Tax implications for the conversion of Eth1 to Eth2

Ethereum just completed its long awaited update. Code named Serenity, Ethereum 2.0 is a total overhaul of the world’s second largest blockchain. Along with significant speed and scalability improvements, the underlying transaction processing algorithm now operates in a completely different way. While all these upgrades certainly are exciting, the changes have some important tax implications. Keep reading to learn everything you need to know to get ready for tax time.

What is Ethereum?

Ethereum has some similarities to Bitcoin. Its native cryptocurrency Ether can be used as a store of value. As is the case with Bitcoin, all Ether transactions are stored on a publicly accessible, distributed blockchain. It’s the second largest cryptocurrency in the world in terms of market capitalization. One Ether is now worth about $1400 USD.

However, cryptocurrency is just one use case of Ethereum. Ethereum is sometimes called a “world computer” because it runs a programming language called Solidity. One of the most exciting things about Solidity is that it can be used to create smart contracts– cryptographically secure computer programs that trigger when certain verifiable conditions are met. Ethereum programmers have been using this feature to create all kinds of innovative dApps (distributed applications) since the blockchain debuted in 2015.

A short history of Ethereum

Ethereum was created by Canadian-Russian computer programmer Vitalik Buterin. Buterin took an interest in Bitcoin shortly after its release in 2009 and began to analyze it from a computer engineering perspective. He noticed that Bitcoin creator Satoshi Nakomoto had placed many restrictions on Bitcoin’s scripting system. Nakamoto felt that these limitations were necessary for security reasons, but Buterin disagreed.

Buterin’s blueprint for a blockchain that could do more than just function as a store of value quickly gained attention from investors, who poured a total of $18 million into the project. Ethereum went live in 2015, and the rest is history. After Bitcoin, Ethereum is the most popular cryptocurrency in the world. Its corporate sponsors include Microsoft, Cornell University, JP Morgan Bank and many others.

A new way of incentivizing transaction processors

Like all cryptocurrencies, Ethereum uses financial incentives to motivate people to help run its distributed network. Ethereum’s transaction processors, called nodes, are the backbone of the system. They compete for the opportunity to write a new block into the blockchain. Whichever node wins the race receives a financial reward.

In the original version of Ethereum, computing power was used to determine the winner of the competition to insert the next block. The rules of this competition are dramatically different in Ethereum 2.0. Computing power is no longer a factor. Instead, the size and age of one’s stake now determines the likelihood of receiving a reward. The more Ethereum the transaction processors buy and the longer they hold onto their positions, the better their odds of winning become.

Ethereum 2.0 tax implications

Eth2 is so radically different from Eth1 that it’s almost like an entirely new cryptocurrency. Fortunately, all the heavy lifting involved in the upgrade is happening behind the scenes. If you own Ether, you don’t have to complete any manual steps on your side. In other words, your Ethereum 1.0 Ether will automatically become Ethereum 2.0 Ether and your cost basis will carry over without resetting.

However, if you decide to become an Ethereum staker, then you will have to pay taxes on any staking rewards that you receive. The main unanswered question about this is: when will that taxation occur?

The most conservative approach would be to add your staking rewards to your annual ordinary income as soon as your ETH rewards land in your wallet. This method seems to make the most sense, since this is how the IRS has specified that airdrops should be treated according to Rev. Rul. 2019-24. A more aggressive tactic would be to wait until you sell your rewards to record your staking income. Crops, mined minerals and other similar assets are treated this way.

Need Ethereum 2.0 tax advice?

Contact Founder’s CPA and set up a free consultation today. Our CPAs are experts in the area of cryptocurrency, especially when it comes to meeting the needs of small businesses and entrepreneurs.

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Crypto

Post by Curt Mastio
Feb 18, 2021 3:51:40 PM

Curt Mastio started Founder’s CPA in 2017 and currently serves as the Managing Partner of the firm. After obtaining both his Bachelor’s and Master’s degrees in accounting from the University of Illinois in Urbana-Champaign Curt started his career in Big Four public accounting. Shortly thereafter Curt served as the Chief Financial Officer of Storage Squad began his stint as an Adjunct Instructor at Northwestern University’s Farley Center for Entrepreneurship and has been teaching Accounting & Finance to undergraduate students for 6+ years. In his current role Curt oversees strategy, operations, and business development at Founder’s CPA. Further, Curt has experience working directly with 200+ startups and small businesses providing accounting, tax, and outsourced CFO services. His industry expertise lies in the SaaS, Blockchain, Marketplace, and Fintech industries. He has served as a key advisor working directly with startups that range from pre-revenue to companies generating over $30 million dollars a year in revenue. Lastly, he serves a key role working directly with the firm’s clients that have collectively raised over $200 million in venture capital funding to date. Curt is also an active advisor, mentor, and investor in the startup ecosystem. He has facilitated numerous workshops, webinars, and presentations to incubators and other startup-centric organizations. He is also an active mentor for Techstars in both Chicago and Iowa. Outside of his daily professional duties Curt is actively involved with Beat the Streets Chicago and was a founding member of its Young Professionals Board. His efforts in both leadership and community involvement were recognized when he was awarded the Illinois CPA Society’s Outstanding Young Professional Leadership Award in 2020. He was also a panelist at their annual conference in 2022 where he spoke about his experiences starting and operating a public accounting firm. He maintains an active Certified Public Accountant designation that he obtained in 2014. Outside of work, Curt can be found spending time with his friends & family including his dog Rufus. His hobbies include golf, boating, cooking, reading, and attending sporting events & concerts.