By Oz Halabi
Crypto transactions have become increasingly popular, not only to crypto experts, but to the public as well. With the ever-growing exchanges, wallets, liquidity providers, tokens, meme tokens, and one Elon Musk, it seems like everyone has something to do with crypto. It seems like everyone is talking about it, opining about the different tokens and their validity, mining, earning tokens through air drops, earning interest, accumulating LP units, farming, cultivating, swapping, wrapping, unwrapping, and more and more hype words.
Staking is another way crypto savvies increase their wealth. Staking tokens is a way of being rewarded for participating in the blockchain system. Users “stake” their tokens (stable or others) to help validate transactions in the blockchain; thus, minting more tokens by utilizing the virtual currency they already own.
From an economic standpoint, staking is analogous to earning interest from cash in a savings account or earning dividends from stocks owned. From a legal perspective, staking may be analogous to receiving stock dividend. If the staking pool reward welders, pro rata of their staking ratio compared to the total pool, then the rewards may be viewed as a stock split. However, digital assets are viewed differently than cash or stock for federal income tax purposes. Convertible virtual currency, according to the IRS, are treated as property for federal income tax purposes, and general tax principles applicable to property transactions apply to transactions using convertible virtual currency.
Although there is no concrete position, taken by the IRS with respect to the treatment of all of the investment alternatives in the digital asset market, or any specific tax guidance on staking transactions, the IRS issued IRS Notice 2014-21 which provides that mining of virtual currency is taxable, with respect to the new virtual currency received. Further, Revenue Ruling 2019-24 provides that an airdrop of new cryptocurrency results in taxable income if the taxpayer has dominion and control of the tokens received, at the time of the airdrop. Similarly, adopting a policy that being rewarded for staking is not considered a realization event, for which a tax liability triggered, seems to be reasonable and fair. So long as the taxpayer does not have dominion and control over the tokens so received.
Although the IRS had not published its official guidance with respect to earning rewards by staking tokens, a recent decision by the IRS to refund tax paid by a taxpayer on their staking rewards, should have shade some light on the IRS position. To mean, staking did not result a taxable income to the taxpayer. Surprisingly (to some) the taxpayer refused to receive the refund, for the mare reason that the taxpayer wanted the IRS (and the courts) to state its approach so that all taxpayers would be enjoying this approach.
In Jarrett v. United States,[1] a taxpayer filed a refund suit against the IRS for slightly over $3,000 federal income taxes paid for staking XTZ tokens during the 2019 tax year. While the new tokens could be sold or exchanged for money or other cryptocurrencies, the taxpayer did not dispose of any of them during 2019.
In seeking a refund for federal income taxes paid, the taxpayer argued that he created property and he should not be subject to tax until he sells or exchanges the new tokens (like any other person that creates an asset). The taxpayer chose the route of paying the tax first and then filing a refund claim, to make sure the IRS addresses the case, issues its opinion, try the case in court, and eventually, adopting a firm policy, given the novelty of the tax issue. The fundamental point of contention underlying the lawsuit is the classification of staking rewards as either taxable income or created property, which is not taxed until it is sold. The taxpayers argue that earning coins by staking is akin to baking a cake or writing a book, and thus these coins should not be treated as taxable income.
Recently, after many negotiations with the IRS and a court hearing scheduled for March 2023, the IRS offered the taxpayer a refund of the income taxes paid for the unsold staking rewards. This offer by the IRS signals an important shift in the way the IRS views crypto staking. However, last week, the taxpayer refused to get the refund and stated that “At first glance, this seemed like great news,” however the taxpayer believes that without a court ruling, there would be nothing to prevent the IRS from taxing his or other taxpayers staking rewards again. Taxpayer said:
“A year and a half into this process, the government didn’t want to defend the position that the tokens I created through staking were taxable income. […] I need a better answer. So I refused the government’s offer to pay me a refund.”
So, what do we have here so far? A taxpayer that claiming that staking is like baking a cake, and arguing, rightfully, that one should not be taxed on baking it, but on selling it; IRS that, perhaps, realized the taxpayer is correct, and to avoid making a public announcement agreeing to the analogy, prefers to refund the tax to the taxpayer and call it a day; a court that is asking the parties to settle outside the court; a crypto industry that shoots in the dark; an interesting case, the fundamentals of which will be an earthquake for the crypto industry; and many amended returns seeking refunds.
[1] Jarrett v. United States, No. 3:21-cv-00419 (M.D. Tenn.)
