ETHDenver 2023 was an emporium of blush-colored unicorns, glossy stickers of every variety, and excitable crypto heads decked out in badges and beanies. There was also a surprising amount of “yeehaw” references - I’m talking about saloon-themed restaurants, corral-style corridors and a faint smell of dog food that surrounded the entire complex. It was a bizarre mix of the ultra-tech and livestock, a juxtaposition of cypherpunk ethics and slow internet. Hash Basis LLP took on ETHDenver for the first time and made a splash with our newly branded business cards, stickers, and a presentation about crypto tax and accounting on the DeFi stage. We had an absolute blast meeting the community and look forward to all the future conferences.💥

Mackenzie, CEO and Founding Partner of Hash Basis, gave the following presentation about tax & accounting implications related to the most common activity on Ethereum. She dove into liquidity providing, wrapping tokens, liquid staking and more. For a more in-depth write up of the content, keep reading!

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How to Tame & Untangle your Crypto Tax & Accounting Activity on Ethereum

‍101 of Crypto Tax and Accounting

Before we dive into the complexities of bridging AXLUSDC to Ethereum or lending Aave, it’s important to understand the first principle of crypto tax: under the IRC (Internal Revenue Code), crypto is treated as property. Digital asset tax treatment is akin to physical real estate, even though crypto exists purely as bits in a server. Under property rules, any income derived is characterized as either ordinary (taxed at normal bracket rates) or capital (taxed at preferential rates). On the crypto side, the following events are either taxable or nontaxable:

‍* Note: bold denotes activities that trigger ordinary income. Non-bold triggers capital gains/losses.

Taxable events: 

• Sending & selling crypto 
• Trading/swapping/exchanging crypto 
• Mining & staking income 
• Airdrops and forks

Nontaxable events: 

• Buying crypto through an exchange with fiat
• Donating (only advantageous to the taxpayer if you itemize deductions)
• Internal transfers (think of a transfer of fiat between two bank accounts that you own)
• Gifting (up to $17k per person for 2023)

Tracking the cost basis (the price that you paid to originally acquire a unit of crypto) is key to getting your crypto taxes correct. Pulling in the correct pricing could be the difference between owing a big liability for the year or getting a refund. Another important concept is the holding period, which is the length of time you’ve held on to your crypto. If you’ve held your crypto for > 1 year and then decide to swap it, you’re eligible for the preferential capital gains rates (0%,15%,20%) instead of being stuck with the ordinary rates, which can creep as high as 37% in the US.

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                                                                                                                                               _{Source: Forbes}

On the US GAAP accounting side, digital assets are generally treated as intangible assets. Under US GAAP, this classification is defined as “assets (not including financial assets) that lack physical substance.” Common intangible assets include intellectual property, trademarks, films and goodwill. On the surface, lumping digital assets in with intangibles makes sense (I can’t physically touch my ETH), but there is one major drawback of this treatment. Intangibles are subject to impairment tests, which means you have to constantly write down your intangibles to the lowest price point since you acquired them. The basic journal entry for digital asset impairment is:

Debit Impairment Expense

          Credit Digital Assets

This treatment decimates the income statement of US companies that hold crypto on their balance sheet, particularly during bear markets. Even if the markets recover and prices soar, the cost of your digital assets on your balance sheet cannot be written back up. The FASB is in the process of creating a new standard that addresses crypto directly, and it’s likely that fair value treatment (AKA no impairment) will be applied to common digital assets like Bitcoin and Ethereum (read the FASB Exposure Draft here). However, other digital assets, such as NFTs and wrapped tokens, are excluded and their treatment remains a giant ⁉️. 

Decoding Ethereum Activity

Now that we’ve set a mental framework, let’s get into the most common activities on Ethereum and break down the tax & accounting components of each.

Level 1 Activity: Simple Sends & Receives of Crypto

‍On the tax side, wrapping and bridging crypto doesn’t have an official treatment. As the taxpayer, you can choose a more aggressive position (i.e. wrapping is an internal transfer) and not report the associated capital gain/loss. On the flipside, the taxpayer can choose the more conservative route (more defensible during an audit) and report the gain/loss attached to the trade from one token into its bridged version.

Level 2: DEX’s

For me, DEX’s are a magical part of crypto and DeFi in general. I can connect my Metamask, put some tokens into a virtual sushi-branded vending machine, and receive a totally new token in a matter of minutes (+ $300 for gas fees). DEX’s like Uniswap or Sushiswap heated up the DeFi summer of 2020 and catapulted crypto into the semi-mainstream. From a tax and accounting perspective, swapping tokens is straightforward: fair market value of tokens acquired - (cost basis of tokens disposed) = capital gain or loss. Swapping on a DEX or any other exchange is going to result in a gain or loss - whether it’s short term (ordinary rates) or long term (preferential rates) depends on the holding period. The basic journal entry behind a swap is:

Debit Digital Assets —> current value of asset acquired

            Credit Digital Assets → cost basis of asset disposed

            Debit/Credit Gain or Loss

It wouldn’t be a lesson on DEXs if we didn’t mention gas fees. For both tax & accounting, the fair value of the gas fee incurred can be added to the fair value of the asset acquired, so the new cost basis is the sum of the two. In general, a higher cost basis is preferred since when it comes time to sell, the gains will either be reduced or the losses will be magnified (tax savings!).

