A while back we wrote about the Jarrett v. USA case and how it will affect the taxation of staking income.
The Jarrett Case’s Importance for Staking
On December 20, 2021 the IRS offered the Jarretts a full refund of their taxes paid. The cryptoverse exploded with people somehow thinking this meant that staking income was no longer taxable.
It doesn’t. Not even close.
This was a settlement offer from the IRS. And settlements do not set precedent. Had the Jarretts accepted the offer – which they did not – it would have only meant they did not owe tax on their staking income for that particular year. That’s it. As it stands now, the Jarretts rejected the offer and the case is continuing in federal court – with the IRS most recently filing a motion to dismiss on the grounds that the matter is settled since the Jarretts were offered the refund they requested.
What received decidedly less fanfare was the IRS’s response to the Jarrett’s complaint. This was filed on August 27, 2021 and only a few publications have even mentioned it.
There are two striking things in the IRS’s responses. The first one is not surprising but the second one very much is:
- The IRS denies that the staking of PoS tokens constitutes the creation of a new asset
- The IRS denies that all cryptocurrency is considered property
Let’s separate these so we can discuss them in more detail.
IRS: Staking Does Not Equal Creation
This stance is completely expected on the IRS’s part, although looking at their specific responses gives us a little more insight into how they are likely to argue the case.
The IRS admits that Tezos tokens are a virtual currency (Paragraph 16), but denies anything that alleges that the Tezos staking is the creation of a new asset:
- In Paragraph 17, the IRS makes sure to note that Tezos uses a delegated proof-of-stake protocol
- In Paragraph 22, the IRS denies that Mr. Jarrett himself created the new Tezos tokens
- In Paragraph 24, the IRS even denies that the Tezos tokens were newly created
This paints a clear picture for how the IRS views (at least this form of) PoS staking: as a passive activity where tokens are being distributed as a reward for holding the asset. This is very similar to dividends being received for holding traditional securities. Paragraph 24 especially is interesting: the IRS even denies the notion that a new asset is being created at all – not simply that delegating is a passive activity.
Cryptocurrency Is Not Always an Asset
This was the real surprise in the IRS’s response that should have been all over the news. In Notice 2014-21, the IRS stated that “for federal tax purposes, virtual currency is treated as property.”
In Paragraph 30 of their complaint, the Jarretts essentially quoted this IRS guidance stating that “virtual currency is property for purposes of U.S. federal tax law.”
So this was not an area that was expected to be under dispute. But the IRS responded that “the United States denies that virtual currency is in all instances property for the purpose of U.S. tax law.”
This is not the first time that the US government has indicated that cryptocurrency could be something other than property. The SEC’s lawsuit against Ripple alleges that the company conducted a $1.3 billion unregistered securities offering. In that lawsuit, the SEC and Ripple’s attorneys have gone back and forth over that categorization – especially given that then SEC director William Hinman stated in 2018 that Ethereum was not a security. But the fact remains that the US government is now trying to claim the opposite.
But the IRS contradicting itself – or at the very least opening the door to the fact that some cryptocurrencies may not be considered property – is huge. Importantly, in their response the IRS denies that “virtual currency is in all instances property for the purpose of U.S. tax law.”
This is something crypto investors are going to need to watch closely. These cases will not only help determine where crypto regulation eventually ends up, but also where the government is going to try to take them. Investors need to keep a close watch on these updates and plan accordingly with their CPA to have the most tax-efficient crypto portfolio possible.
Any accounting, business, or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
