The Issue Of Crypto Taxation

There may be good news ahead for those looking to earn new tokens by providing security to major blockchains that operate using proof-of-stake. 

Joshua and Jessica Jarrett on Dec. 20 received a letter from the Department of Justice saying that the Internal Revenue Service (IRS) had approved a full refund of their 2019 taxes against the tokens they earned through staking in the Tezos network, plus statutory interest. This is all according to a packet from the Proof of Stake Alliance (POSA) on the case attained by The Defiant.

The resolution marks an important milestone for the nascent staking industry’s fight to have staking rewards classified as property and not taxable income. The industry has reached an estimated $18B in size, according to Staked, a major provider of staking services.

So, why is this a big deal?

One of the biggest reasons taxes in the US are something to concern yourself about, even if you don’t live there, is that any crypto taxation clarity will be a guidepost for other nations of the world looking to use the US as an example. U

ntil now, crypto in the US has existed in a liminal legal and taxation grey zone. For those that are unfamiliar, the IRS views cryptocurrency as property, a capital asset. There are two methods of taxation, capital gains tax and income tax. When you sell, trade, or dispose of a capital asset you incur capital gains tax. When you receive crypto through staking rewards, mining, airdrops, the IRS views that as income and it’s subject to income tax, just like interest you earn on fiat in a traditional bank. You owe income tax on it whether you sell or not.

This is what is in question, taxing something that has not been sold or traded, only created.

Hence, the question of whether or not staking rewards are taxable. Let’s explore this some more before talking about the IRS’ decision.

Gross Income

In Notice 2014-21, the IRS said, “A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency measured in U.S. dollars, as of the date that the virtual currency was received.” Supporters of the Jarretts argue that cryptocurrency earned via staking is not the same and should not be taxed until it is sold or traded.

“Proof of stake tokens will only increase in popularity in the coming years as web3 becomes mainstream, and the IRS must signal that it’s prepared for  innovations in the space,” Evan Weiss, founder of the POSA, said in an attached statement. “Today we continue to urge the department to put forth an advisory that makes it clear that staking rewards will only be taxed when sold. We cannot risk making the US a second-rate market for staking.”

Despite the initial victory, on Jan. 25, the Jarretts’ attorney rejected the IRS’s offer of a tax refund on the grounds that the agency provided no guarantee against such taxation in the future.

Litigation

“The IRS will also apparently not provide any assurances with respect to the sole issue that gave rise to this litigation – whether tokens created through staking a particular cryptocurrency constitute taxable income at the time of their creation,” said David Forst, an attorney at Fenwick & West, LLP, wrote in the letter to the U.S. Department of Justice (DOJ). “As the question will arise for the Jarretts again in subsequent tax years, they would remain at risk even if they accepted the proffered refund.” 

In other words, the Jarretts won the first round of their case (Jarrett et al v. United States of America) currently before Tennessee Middle District Court, first filed in May 2021, but that victory would only be good for their 2019 taxes. They want to continue the matter in courts, to attain ongoing protection. This could set precedent for everyone hoping to to earn income from staking cryptocurrencies.

“Until the case receives an official ruling from a court, there will be nothing to prevent the IRS from challenging me again on this issue. I need a better answer. So I refused the government’s offer to pay me a refund,” Joshua Jarrett explained in a statement attached with the letters from his attorney and the Department of Justice.

Skin in the Game

Cryptocurrencies are staked — that is, locked up under some set of conditions, usually to earn some kind of emission of additional tokens — for a variety of reasons, but the most common reason is to serve as a validator in the proof-of-stake (PoS) network. In such networks, validators put tokens at risk, as skin in the game on the network. In a proof-of-work network, it’s capital and operational expenses (machines and electricity) that serve that role. Both are measures to insure against spamming and malicious behaviors by the distributed set of people verifying transactions on the network.

