledger (blockchain).

.03 Digital assets rely on cryptography and economic mechanisms designed to reduce reliance on designated trusted intermediaries to verify transactions and provide settlement assurances to users. Each protocol has a consensus mechanism that enables a distributed set of unrelated computers (commonly referred to as “nodes”) to agree on the authoritative record of digital asset address ownership balances, transactions, and other data relating to a digital asset’s blockchain at any given time (state). The consensus mechanism is intended to maintain the integrity of the blockchain by validating transactions and ensuring transactions added to the blockchain are valid. This

1 Unless otherwise specified, all “section” or “§” references are to sections of the Code, the Income Tax Regulations (26 CFR Part 1), or the Procedure and Administration Regulations (26 CFR Part 301).

2 See Notice 2014-21, 2014-16 I.R.B. 938.

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can be done, for example, by rejecting transactions that attempt to move the same units to two different wallet addresses at the same time (so-called “double spending”). Preventing such transactions from being recorded on a blockchain is essential to the security and integrity of a digital asset’s blockchain. Absent such assurance, users could lose confidence in the digital asset network and the corresponding digital assets could lose value.

.04 Proof-of-stake is a type of consensus mechanism. In a proof-of-stake consensus mechanism, a validator node is a type of node that actively participates in the consensus mechanism (in addition to the typical duties of a node, which include maintaining and verifying blockchain data). Non-validator nodes typically only store and relay blockchain data, and do not propose or create new blocks. Validator node operators commit or “stake” digital assets to become eligible to be selected by the relevant protocol to validate a new block of data to, and update the state of, the network’s blockchain. While staked, digital assets are “locked up” and cannot be transferred for a period of time under the terms of the applicable protocol. Some protocols employ specific criteria for selecting validators, such as the number of digital assets staked by the validator node operator.

.05 For the validation process to be effective in ensuring the security and integrity of a digital asset’s blockchain, there must be enough node operators that no one validator or group of validators can control a majority of the total staked digital assets, which would allow that party or group to manipulate the blockchain by influencing the validation of transactions and potentially altering the blockchain’s transaction history. Consequently, an increase in the number of digital assets staked by different validator nodes can increase the security of blockchains using proof-of-stake consensus mechanisms. To incentivize multiple validator node operators to participate, and in exchange for providing validation and related activities, newly minted digital assets specified by the protocol and/or fees paid by parties seeking to add their transactions to the blockchain (collectively, “rewards”) are credited or transferred to validators. Rewards generally are received in the

form of a blockchain’s native digital asset. Conversely, if a validator fails to act in accordance with a blockchain network’s consensus mechanism, some staked units may be forfeited as a penalty (slashing).

.06 Digital asset owners can participate in staking in various forms. One such form is custodial staking, in which a third party (custodian) takes custody of the owner’s digital assets and facilitates the staking of such digital assets on behalf of the owner. Generally, a custodian focuses on securely holding, storing, and safeguarding digital assets on behalf of digital asset owners. The custodian, acting on behalf of the owner, selects and enters into contractual arrangements with one or more validator node operators who engage in proof-of-stake activities for digital asset blockchains (staking provider). In some cases, the legal entity that is the custodian also may act as the staking provider. The arrangement between the custodian and the staking provider generally provides that an agreed-on portion of the staking rewards are allocated to the owner of the digital assets.

.07 Some legal entities formed as trusts under applicable State law that hold digital assets intend to be treated for Federal income tax purposes as investment trusts under § 301.7701-4(c) and as grantor trusts. Certain actions of the trust may be directed by the trust’s sponsor.

.08 The Department of the Treasury and the Internal Revenue Service have received requests for guidance on: (1) whether staking prevents a legal entity formed as a trust under applicable State law from qualifying for Federal income tax purposes as a trust classified as an investment trust under § 301.7701-4(c) and as a grantor trust; and (2) if not, whether an existing trust agreement may be amended to authorize the staking of some or all of its digital assets without impairing qualification of the trust as an investment trust under § 301.7701-4(c) and as a grantor trust.