ESG, Crypto, And What Has The IRS Got To Do With It?

Abstract

Regulation almost always lags behind innovation, and this is also the situation with many FinTech-based products and services, and particularly those offered by crypto industry players. The crypto sector is a new and innovative one, which has proven to be not only based on highly technical concepts, but also by high levels of volatility and financial risk. In attempting to understand how to address many of the issues it raises in legal fields ranging from to financial regulation such as tax requirements to environmental law, and specifically matters that relate to climate change and energy wasting, regulators often find themselves trying to implement existing legal frameworks rather than creating new, clear rules. Much has been written about the SEC’s regime of regulation by enforcement of the crypto industry, and the impact of this type of rulemaking on businesses and persons. However, other financial regulators adopting a similar style of rulemaking—such as the IRS—have gotten much less attention for the impact of their regulatory actions. As noted within this Article, prominent industry associations continue to push back against applying existing tax law and protocols to specific crypto activities. One such notable example, which is relevant in the Environmental, Social and Governance (ESG) awareness era, relates to the unintended consequences of the IRS’ regulation by enforcement, given the impact that such new rules have on the transition to greener energy. This happens in the crypto industry in connection with proof-of-stake (PoS) consensus mechanisms—one of the two prominent transaction validation mechanisms. The PoS mechanism includes staking rewards – reward tokens that are earned/generated from securing a PoS blockchain – that validators, also known as stakers, get when they validate transactions. The IRS has asserted that cryptocurrencies are considered property for income taxation purposes, which means that every transaction results in a gain or loss equating to the difference between the price of the crypto asset at purchase and the price of the sale.
In the case of the PoS mechanism’s staking rewards, the debate behind deciding whether the rewards should be classified as taxable income when received versus when sold can also be framed as either applying existing tax code, word for word, to what many consider a new asset category, or eventually changing the code to reflect new economic models supported by some industry actors. This issue, which might seem minor, has recently become the subject of a lawsuit that one validator brought against the IRS, arguing that staking rewards should be taxed at the time they are sold, rather than created as the IRS has argued. Although just one specific court case with limited implications to other taxpayers, it is illustrative of the frustration felt by some market participants. In early October 2022, the case in question was dismissed by the court. Much like the Department of Justice several months earlier, the court found that Jerret presented no case or controversy, as it was moot. The reason for this is that the case had no issue that remained unsettled because the IRS had issued a full refund, including the interest, as was initially requested by the taxpayers. Ultimately this ongoing debate and conversation highlights the following: under strict application of existing tax rules, staking rewards are taxable when received, but should that be the case? Practically speaking, following the dismissal of the Jerret case, the immediate consequence is that taxpayers should assume that staking income is taxed as income at the time of receipt, unless explicitly excluded by the IRS in future tax guidance. That said, this Article argues that having legal clarity is important and that regulation by enforcement is less equitable. Additionally, this Article argues that proper lawmaking is especially needed in this PoS-based staking situation, given the importance of incentivizing persons to use PoS mechanisms due to environmental considerations, and the implications of financial regulation’s nudges on the behavior of persons and the promotion of ESG-based goals. Indeed, this clarity is needed because current legal ad hoc structures do not have the capacity to keep pace with the negative impact on the environment and the energy consumption issues that the crypto sector causes and also prompted the Ethereum merge. It is clear, therefore, that we need additional behavioral incentives for the law to rely on to support and facilitate the objectives of greener environment goals’ promotion.

Keywords: ESG, Environment, Regulation, Incentives, Crypto, Lawmakers, Taxation