A number of sponsors have now amended their spot ETH ETF applications to provide for staking. Staking within a spot ETH ETF raises hairy tax issues. This article summarizes them and how they might be resolved.
Disclaimer: These are some initial thoughts on how a spot staked ETH ETF might work for tax. These are my own thoughts, and do not necessarily represent those of my firm. There also might be nontax reasons why staking could create issues for spot ETH ETFs.
GRANTOR TRUST. Like BTC ETFs, an ETH ETF needs to be a grantor trust for US tax purposes. Grantor trusts are effectively nonentities: they are so passive that they aren't subject to entity-level tax and holders are treated as owning the underlying assets directly.
To avoid misuse of grantor trusts, the tax law imposes a restriction: they can't have a "power to vary," which is "managerial power over the trusteed funds...to take advantage of variations in the market." A staked ETH ETF with power to vary would probably be taxed as a US corporation.
One way to avoid a power to vary might be to make staking nondiscretionary, subject only to reasonable reserves to fund expenses and redemptions. The trust agreement would have to be carefully drafted, but a true staking mandate should eliminate managerial power.
WITHHOLDING. US-source income generally is subject to 30% withholding. The IRS seems to believe (rightly or wrongly) that staking income is income from services provided to Ethereum users. Services income is sourced based on where the services are performed.
To eliminate the risk of US withholding tax on non-US ETF investors, a staked ETH ETF could delegate staking to a provider located offshore. That way, even if staking is a service to blockchain users, the service is performed offshore and the income is non-US source.
US TRADE OR BUSINESS. Non-US investors are subject to US income tax (and have to file US tax returns) if they derive income connected to a US trade or business (a USTB). It's not entirely clear whether staking from within the United States is a USTB.
Again, however, delegating staking to an offshore provider, and giving them discretion over how they stake, likely eliminates USTB risk. Even if their actions are imputed to the ETF, non-US investors shouldn't be treated as in a USTB, because the business is being done offshore.
UBTI. US investors that are otherwise tax-exempt (including IRAs) are nevertheless subject to US income tax on income from a business unrelated to their tax-exempt purpose (often called unrelated business taxable income, or UBTI). It's unclear whether staking is an unrelated business.
Any unrelated business giving rise to UBTI needs to be a "trade or business" within the meaning of section 162 of the tax code, which is a different standard from USTB. Under Mayer v. United States, a taxpayer isn't imputed the activities of an independent money manager for determining if they are in a section 162 trade or business. 32 Fed. Cl. 149 (1994).
Ensuring the staking provider is both legally and economically dependent from the ETF thus should mitigate UBTI risk. Incidentally, concluding "no UBTI" might be more conservative; if staking were a trade or business, US taxpayers should be able to deduct the staking-as-a-service fees instead of having to capitalize them.