On Wednesday May 26, 2021, Joshua and Jessica Jarrett filed a complaint in the U.S. District Court for the Middle District of Tennessee relating to cryptocurrency token rewards created via a Proof of Stake (POS) protocol.
The complaint states that Joshua and Jessica Jarrett (the Taxpayers), intend to submit an amended income tax return for the tax year 2019 and are seeking a refund in the amount of $3,793, plus interest. The Taxpayers claim that the amount at issue is a result of overpayment of tax due to the fact that staking rewards created by Mr. Jarrett via the Tezos blockchain POS protocol were erroneously added into gross income. The complaint asserts that tokens attained through POS protocols are taxpayer created property, similar to that of an artist who has created a piece of artwork, and were not paid to Mr. Jarrett by any person defined under 26 U.S.C. section 7701(a)(1).
The complaint further states that nothing under U.S. law (including the Internal Revenue Code and related regulations, case law and the Constitution) allows the government to treat taxpayer created property as income. Thus, staking rewards should not be included into gross income until they are disposed of and a realization event takes place. In order to fully understand this argument, it is essential to understand a few fundamental elements of cryptocurrency and how staking rewards work.
What is a Proof of Stake protocol?
Cryptocurrency is a complex and evolving area of the financial market and the terminology can befuddle even the most savvy investor. There is currently limited guidance from the IRS on how to tax crypto-assets, although this is soon expected to change.
The Proof of Stake consensus algorithm is a Blockchain consensus mechanism developed to facilitate and validate transactions of cryptocurrency on certain blockchains, such as the Tezos blockchain. A blockchain is a cryptographically secured digital ledger for publically recording transactions in digital assets (e.g. Tez, Ether, Bitcoin) that are maintained jointly by numerous individual nodes connected to a network. The appeal of blockchain is that it is a decentralized trustless verification system based on cryptography, which allows it to maintain all transactions publicly and transparently with a full audit log, eliminating the need for a middleman to facilitate transactions or value exchange (i.e. banks and other financial institutions), thus reducing costs, increasing efficiency, and improving transparency of financial transactions.
As a part of the transaction validation process, virtual currency can be validated via numerous different consensus mechanisms, the most popular of which are Proof of Work (POW) and Proof of Stake. The POW validation process involves ‘miners’ who compete in the task of solving a cryptographic puzzle in order to earn the right to validate a new block in a Blockchain and receive the transaction fees and newly minted virtual currency (collectively ‘mining rewards’) in exchange for their efforts. The Treasury and the IRS published Notice 2014-21, 2014-16 IRB 938 regarding blockchain transactions and determined that mining rewards are includable in gross income.
In contrast to miners solving a cryptographic puzzle in order to validate a new block and receive mining rewards, ‘validators’ in a POS system, the equivalent of miners in a POW system, are chosen to validate a new block based on their proportional representation in a random number lottery process. The POS system has gained in popularity recently as it is more environmentally friendly than a POW system as the energy consumption is dramatically lower. Under the POS consensus mechanism, validators must have an economic stake in the underlying blockchain in order to earn the potential right to validate a new proposed block. A validator is required to place their own tokens (which need to meet a certain staking threshold in order to qualify) into a smart contract where they are held for a period of time during and after the block a validator validates (the lock-up period is subjective and variable based on the blockchain).
In the argument asserted by the Taxpayers, validators create staking rewards as a result of their participation in the POS process and do not just passively receive the rewards for services rendered from an outside source. Thus, the rewards are akin to a baker creating a loaf of bread or an artist creating a sculpture, where the source of the income stems from the labor of the individual creator and not from an external source. The reason for this assertion is the fact that the tokens did not exist before and would have not existed unless the validators created them during the validation process. Staking rewards are newly ‘minted’ or ‘forged’ coins created during the POS protocol. The argument logically follows that income would not be considered to be income under IRC section 61, which defines gross income as “income from whatever source derived” as there is no source other than the labor of the validator. Additionally, the tokens are issued via the POS algorithm, which would not be considered to be a US person under 26 U.S.C. section 7701(a)(1). Therefore, similar to property created by an artist or a baker, the IRS cannot tax the efforts of the individual creator of staking reward tokens until a realization event takes place and income is actually received (e.g. the artwork, sculpture, loaf of bread, token is sold).
As mentioned above, there is currently limited guidance on the taxation of digital currency provided by the IRS and Department of the Treasury, as digital assets are a new and rapidly evolving area. Notice 2014-21, 2014-16 IRB 938 (the Notice) only addresses virtual currency and convertible virtual currency (defined as “virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency”), and treats both as property and not as currency for federal tax purposes. Additionally, Question 8 of the Notice states that a taxpayer who mines virtual currency would need to include the fair market value of the mining rewards into gross income as of the date of receipt of such rewards. Based on the Notice, the mining rewards would likely be taxed at ordinary income rates and not at capital gains rates since miners are receiving compensation in exchange for providing a service and the rewards would likely not be seen as a capital asset in the hands of the miner. The Notice does not include specific guidance relating to POS transactions and staking rewards, because such protocols did not exist in 2014, but the IRS will likely be coming out with guidance in the future.
Taxpayers in possession of staking rewards should expect to see additional regulations and reporting requirements in the coming years. As additional guidance is formalized, it is imperative that taxpayers and those with information reporting requirements stay informed on their obligations; especially the effective dates as missed reporting requirements can be costly to remediate. Digital asset businesses with potential exposure should consult with their tax advisors.
