If you aren’t familiar with blockchain technology but you’re interested in learning more, our crypto CPA can help! One popular topic that you might have heard of includes layer 1 and layer 2 networks. Before we delve into the definition of layer 2, we need to first establish what layer 1 is.
A layer 1 network refers to the base layer, or the underlying infrastructure of blockchain technology. Layer 1 technology is often referred to as the main network that outlines the essential rules of the blockchain, and it can also finalize and validate transactions. Layer 1 blockchains are decentralized and have a high focus on security.
Defining Layer 2s In Cryptocurrency
Layer 2 is a set of off-chain (separate) blockchains that are built on existing layer 1s. The purpose of layer 2s is to help eliminate bottlenecks through scaling and data. To illustrate the relationship between layer 1 and layer 2, think of layer 2s like a meal prep station in a kitchen. There are different stations for cutting, cooking, assembly, etc. This helps each task become more efficient. When the timing is ideal, the final person can assemble the dish and send it to the customer.
Simply put, layer 2 is an umbrella term that describes the solutions that are built on top of layer 1 to help make networks more scalable.
Why Are They Needed?
Layer 1 blockchains are handicapped by a lack of speed and scalability. However, the layer-2 blockchain is a solution that allows thousands of low-value transactions to be processed following validation on parallel blockchains. Despite allowing for scalability and additional output, layer 2 solutions also help to hold the integrity of the blockchain meaning that there is complete decentralization and security. It also helps to reduce the carbon footprint as less gas and less energy is used, minimizing how much carbon is used.
The fees with layer 2s are also lower compared to layer 1 transactions as they combine multiple off-chain transactions. Because layer 2s have less fees and offer a higher number of transactions per second, many users like using them.
Layer 2 Rollups
One key component of layer 2s includes rollups. This is a specific solution that executes up to hundreds of transactions outside of layer 1 and combines them (rolls them up) into one piece of compressed data. This data is then posted back to the mainnet for review or dispute if it is deemed suspicious. Rollups are designed to help tap into the security that Ethereum offers as well as reduces gas fees.
Common types of rollups include:
- Optimistic rollups
- ZK rollups
Sidechains
Another component of layer 2s includes sidechains. This is an independent EVM-compatible blockchain that runs parallel to layer 2s and uses bridges to interact with the mainnet. Even though they aren’t technically considered layer 2, it operates in the same way.
Taxability of Layer 2 Transactions
Regarding taxing layer 2 transactions, they are taxed in the same way as a layer 1 transaction. We always advise that you seek the guidance of an experienced crypto CPA to help you with your taxes so you can ensure your filings are timely and accurate.
Contact Founder’s CPA for Guidance
Our team at Founder’s CPA is on standby ready to help you navigate your cryptocurrency transactions and taxes. We offer free consultations to get started! Call us today to see how we can help.
