Novel Lawsuit Introduced Towards IRS Regarding Tax Implications of Staking

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According to the Coinbase website, “staking” is “the process of actively participating in transaction validation (similar to mining) on a proof-of-stake (PoS) blockchain. On these blockchains, anyone with a minimum-required balance of a specific cryptocurrency can validate transactions and earn Staking rewards.” On May 26, 2021, a Tennessee couple sued the IRS seeking a refund for taxes they paid on Tezos tokens that they earned through staking. As explained in their complaint:

The Tezos public blockchain is built via a “proof-of-stake” process, whereby persons can employ their Tezos tokens and computing power to validate transactions that use Tezos tokens. This process creates new “blocks” on the Tezos public blockchain, and as part of the creation of a new block, the participants each create new Tezos tokens. If no such persons utilize their computing power and tokens to validate transactions, no new blocks or new Tezos tokens would be created.

The complaint further alleges the following facts: In 2019 Mr. Jarrett engaged in a staking enterprise, whereby he employed his tokens and his computing power to contribute to the creation of new blocks on the Tezos public blockchain and which resulted in his creation of 8,876 new Tezos tokens. The new Tezos tokens that Mr. Jarrett created in 2019 can be sold or exchanged for other cryptocurrencies, fiat currency, or for goods or services. However, during 2019, Mr. Jarrett did not sell or exchange any of the 8,876 new Tezos tokens created through his staking enterprise. He kept all of these newly created Tezos tokens in his digital wallet throughout 2019. Nevertheless, when they filed their 2019 tax returns, the Jarretts reported as “other income” the amount from the creation of the new tokens.

The Jarretts analogized the staking activity to that of a baker:

The federal income tax law does not permit the taxation of tokens created through a staking enterprise. Like a baker who bakes a cake using ingredients and an oven, or a writer who writes a book using Microsoft Word and a computer, Mr. Jarrett created property. Like the baker or the writer, Mr. Jarrett will realize taxable income when he first sells or exchanges the new property he created, but the federal income tax law does not permit the taxation of the Jarretts simply because Mr. Jarrett created new property.

The Jarretts maintain that new property—property not received as payment or compensation from another person but created by the taxpayer—is not and has never been income under U.S. federal tax law. They thus seek a refund for taxes paid on the tokens generated by the staking activity

This is a novel suit because, while we have reported about the aggressive actions being taken by the IRS with respect to cryptocurrency, and the IRS has issued certain guidance in this space, it has not issued guidance for staking. The issue is significant as more and more blockchains are moving to proof-of-stake systems.