The merge is coming… but what does that mean for the tax and accounting of Ethereum-based assets?
The Ethereum Foundation voted to switch from a Proof of Work (POW) algorithm to a Proof of Stake (POS) algorithm in late 2020. As of right now, the main Ethereum chain will ‘merge’ with the Beacon chain, which is the Proof of Stake mechanism in September. Ultimately the change is being made to improve scalability and reduce energy consumption. The merge will have major implications for businesses and individuals who use Ethereum, as well as for the overall Ethereum ecosystem – including Ethereum tax and accounting.
As you may know, the Ethereum blockchain is a decentralized platform that runs smart contracts. These contracts are apps that run exactly as programmed without any possibility of fraud or third-party interference. The main difference between POW and POS is that POW requires miners to validate transactions, while POS only requires validators. This change will thus reduce the amount of energy needed to run the Ethereum network by a significant amount.
But how will this impact tax and accounting for businesses and individuals?
After all, you don’t often see fiat currencies changing the way they function; there are unique scenarios presented by the merge and by proxy digital assets. Unfortunately for those looking for clear guidance on the subject, tax law on surrounding scenarios is lacking – and that’s being generous.
Currently, Ethereum is taxed as a property, like stock or real estate. This means that capital gains tax applies whenever ETH is sold for a profit. On the surface, this may seem simple, but with the merge approaching, there becomes a heightened need to understand the tax implications of staking and staking income, especially as it applies to staked ETH (stETH).
The IRS hasn’t exactly been clear about how staking is taxed, at least with hard regulation. One of the most recent signals on its interpretation of staking tax is that of the Josh Jerret case (Jarrett v. United States, No. 3:21-cv-00419 (M.D. Tenn.). In the latest ruling, the IRS backed down from classifying staking income as taxable earnings, signaling a new interpretation of existing tax law.
ETH 2.0, PoW Hard Fork, and Staking Income
As the merge shifts the Ethereum blockchain to a proof-of-stake ecosystem, it only complicates the tax guidelines for trades on the Ethereum blockchain.
The merge could potentially impact the value, use, and functionality of Ethereum, as it shifts the entire blockchain system from PoW to PoS, eliminating Ethereum mining on the PoS Ethereum blockchain in the process. There’s of course been much discussion about a PoW chain fork that would keep the original chain running - again, providing even more complexities to the tax scenarios around traders, miners, and HODLrs of ETH or stETH.
Dealing with hard forks, staking, and the merge each present their own unique tax scenario, one that’s quite the challenge to manage over spreadsheet - necessitating automated tools that aggregate, normalize, and make all of these crypto transactions legible for tax filing purposes.
In fact, complex scenarios like often require the transposing of complex crypto data into traditional tax and accounting workflows, something Ledgible is best-in-class at.