In 2014, the IRS ruled that cryptocurrencies are property. The many forms that cryptocurrency is created and distributed has evolved greatly since then, and the agency has provided little guidance to reflect this swiftly changing environment. The core question here is: Does the receipt of new tokens in a staking network count as income, or does it only become income once the tokens are sold? 

Tezos is a PoS blockchain that was launched in June 2018, created by Arthur and Kathleen Breitman, with a focus on upgradeability. Its coin is XTZ, which traded for $3.75 on Wednesday afternoon, New York time, with a $3.3B market cap, making it the 39th largest cryptocurrency on CoinMarketCap. 

“Staking is how Tezos maintenance remains decentralized, and maintaining this decentralization is the most critical part of network maintenance. New blocks, and new tokens, must be created by a number of different people, or else Tezos wouldn’t work as a public cryptocurrency,” Abraham Sutherland, an attorney for the Jarretts and a legal advisor to POSA, wrote in a brief in support of their case against the United States.

Property vs. Income

POSA said paying taxes on newly created tokens would be akin to a baker paying taxes on freshly-made bread when it’s out of the oven, instead of when it’s sold. 

“Tax is paid when such property is sold or exchanged, but not when it is created,” the organization said in a statement. “The same can be said of staking rewards. Newly created tokens are property, not income. They should be taxed accordingly.”

POSA is an organization dedicated to advancing the technology, both through fostering collaboration in the industry and seeking regulatory clarity. Weiss, the founder, is part of the business development team at Coinbase, following its acquisition of Bison Trails in Jan. 2021. Other members of its board come from the Tezos, Polkadot and Avalanche communities, each of which run PoS blockchains. POSA launched in 2019.

It also has the support of organizations backing other PoS blockchains such as Cosmos, Harmony, Near, Solana, and others. 

Taxpayers at a Disadvantage

In an August 2020 article in Tax Notes from Mattia Landoni of the Federal Reserve Bank of Boston and Sutherland of the University of Virginia School of Law, write that the way PoS networks continuously dilute their tokens puts taxpayers at a disadvantage if they are taxed at the  moment of the tokens’ creation. 

“To participate in network maintenance and obtain block rewards, one must suffer dilution as well,” the article said. “If block rewards are taxed as realized income, without a way to quantify the effect of dilution, cryptocurrency owners are likely to suffer from overtaxation.”

“The IRS doesn’t just lay down in court, especially in cases that could affect millions of taxpayers on a very basic point of law. It means they’ve got a losing argument,” Alison Mangiero, acting executive director of POSA said in the press release. “For the sake of fair tax administration, and American innovation, I hope the IRS follows this up quickly with clear guidance that staking rewards aren’t taxable income.” 

Tax Free Crypto?

In a win for cryptocurrency stakers and miners, the IRS has offered to refund the couple taxes paid on rewards gained — but not redeemed — from staking on the Tezos blockchain, according to people familiar with the matter.

Official court filings were made public on Thursday, indicating that a bench trial is set for March 2023, unless the case is settled following the conclusion of the discovery process in mid-March of this year. 

In May 2021, Joshua and Jessica Jarrett requested a refund of $3,293 of income tax paid in 2019 for the receipt of 8,876 Tezos tokens, according to a legal complaint filed on May 26, 2021, with the US District Court for the Middle District of Tennessee. The couple also sought a $500 increase in tax credits for lost income. 

Tokens attained through proof-of-stake protocols are taxpayer-created property and should not be taxed until sold or exchanged, the Jarretts argued. The complaint claims that nothing under United States law or IRS code and regulations allows for taxpayer-created property to be taxed as income. 

The decision to offer a refund — which was rejected by the plaintiffs — has potentially large implications for how proof-of-stake miners and stakers are taxed in the future. 

All this being said, the IRS has not yet published any formal policy statement — which is what the Jarrets are seeking in this case — and that’s significant because an offer of a settlement is not the same as a binding precedent. 

Still, a very interesting development, and one that puts us that much closer to regulatory clarity regarding cryptocurrency.