November 24, 2022
  • November 24, 2022

Tennessee Taxpayer Lawsuit Cryptocurrency Tokens Through Staking

By on October 11, 2022 0

The early dismissal of a federal lawsuit that could have determined whether certain cryptocurrency tokens can be taxed, as federal revenue looks like business as usual for an industry used to uncertainty. The issue in this taxpayer-initiated lawsuit was whether the cryptocurrency tokens generated through the staking process were properly taxed as income. Fixing this problem was poised to have a significant effect on the tax regime for digital assets, especially after Ethereum – the world’s second-largest cryptocurrency by market capitalization – recently jumped to a low. proof-of-stake consensus protocol.

The plaintiffs, two Tennessee taxpayers, engaged in a cryptocurrency staking transaction involving Tezos, a cryptocurrency that uses the proof-of-stake mechanism to validate transactions. Transaction validators for proof-of-stake platforms must first “stake” or pledge a number of their own tokens as their “buy-in” to be chosen as a validator. If chosen, the staker-validator then uses their computing power to validate transactions, or blocks of data, that are added to a blockchain. Successful validators are rewarded with cryptocurrency tokens that are created when new blocks of data are validated and added to the blockchain.

In 2019, applicants’ Tezos staking efforts created 8,876 new Tezos tokens. When tax season arrived, the plaintiffs initially reported $9,407 of “other income” from the new Tezos tokens on their 2019 tax returns. Later claiming that the new Tezos tokens were not subject to tax. federal tax as income, the plaintiffs requested a refund of nearly $4,000 from the IRS.

According to the plaintiffs, the creation of Tezos tokens through the proof-of-stake validation process was no different from a baker baking a cake where that freshly baked cake is considered new property, not income subject to tax. tax. It wasn’t until the plaintiffs sold those new tokens – much like the baker selling the cake – that they would be subject to federal income tax based on that realized gain, or so the claimants would. plaintiffs argued.

The government initially rejected the plaintiffs’ claim that the tokens generated from staking were not revenue and denied the claim for reimbursement. But as the case progressed, the government changed its tune and agreed to issue a full refund – every penny requested by the complainants – to resolve the case. The government did not explain why it decided to issue the refund or whether the tokens generated by staking were indeed taxable.

Determined to obtain a judgment that the newly created tokens did not constitute income for tax purposes, the plaintiffs rejected the refund. From the plaintiffs perspective, if they accepted the refund for that year, they would be forced to fight with the IRS every year to find out if the tokens they generated that year from staking were taxable.

The plaintiffs tried to reject the refund ‘offer’, but the government issued it anyway, then decided to dismiss the case as moot. The government argued that the case was moot because the plaintiffs’ complaint only focused on whether the denial of refunds in the 2019 tax year was appropriate. Since the government issued a full refund to claimants for the 2019 tax year, the question (refund eligibility for 2019) was moot and unable to repeat itself. According to the government, the plaintiffs’ lawsuit did not actually involve the larger political issue of whether tokens generated by staking are taxable as income.

The Court agreed with the government’s position, rejecting the plaintiffs’ assertion that a problem remained or that the problem would recur each year the plaintiffs continued to engage in staking. The Court also disagreed with the plaintiffs (supported by an amicus brief from Coin Center) that the matter was of significant public importance requiring judicial resolution.

In the absence of an appeal in this case, those who hoped for clarification on this question remain disappointed. What is certain is that the government was careful not to leave too many clues as to whether it changed its position on whether tokens generated from staking were taxable income. Buried in a footnote in the government’s motion to dismiss, he noted that “granting a refund to a taxpayer for one year is neither a forward-looking nor universal statement of IRS policy. regarding the many individual items reported in a tax return for a given year.” This appears to respond to a statement from the Proof of Stake Alliance that the IRS’ decision to issue a refund in this case was an indication that it no longer considered tokens generated from staking as income.

This case was also particularly significant because the popularity of proof-of-stake protocols is growing, due at least in part to the perception that they are more energy-efficient than proof-of-work consensus protocols (e.g., Bitcoin ). But how the IRS will deal with tokens generated by staking remains unclear. In 2014, the IRS issued guidance that “mining” cryptocurrency or tokens issued to validators who successfully validate transactions on proof-of-work platforms (no staking required) constituted income. See IRS Notice 2014-21 (“when a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency on the date of receipt is included in gross income”) (https://www .irs.gov/pub/irs-drop/n-14-21.pdf). Interestingly, the absence of the government’s response to the plaintiffs’ complaint or its motion to dismiss contained no strong argument leveraging these old guidelines for the point that any tokens created or received upon validation of blockchain transitions are taxable income, whether or not those tokens are generated through a proof-of-work or proof-of-stake protocol.

We may not get our answer unless and until claimants file for reimbursement next tax season!

Tax lawsuit for crypto staking ruled moot after refund issued by IRS

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