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Crypto Clarity on the Horizon? Taxpayer Rejects Complete Government Concession for Issue Clarity

By Jeffrey M. Glassman on February 16, 2022
It is not every day that the IRS agrees to pay a refund and the taxpayer declines. In Jarrett v. United States, No. 3:21-cv-00419 (M.D. Tenn.), one taxpayer did just that.

At issue in Jarrett is whether the taxpayer must pay taxes on new cryptocurrency tokens he created through a staking enterprise (more on this later). Jarrett’s tokens could be sold or exchanged for other cryptocurrencies, government-backed currency (e.g., U.S. Dollars), or for goods and services. Jarrett, however, did not sell or exchange any of the tokens he created.

Jarrett’s principal argument was that he created property, which generally is not taxable. Jarrett readily admits that he will realize taxable income when he first sells or exchanges his new property.

Interestingly, the lawsuit seeks a refund of a relatively modest sum of money (under $4,000). Apparently more important than the money at issue is the hope that a federal court will provide clarity to the taxpayer—and likely to similarly-situated taxpayers as well—of a tremendously important, and murky, issue in the realm of cryptocurrency taxation.

To best understand what is at issue in Jarrett, below is some background on some of the relevant cryptocurrency concepts.

When one first thinks of cryptocurrency, they often think of Bitcoin—the most well-recognized cryptocurrency. The key component that makes cryptocurrency a viable store of value is the blockchain, a public, distributed ledger of a particular cryptocurrency’s transactions. Each block of the blockchain contains records of the previous block, a timestamp, and transaction data. To ensure reliable and accurate blockchains, particular blockchains rely on consensus methods for validating the status of the blockchain ledger (e.g., past transactions and new blocks).

Bitcoin transactions are verified through a consensus method known as “proof-of-work.” The proof-of-work system relies on “miners” to use immense amounts of computing power—and energy—to solve mathematical puzzles. If the puzzles are solved, prior transactions on the blockchain are verified and new blocks on the blockchain are created. When a new block is added to the blockchain, the miner is rewarded with 6.25 bitcoins. The IRS has already ruled that receipt of a mining reward is a taxable event, typically recognized as ordinary income to the miner, but the IRS appears to have analyzed the issue only through the lens of a proof-of-work method. See IRS Notice 2014-21.

Another consensus method for verifying cryptocurrency transactions and adding to the blockchain is known as “proof-of-stake.” This method applies to certain “altcoins”—i.e., cryptocurrencies other than Bitcoin—including Tezos, which is the cryptocurrency at issue in Jarrett. This method is much more energy efficient, as it requires far less computing power than “proof-of-work.” As the method’s name implies, this method relies largely on current holders of a particular cryptocurrency to offer their coins as collateral, i.e., to “stake.” This is what is typically known as a “staking pool,” which generally acts as an escrow account to serve as collateral for validating further blocks and transactions. Unlike proof-of-work, where anyone can validate transactions on the blockchain, in a proof-of-stake system only those who stake a particular number of coins are allowed to validate transactions. When someone engages in a staking enterprise and validates transactions, the particular cryptocurrency rewards the validator, generally, with tokens—which can be used for a variety of purposes including purchasing cryptocurrency.

Staking ultimately serves a similar function to mining—validating the blockchain—but the process of validation is radically different. For example, under the proof-of-stake method, if transactions under a new blockchain are determined to be invalid, a user can have a certain amount of his or her stake “slashed” by the network, losing an amount of the stake forever, sometimes along with the opportunity to participate in the system. This is meant to discourage a stakeholder’s misbehavior by attempting to break the rules of the blockchain. In essence, the proof-of-stake concept verifies the blockchain by “trusting, but verifying” the stakeholders with the highest collateral, rather than through working computations, as in a proof-of-work concept.

Whether creation and receipt of tokens is a taxable event under the proof-of-stake concept remains unclear. As with the case of much of cryptocurrency taxation, the landscape continues to evolve. The fact that the IRS offered a complete refund to the taxpayer could shed light on how the IRS views the issue. Or it could be a litigation tactic that may eventually render the lawsuit moot while the IRS develops guidance. Regardless, that in itself could be a sign that the IRS views proof-of-stake tokens differently.

For questions regarding this article or any civil or criminal tax matter, please feel free to contact Jeffrey M. Glassman at 214-749-2417 or jglassman@meadowscollier.com.