iThe IRS has not issued any clear guidance on the taxation of staking rewards. In 2014, the IRS issued Notice 2014-21, which provides that cryptocurrency is treated as property for federal tax purposes, but Notice 2014-21 and subsequent Revenue Ruling 2019-24 and frequently asked questions do not provide any further guidance on the tax treatment of staking rewards. This absence of guidance has produced widespread interest in a case before the Middle District of Tennessee, Jarrett v. U.S., which centers on the tax treatment of staking rewards.
What Is Staking?
Staking (or proof-of-stake) is a prevalent method of validating blockchain-based transactions. It is often compared to mining (or proof-of-work), another method of validating blockchain-based transactions. Mining involves an intensive process of solving complex mathematical problems using energy, computing power, and other sophisticated hardware. While the object of staking is the same as mining (i.e., validating blockchain transactions and earning reward tokens), the process involves committing or pledging specific cryptocurrency to support a blockchain protocol for validating transactions. Each time a block is added to the protocol, new cryptocurrency within the same protocol are minted, which are then rewarded to the participants. Notice 2014-21, which predates the concept of staking, clarified that a cryptocurrency miner will recognize ordinary income when the reward tokens are received. The income will be equal to the fair market value of the mined tokens at the time of receipt.
Jarrett v. U.S.
In 2019, Joshua Jarrett engaged in staking, by which he used his existing Tezos tokens to contribute to the creation of new blocks on the Tezos public blockchain. This resulted in Jarrett’s creation of staking rewards in the amount of 8,876 new Tezos tokens. Jarrett and his wife, Jessica, reported the value of the staking rewards on their 2019 jointly federal income tax return as ordinary income and paid the related taxes.
In July 2020, the Jarretts filed an amended tax return, asserting that their staking rewards were not income subject to tax and requested a refund from the IRS in the amount of $3,793. The IRS did not at first respond to the request for a refund, which allowed the Jarretts to sue for a refund in May 2021. The Jarretts’ complaint asserted that federal income tax law does not permit the taxation of tokens created through a staking enterprise and that tokens created through staking are only taxable upon the sale or exchange of the tokens.
In December 2020, the Jarretts received a letter from the U.S. Department of Justice notifying them that the IRS had been authorized to provide the Jarretts a full refund, plus interest. The Jarretts rejected the refund offer because the IRS did not provide a reason for the refund and left open the issue of whether the creation of tokens through staking is a taxable event.
A trial in the Jarrett case is scheduled for March 2023. But in a conference on Feb. 10, 2022, counsel for the United States reported they intend to move to dismiss the case on mootness grounds. If the judge does not grant the motion to dismiss, the case can proceed to the merits of the issue.
The IRS’s refund offer has generated considerable speculation about the taxation of staking rewards. But the offer is not a concession as to the tax treatment of staking rewards and cannot be relied on as precedent by other taxpayers in similar positions. Taxpayers engaged in staking should consult their tax advisors before taking a position on their staking rewards in their tax returns.
