Proof-of-Stake Blockchain: Taxable or Not?

As I filled my tank at the local gas station this weekend, I noticed a “Get Bitcoin Here” sign staring at me. I quickly realized how conventional the exchange of digital assets has become. Back in 2014, the IRS issued guidance on the tax treatment of some early forms of digital assets. Now, the disclosure of virtual currency transactions is required on all individual income tax returns. But limited guidance exists today on the tax treatment of the breadth of virtual currency transactions that have emerged.

With the introduction and growing popularity of new types of virtual currency (from Bitcoin to Ethereum to Tezos tokens, for example), taxpayers are eager for more direction. That’s the case with Jessica and Joshua Jarrett, who are trying to forego a tax refund in exchange for clarification on the tax treatment of staking rewards acquired in 2019. With existing tokens and a home computer, Mr. Jarrett employed a staking process to validate transactions on a proof-of-stake (PoS) blockchain that uses Tezos tokens. In the process, Mr. Jarrett created 8,876 new Tezos tokens which he maintained in his digital wallet throughout 2019.

On Form 1040 for 2019, the Jarretts reported the fair market value of the newly created Tezos tokens as income under IRC Sec. 61. Subsequently, in July of 2020, the Jarretts filed an amended return claiming a refund of $3,793 on the basis that the created tokens were not subject to tax because they had not been exchanged so no realization event occurred.

As permitted under IRC Sec. 6531, once the government did not act on the refund claim for six months, the Jarretts filed a refund suit in District Court for the Middle District of Tennessee, Case No. 3:21-cv-00419. Therefore, we will never know if the government would have disallowed the refund claim had the taxpayers waited for the IRS to process the amended return (the coronavirus pandemic has delayed the processing of millions of amended returns filed during the same period of time). Interestingly, in the answer to the taxpayers’ complaint, the Department of Justice denied that “virtual currency is in all instances property for the purpose of U.S. tax law,” keeping taxpayers in the dark about the tax treatment of assets created through staking.

In December of 2021, the Department of Justice informed the Jarretts that the IRS authorized the issuance of the refund, which appears to render the refund suit moot and the tax treatment a non-issue for the Court. Yet the Jarretts believe they can now forego the refund to push the government for clarity on how staking rewards are treated for federal tax purposes.

In Notice 2014-21, Question 8, the IRS addressed when a taxpayer who “mines” virtual currency realizes gross income from those activities. The government stated that for taxpayers who successfully mine (for example, use computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger), the fair market value of the virtual currency is includible in gross income as of the date of receipt. Subsequently in FAQs, the IRS stated if a hard fork is followed by an airdrop and a taxpayer receives new cryptocurrency, the value would also be included in income in the year the cryptocurrency is received.

Does that same logic apply to proof of stake blockchains where the staking process continues, and taxpayers earn staking rewards or interest, until the tokens are taken out of a digital wallet? Taxpayers are now not likely to get the answer through the Jarrett suit.

Our Current Issue: Q1 2022

• IRS’s Legal Authority for Requesting Electronic Accounting Records and Software
• IRS Continues Targeting of Micro-Captive Insurance Companies
• Failed to Disclose Foreign Income/Assets? Streamlined Filing Procedures May Be the Answer.
• Proof-of-Stake Blockchain: Taxable or Not?