The Jarretts raise the stakes

The current tax treatment of cryptocurrency as property provides no direct guidance on the taxation of staking rewards. The pending case of Jarrett v. United States, filed in the US District Court for the Middle District of Tennessee, is unlikely to provide clarity on this pressing issue.

Proof-of-stake validation, or staking, is a consensus mechanism that informs how blockchains function. Often seen as an alternative or successor to proof-of-work (ie, mining), staking allows owners of cryptocurrency to pledge (or stake) their coins and create “validator nodes” to review and validate new blocks, helping to maintain the blockchain. In return for these tasks, successful validators receive new coins known as “staking rewards.”

There is currently no direct guidance from Internal Revenue Service (IRS) on how staking rewards are taxed. Existing guidance has addressed instances where a taxpayer receives tokens as part of a split in the blockchain (eg, an airdrop) and from mining. In each of those cases, the IRS has determined that, since cryptocurrency is property for tax purposes, the coins received were ordinary income immediately where the taxpayer can dispose of the new coins at the time they are generated. Many practitioners have anticipated that staking rewards would be treated similarly, but the absence of specific guidance has emboldened some taxpayers to take the view that staking rewards are not taxable until the recipient disposes of those rewarded coins.

Two such taxpayers are Joshua and Jessica Jarrett, whose request for a refund of $3,293 of tax paid on staking rewards they earned, and the response from the IRS, has led to widespread, albeit premature and hyperbolic, claims that the IRS is “waiving the white flag” on staking rewards.^[1] While an IRS capitulation on staking rewards cannot be ruled out entirely, the discussion of the Jarretts’ case below puts the IRS’s actions in a more realistic perspective.

The Jarrett case

In 2019, Joshua Jarrett was engaging in proof-of-stake exercises on the Tezos public blockchain. As reward, Mr. Jarrett received 8,876 Tezos tokens worth roughly $9,407, which he did not sell, exchange, or otherwise dispose of in 2019.

On the Jarretts’ initial 2019 tax return, they reported $9,407 as “other income,” which reflects the views of practitioners on the treatment of staking rewards noted above.  On or around July 31, 2020, the Jarretts filed an amended tax return changing their position on the Tezos tokens, based on the position that the tokens were not income in 2019 since they were not disposed of in 2019, and claiming a refund of $3,293 of US federal income tax paid on the staking reward.^[2] The IRS neither issued a refund nor responded to the Jarretts’ changed position.

On May 26, 2021, the Jarretts filed a complaint in the US district court for the Middle District of Tennessee for a refund. The complaint states that a refund is justified because the Tezos tokens were not taxable at the time they were received, but rather should only be taxable at the time they are sold. As support, the Jarretts cited an established tax law principle that newly created property is not an “accession to wealth” that is “clearly realized,” and therefore, the Tezos tokens should not have been included in income for the 2019 tax year, the year received.

In a letter signed December 20, 2021, the US Department of Justice Tax Division (DOJ) informed the Jarretts that “a full refund of $3,793, plus statutory interest, sought in the complaint for the 2019 tax year has been approved on behalf of the Attorney General,” and that the IRS had been directed to issue the refund to the Jarretts.^[3] However, in a letter from their counsel, dated January 25, 2022, the Jarretts rejected “the proffered refund” and stated their intent “to continue vindicating their rights in court.”

What does the DOJ/IRS decision to issue a refund mean?

The decision to issue a refund to the Jarretts is interesting. First, it should be noted that this decision was likely a joint decision made by the IRS and DOJ. Second, the decision is not, as some have trumpeted, the IRS and DOJ waving the white flag. Instead, the fact that the IRS and DOJ directed a refund does not provide any inference of guidance on which taxpayers should rely. Still, this action raises questions as to the motivation behind eliding litigation in this case. There are number of reasons that may have motivated the IRS and DOJ to offer the refund, including:

• There may be another case that the IRS anticipates would be a better vehicle to establish precedent, whether for factual or procedural reasons.
• The facts of the case may not be applicable to enough taxpayers for the government to warrant using time and resources to litigate the amount at issue ($3,293).
• The IRS and DOJ may anticipate guidance being issued to clarify the appropriate tax treatment of staking rewards.

Even if none of the above are true, it is simply premature to attach significance to the IRS’s/DOJ’s actions concerning the Jarrett’s case, especially since the case itself may be moot.

Mootness

An important procedural issue raised by the IRS/DOJ directing a refund to the Jarretts, and one unsurprisingly overlooked by the myriad Internet posts claiming victory for staking rewards, is whether the refund renders the Jarrett’s case moot as there is no live controversy to settle.

For example, the Tax Court has noted in Vigon v. Commissioner, 149 T.C. 97 (2017), that “[o]rdinarily, once the Commissioner concedes that there is no unpaid liability for a disputed year upon which a collection action could be based, a proceeding filed in this Court pursuant to section 6330 is moot.”^[4] In Vigon, however, although the taxpayer’s penalties were abated and the lien was released, because the IRS reserved the right to reassess penalties, the Tax Court held that the case was not moot because "[t]here is a difference between the controversy having gone away, and simply being in a restive stage."^[5]

In the Jarrett’s case, however, the IRS and DOJ do not seem to have left any controversy alive, for example, by maintaining any non-concessions about the case or the liability. This is a strong argument that providing a full refund to the Jarretts makes their claim and continued litigation moot.

One potential objection to this case being deemed moot is that the issue of whether staking rewards are income upon receipt or upon disposition remains unresolved, so that the IRS could challenge the Jarretts’ position on post-2019 tax returns.

To us, this is not persuasive. This argument was addressed in Christian Coal. of Florida, Inc. v. United States, 662 F.3d 1182, (11th Cir. 2011), where the taxpayer had filed tax returns as a nonprofit corporation even though its status as a nonprofit corporation had not been determined. When the IRS ultimately denied the taxpayer’s application to be treated as a nonprofit corporation, it also instructed the organization to file corporate tax returns and pay the tax due, which the organization did, but the organization then filed refund claims.

When the refunds were not made, the organization filed suit for refunds and a determination on its tax-exempt status, but shortly thereafter, the IRS issued full refunds. The district court held that the organization did not have a viable refund claim because the IRS refunded to the corporation all taxes and interest and had waived all penalties, and specifically rejected the corporation’s argument that its case was not moot because the question of whether it was tax-exempt would recur in subsequent tax years. 

In our view, the lack of resolution on the treatment of staking rewards, like the lack of resolution of a taxpayer’s tax-exempt status, is not likely to be a strong argument against mootness.

Next steps

To date, the government has not issued any guidance related to the tax treatment of staking rewards and there is no indication when such guidance will be available.

Although the Jarretts have indicated their intention to press the issue and achieve binding guidance with respect to the tax treatment of staking rewards, there are, as noted above, procedural and substantive reasons for thinking the Jarrett’s case may not be the vehicle to produce judicial guidance. Given the continued lack of certainty, and despite the buzz surrounding the Jarrett’s case, taxpayers should remain cautious and reasonable with positions taken with respect to staking rewards given existing guidance with regard to the treatment of cryptocurrency as property.

Learn more about the implications of this case by contacting the authors or your DLA Piper relationship attorney.

The authors wish to thank Diana Erbsen and Ellis Reemer for their contributions to this article.