Amid the crypto boom, mining has become an extremely lucrative venture for many and critical to maintaining decentralized cryptocurrency networks. It is no surprise then that mining has been subject to IRS scrutiny and enforcement. But how is mining taxed? Are the tokens received by taxpayers as rewards for their mining activities deemed to be capital or ordinary gain?
Fortunately, the IRS has released detailed guidance on this front in the form of a notice it originally issued in 2014, but which the Service updated this year amidst a skyrocketing crypto market. In this posting, we will provide a general overview of the tax implications of crypto mining, including the taxation of reward tokens and tax reporting considerations. Taxpayers engaged in such activities should generally be aware of how mining should be taxed, especially in light of increased IRS attention to cryptocurrencies.
Overview of Mining
Miners play a critical role in securing cryptocurrency networks, with Bitcoin being the most prominent example. Cryptocurrencies are powered by blockchain technology, a decentralized public ledger of transactions that are grouped into "blocks" and that do not rely on a centralized authority to police such transactions. The absence of a financial middleman can, however, result in a "double-spending" problem whereby a cryptocurrency is spent more than once. To prevent double-spending, cryptocurrency networks rely on a consensus mechanism known as Proof-of-Work. Under a proof-of-work consensus mechanism, miners compete to solve complex mathematical problems in order to validate and add a block of transactions to the ledger. Miners are rewarded with the network's cryptocurrency for solving problems and adding blocks to the blockchain. Thus, mining has the effect of putting more of the network's cryptocurrency into circulation while ensuring the integrity of the network itself.
Tax Implications of Mining
Crypto miners will generally face tax consequences (1) when they are rewarded with cryptocurrency for performing mining activities, and (2) when they sell or exchange the reward tokens. With respect to (1), the IRS has issued Notice 2014-21 which directly addresses the tax implications of crypto mining. Under the Notice, a miner will recognize gross income upon receipt of the reward tokens in an amount equal to the fair market value of the coins at the time of receipt. Additionally, if a taxpayer's mining activities constitute a trade or business or the taxpayer undertakes such activities as an independent contractor, the reward tokens/virtual currency payments are deemed to be self-employment income and accordingly, subject to self-employment taxes. Similarly, if a taxpayer performs mining activities as an employee, payments made in cryptocurrency are treated as wages subject to federal income tax withholding of Social Security/Medicare and unemployment taxes.
On the other hand, a taxpayer that pays more than $600 worth of virtual currency to an independent contractor in exchange for mining services will be required to prepare and file a Form 1099 with the Service for every taxable year that it uses contractors for such services. If the taxpayer employs miners in the ordinary course of his trade or business, the taxpayer is subject to more tax compliance requirements in the form of federal withholding and issuing the employee a Form W-2 every taxable year.
An example may crystalize the concepts outlined in the Notice above. Suppose that Adam mines Bitcoin and receives 6 Bitcoin tokens when the price per coin is $45,000. If we assume that Adam's mining activities constitute a trade or business, or Adam receives the Bitcoin in his capacity as an independent contractor, the $270,000 ($45,000 x 6) worth of Bitcoin he receives will be treated as income taxed at ordinary tax rates. Additionally, under both circumstances, Adam will be subject to self-employment taxes and be required to remit estimated tax payments on a quarterly basis. If Adam performs mining as an employee, the $270,000 he receives will be subject to federal income tax withholding, with Adam receiving a Form W-2 every year.
A miner will trigger a second taxable event upon the sale of the reward tokens, with the amount of gain (or loss) equaling the difference between the sales price and the gross income recognized by the taxpayer when he or she initially received the coins in exchange for performing mining activities. By way of example, assume that Adam sold three of the Bitcoin tokens two years later when the price per coin is $60,000. Adam would recognize a gain of $45,000 ([$60,000 x 3 tokens] - [$45,000 x 3 tokens]). Since Adam held the three Bitcoins for more than year, his gain would be subject to the more preferential long-term capital gains tax rate.
The Takeaway
Ultimately, the reward tokens that taxpayers receive in exchange for performing mining activities is taxed as ordinary income upon receipt. The received tokens are also subject to self-employment or payroll taxes, depending on whether the taxpayer is mining as a trade or business, independent contractor or an employee. A taxpayer will trigger another taxable event when he or she ultimately sells the reward tokens, which is subject to short-term or the more preferential long-term capital gain rates, depending on the holding period of the tokens.
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