Jarrett Case and Staking Taxation Redux

With the recent resurgence of cryptocurrencies as investment vehicles, the spotlight turns again to the taxation of cryptocurrencies and their derivative applications. In addition, there is a “new sheriff in town” who is likely to be more amenable to reduced restrictions and regulations on investing in “tokens,” making them more appealing to a greater cross-section of the investing public.

One of the more important cases in recent years has been the Jarrett case, which involved the question of whether “staking” rewards are immediately taxable upon receipt or whether taxation can be deferred until the tokens are disposed of. Briefly, staking rewards are received by owners of certain tokens who agree to participate in validating the blockchain by temporarily restricting their token use and also participating in certain blockchain validating activities. This activity is rewarded by the creation of new tokens which are awarded to the participants in the staking activity.

The basic question for taxation is whether this new token creation is akin to being paid for a service and therefore taxable upon receipt, or similar to the birth of farm animals which are not taxable until they are sold. This is an oversimplification and there are deep and complex fundamental tax issues involved in leaning toward each position. A good source for understanding the technical aspects both of staking itself and the taxation thereof is the Proof of Staking Alliance website.

Mr. Jarrett owned Tezos tokens and bought computer equipment and software that allowed him to do the staking of those tokens himself, as opposed to granting their control to others to do the staking for him (this would be referred to as delegating their staked tokens to a validator). He initially paid the tax on his 2019-year return based on the awards created and given to him, but then filed a refund claim for erroneously including them in taxable income. The IRS ignored his claim for refund and, eventually, he sued them. The amount of the claim was relatively small, about $3,300. Ultimately, the IRS simply granted him the refund. But he sued anyway for resolution to the fundamental issue of whether staking awards are taxable or not. After some countersuits and appeals, the issue was held to be moot as he was refunded his money.

Meanwhile, the IRS issued Rev. Rul. 2023-14 in July 2023 and summarily, and without much technical discussion, ruled that staking awards received by cash basis taxpayers were taxable once “dominion and control” passed to the recipient. Taxable income is measured based upon the fair market value on that date.

Well, Mr. Jarrett is back; he filed suit in October 2024 in U.S. District Court. His original case was never adjudicated on the merits of the issues as his standing for adjudication was rendered moot by having been refunded his tax. But as forewarned in the pleadings up to the release of his case, the issue is still relevant. Mr. Jarrett continued his staking activities and in 2020 realized about $32,000 in value from the creation of new Tezos tokens and paid about $12,000 in tax. Once again, he filed a refund claim to have the $12,000 refunded using the same arguments he previously made. He argued: These tokens were created by him; the creation of new tokens dilutes the value of existing tokens so they are akin to a stock split; there was no party who paid him these tokens as they were created by the decentralized protocol/blockchain; and there should be no taxable event until sold. The case also asks for final adjudication of the issue, so he doesn’t have to keep filing suit every year.

It will be interesting to see how this plays out in light of the incoming administration being more understanding of cryptocurrency issues, a change in both IRS and SEC leadership, and the recent Loper Bright Supreme Court decision that limited the powers of federal agencies to promulgate regulations where the law is ambiguous. The IRS has to take further steps to engage with commentators; show that their interpretation of the statute is not only a “reasonable” reading but the “best” reading; and ultimately defer to the Court system when challenged. Many areas of the law are old and written before recent technological advancements. Agencies have had the discretion to analogize current technological nuances to decades-old laws that might not fit well with new technologies arising out of the internet, blockchain, telecommunications, new media channels and the like.

We live in interesting and changing times. The law must adapt to these changes but only Congress can change the law.