Novel lawsuit in opposition to IRS for tax implications of staking

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 balance of a certain cryptocurrency can validate transactions and earn staking rewards. ”In May 2021, a couple from Tennessee sued the IRS for a refund of the taxes they had paid on Tezos tokens that they had earned by staking. As stated in their complaint:

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

The complaint continues to allege the following facts: In 2019, Mr. Jarrett was involved in a staking company where he used his tokens and computing power to help create new blocks on the Tezos public blockchain, leading to its creation of 8,876 new led 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, in 2019, Mr. Jarrett did not sell or trade any of the 8,876 new Tezos tokens created by his staking company. He kept all of these newly created Tezos tokens in his digital wallet throughout 2019. Nevertheless, when filing their 2019 tax returns, the Jarretts reported the amount from the creation of the new tokens as “other income”.

The Jarretts have analogized staking activity with that of a baker:

The federal income tax law does not allow taxation of tokens created by a staking company. Like a baker making a cake with ingredients and an oven or a writer writing a book with Microsoft Word and a computer, Mr. Jarrett created property. Like the baker or the writer, Mr. Jarrett will earn taxable income the first time he sells or trades on newly created property, but federal income tax law does not allow Jarrett to be taxed just because Mr. Jarrett created new property.

The Jarretts contend that new property – property created by the taxpayer, not received in payment or compensation – is and was not federal income income. They are therefore demanding a refund of the taxes paid on the tokens generated by the staking activity

This is a novel lawsuit because although we have reported on the aggressive actions taken by the IRS in relation to cryptocurrency and the IRS has issued certain guidelines in this area, it has not issued any guidelines on staking. The problem is significant as more and more blockchains move to proof-of-stake systems.