Level 3: Lending and Borrowing

Aave is the quintessential example of a lending and borrowing protocol. Meaning “ghost” in Finnish, it really is ethereal how anyone can access instant liquidity without going through the rigmarole of Tradfi. There are different flavors of lending & borrowing protocols, but in the case of Aave, here’s the high level token flows:

Lender

• When tokens are lent, the lender receives “atokens” back → so if a user lends 100 DAI, they receive 100 aDAI in their wallet.
• The atoken balance increases over time due to interest accruing to the lender.
• When the user closes their position, they deposit their atokens (i.e. aDAI) and receive the underlying token (i.e. DAI) back in the same ratio.

Tax implications for lending include: 

• A capital gain/loss event is triggered upon lending tokens (the dynamic between DAI and aDAI could be viewed as an exchange).
• Accrued interest is ordinary income to the lender.
• When the lender unwinds, there is also another exchange between aDAI and DAI (taxable under the conservative guidance).

Accounting Entries for Lenders:

Lending tokens and receiving atokens back

Digital Assets - aDAI       xx

           Digital Assets    xx

           Gain/Loss           xx

Receiving Interest Income

Digital Assets       xx

           Interest Income     xx

Borrower

• Collateral is deposited into the protocol.
• Borrower has instant access to the funds.
• Borrower runs the risk of liquidation if their loan health score is not within the acceptable range
• When the position is ready to pay back their loan, they send the principal back into the protocol and receive access to their collateral.

Potential tax implications for borrowers include:

• Depositing crypto as collateral is nontaxable (🎉).
• Paying interest into the protocol is a crypto send, so it is taxable (capital gains/loss).
• The interest expense could be deductible, depending on if you’re filing as a business or individual. 

Accounting Entries for Borrowers:

Depositing collateral

Collateral Receivable     xx

            Digital Assets      xx

            Gain/Loss             xx

Receiving Loan *

Digital Assets    xx

            Loan Payable        xx

*Note: if you are receiving a loan in tokens, there is likely an embedded derivative on the payable that will need to be marked to market each period. The loaned digital assets will also have impairment.

Paying Interest

Interest Expense       xx

            Digital Assets          xx

Level 4: Liquidity Providing

One of my favorite blockchain applications is Osmosis liquidity pools! Osmosis makes me feel like a mad hashing scientist, as I feverishly swap into a JUNO / ATOM pair and throw them into the pool (current APY: 6.54%). The Ethereum equivalents are Uniswap and Sushiswap, which pioneered the Automated Market Maker (AMM) model to provide users with instant liquidity. Liquidity pool activity can be broken down into the following steps:

Remember: the whole machine of liquidity pools exists so that users can swap tokens on-chain. Those who are providing the liquidity are incentivized to keep doing so since they earn rewards (i.e. fees and governance tokens) that are supposed to accrue more value over time.

There’s no standard tax treatment for your LP activity, but there a few approaches:

Conservative approach

• Entering and exiting the pool could be considered trades of the underlying pair (i.e. USDC / WETH) for LP tokens. 

• Triggers capital gains

• LP rewards are taxed as ordinary income.

Aggressive Approach

• “Containerize” the asset pair and not recognize gain/loss upon the entire position when entering and exiting a pool.

• The LP would have to track the trades happening in their pool and the relative changes in their underlying pair (so essentially recognizing mini gains & losses throughout the life of their position).

• LP rewards are still ordinary income.

Level 5: Let’s Stake!

With Ethereum’s move from Proof of Work to Proof of Stake in 2022, the demand for protocol and liquid staking has skyrocketed. 🚀About 14.93% of the total circulating supply of Ethereum is staked, and I predict this percent will only increase over time since the Shapella upgrade was a success.

When validators stake Ethereum, they send 32 ETH into the Beacon Deposit Contract. Luckily, this is treated as a non taxable event since it’s akin to an internal transfer. Validators earn rewards on a block-by-block basis, which is considered ordinary income at the fair market value at the time of receipt. The topic of taxation of protocol rewards is a divisive one (see the Josh Jarrett Tezos drama here), so it’s up to the taxpayer what approach they use. Some subledgers (such as Koinly) feature a suite of toggle options so if the taxpayer wants to defer taxes on staking rewards, they can do that easily:

The US GAAP accounting for ETH staking rewards is fascinating since until Shapella happened, the validators couldn’t withdraw rewards (or their 32 ETH principal). To account for the rewards, the journal entry looked like this:

Tokens receivable xx → at FMV at time of receipt

     Staking income xx

The receivable would then flip to liquid digital assets once the rewards are liquid.

On the liquid staking front, the treatment is (slightly) less murky. When a user deposits ETH into Lido, they receive the stETH token back. Similar to liquidity providing & lending, this action could be viewed as a taxable exchange (with gain/loss recognition).

The staker also earns liquid rewards daily in stETH, which are taxable as ordinary income (debit digital assets, credit staking income).

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Overall, it’s going to be a wild and illuminating year for crypto accountants. The FASB’s new fair value treatment of digital assets and the changes in NFT collectible taxes will certainly keep us busy (that is, until ChatGPT-4 understands complex accounting!). Until then, we’ll keep on parsing JSON files and reading docs on Chainlink staking until past midnight. ✨🧙🏻

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* BONUS: in case you missed Mackenzie's presentation earlier this year at ETHDenver 2023, you can catch the full recap here and the slide deck she used for the presentation here:

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