A Precedent-Setting Crypto Tax Case Is Brewing Around Whether Staked Crypto Is Income or Property

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The final resolution of this case will likely have far-reaching implications, affecting billions of dollars in potential tax revenue.

Key points

  • Last May, a couple sued the IRS to refund them the equivalent of $3,293 in crypto that was produced as 8,876 Tezos tokens while operating a proof-of-stake (PoS) protocol to validate Tezos blockchain transactions.
  • The complaint asserted that those Tezos tokens were "taxpayer-created property" like the bread a baker makes or the book a writer publishes -- which do not produce taxable income until sold.
  • The Tezos was never sold, so the IRS agreed to settle, but didn't make assurances against future taxation of the same unsold, staked crypto.
  • The couple has rejected the refund and plans to advance the case, potentially creating a precedent that benefits all crypto investors who run a PoS protocol or stake crypto on the side.

Last May, a couple from Nashville filed a civil lawsuit against the IRS seeking a refund of $3,293 that they allege they overpaid to the IRS. That was the estimated dollar value of 8,876 Tezos tokens that Joshua and Jessica Jarrett produced running a proof-of-stake (PoS) protocol. PoS is an increasingly popular way to verify blockchain transactions, where owners who hold a certain number of those blockchain tokens can validate on-chain trades and be rewarded more tokens.

The other way to confirm trades is using massive electricity and computing power to generate the singular answer to a complex transaction code to "mine" a cryptocurrency. This is called proof-of-work (PoW) and it's how Bitcoin, Ethereum, Dogecoin, and others run their blockchains.

It's important to note that none of the token rewards owned by the Jarretts had been sold, exchanged, or disposed of for funds or anything of value. The rewards came exclusively by the couple operating a PoS computer rig.

The suit claims staked, unsold crypto is property not income

The couple astutely argued in the legal filing that PoS-derived funds are not earned through any exchange, sale, or transaction but are rather taxpayer-created property that should not be taxed until those assets are sold or disposed of in some manner or form. The complaint further stated that there is no current provision in U.S. tax code or IRS rules and regulations that requires taxpayer-created property to be taxed as income

In a surprising move, the IRS issued the full refund as well as statutory interest. This preliminary decision is a major symbolic step forward in the nascent staking industry’s fight to have staking rewards classed as property rather than taxable income.

The proof-of-stake consensus method is growing like gangbusters

According to the most recent report on staking from DeFi tracking firm, Staked, the total amount of PoS crypto assets as of December 2021 was $728 billion, marking a 571% increase compared to the year before. Those assets realized an annualized yield of 14% on average with total "unsold" values of $15 billion -- those are significant funds at stake, both figuratively and literally.

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Because those stakes are so high, the Jarretts issued a statement refusing the proposed settlement from the IRS for their initial complaint, because that victory would only apply to their 2019 taxes. The IRS did not promise that future PoS gains would not be taxed -- and that's what the Jarretts want, long-term tax protection for their taxpayer-created property.

The impact of this case could impact millions of crypto stakers

The Proof of Stake Alliance (POSA), a leading blockchain industry association, issued a statement yesterday in support of the Jarrett's decision to decline the IRS refund to settle the suit.

"POSA, and the broad coalition it represents, applauds Jarrett's decision to continue his lawsuit. He has rejected the IRS's offer of a refund, opening up the possibility of a court ruling that will give him, and millions of other taxpayers in the same position, the ability to confidently plan for the future. The importance of this issue has been raised by many, including Coin Center, the Blockchain Association, and several Members of Congress," the POSA statement read.

Depending on how this case is finally settled, it is likely to have far-reaching consequences for cryptocurrency holders, individuals who stake a portion of their holdings, and PoS whales who use that option as a primary method of asset utilization. As with so much else within the cryptocurrency space lately -- we'll have to wait and see how this unfolds.

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