Last year, a couple in Nashville Tennessee sued the Internal Revenue Service over the tax watchdog’s refusal to cut them a refund on their cryptocurrency staking rewards.
Now, recent developments in the court case have some wondering if the IRS has had an important change of heart about staking. But experts say that’s not necessarily the case – yet.
Joshua and Jessica Jarrett are “bakers” in the Tezos ecosystem, meaning they act as validators in the proof of stake mechanism by staking tokens. In return, they receive a payout in tokens. The IRS contends that under current law these reward tokens are taxed as income, upon receipt.
The Jarretts and other proponents of the industry believe these rewards better resemble property than income. Specifically, they argue that the mechanism for creating the tokens is literally like baking a cake: the taxpayer uses their own inputs to create an output. A baker’s cake is taxed as property, with taxation incurring upon the sale of the good.
The Jarretts requested a refund of their 2019 staking rewards, totaling $3,293, but the IRS refused. Then, with the backing of the industry group Proof of Stake Alliance, the Jarretts took the tax regulator to federal court in their home Middle District of Tennessee. The couple sued for its refund and an additional $500 in tax credits for lost income.
Now, the IRS has offered to settle, agreeing to the Jarretts’ initial ask without officially validating the reasoning behind it. But the Jarretts are refusing to take the refund and want to continue to hammer out the case out in court, saying they want clear guidance going forward.
The meaning of a settlement
Some view an IRS settlement as a sign the agency recognizes its current interpretation of the law won’t stand up in a court. The Proof of Stake Alliance went so far as to say that the IRS had “waved a white flag.”
Perhaps, but it is important to keep in mind that a loss in the Middle District of Tennessee would only be precedent-setting for that district. To set a federal precedent, the case would either have to be decided in tax court, which can only occur when the IRS issues a taxpayer a penalty that the taxpayer wishes to challenge — or reach a higher court, say if the District court’s decision is appealed.
A settlement from the IRS doesn’t necessarily mean it’s conceding the point, according to industry experts. It could reflect a desire to buy time to issue more specific guidance on the issue, according to TaxBit’s Senior Director of Global Relations & SME, Seth Wilks.
The IRS has a wealth of crypto-related topics it is expected to eventually clarify, but the added pressure from the pandemic has caused delays.
Additionally, issuing guidance has become more challenging due to the many types of crypto-related activities that fall under similar terms. For instance, the staking that the Jarretts are doing on Tezos is closer to bitcoin mining than, say, staking tokens in decentralized liquidity pools. If the IRS rushed to issue guidance on “staking,” it could accidentally further complicate the issue.
According to Wilks, it learned this lesson in 2019 when it issued its hard forks and airdrops guidance. That publication initially led to confusion over whether new tokens received after a hard fork should be taxed, since they were not received via an airdrop mechanism. Last spring, the IRS issued a follow-up piece of guidance focused on the bitcoin/bitcoin cash hard fork, clarifying that it doesn’t matter if the mechanism of receipt was an airdrop. In that case, the agency may have misunderstood the way the industry used the term “airdrop.”
A moot point?
What does all this mean for crypto? That depends on what the judge in the Jarrett case does next.
Keep in mind that the issue at the heart of this case is a refund, and the IRS has agreed to issue it. The judge may see this as the natural end to the case since the stated reason for filing has been resolved. If that happens, the case would end without ever reaching a higher court.
Already, in a February 10 phone conference, a judge signed off on a plan for the Counsel for the US to file a plan for each side to respond to a motion to dismiss by February 25, indicating the US plans to file for dismissal. Still, the timeline for experts and discovery would continue, so the case is far from over.
The next phase of the case will involve the Jarretts’ lawyers explaining why the issue should continue to be argued in court.
Peter Van Valkenburgh, Director of Research at crypto policy think tank Coin Center, said the judge may use the opportunity to clarify staking taxation in this case in order to avoid the need for future similar cases.
“The judge will recognize that this is a tactic to avoid future case law,” said Van Valkenburgh. “A judge knows it’s their place to clear the law when there’s a case in controversy, and the judge is going to recognize that this attempt to remove the controversy in this one isolated point is just going to be a problem because someone else is going to sue again.”
Still, Stephen Turanchik, a tax attorney at Paul Hastings, LLP, said judges aren’t usually interested in litigating an issue further than what the case requires. This case centers on a refund, and a refund has been offered.
“You’d have to have a really active judge say, ‘I want more briefings on this.’ If they can get rid of one more case on their docket, they’re going to do so,” he said.
Either way, the case has brought widespread attention to the issue, and the settlement may embolden other taxpayers to bring similar cases in other districts. That would put more pressure on the agency to clarify the issue once and for all.
Or, if the judge does let the case proceed from here and the IRS loses, the agency could appeal higher and higher up the ladder until a precedent-setting decision is required.
“Everything starts in a small district, then it gets appealed and appealed,” said Van Valkenburgh. “It’s not going to happen right away, but it could have a lot of precedential weight going forward if the IRS ends up losing and has to defend itself in the appellate courts.”
© 2022 The Block Crypto, Inc. All Rights Reserved. This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.
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