What Might Bakers, Writers, and Cryptocurrency Stakers All Have in Common? Deferred Tax Liability!

A recent Internal Revenue Service (“IRS”) decision to offer a refund for taxes levied on an individual's “Proof of Stake” cryptocurrency rewards could signal a major shift for the agency.  At the very least, the decision could incentivize blockchain networks to accelerate their adoption of Proof of Stake consensus mechanisms, and encourage more participation in the staking process.

Consensus mechanisms are a key part of how blockchains function.  Participants need to agree that the transactions added to the blockchain are genuine. 

• In a “Proof of Work” consensus mechanism (also known as “mining”), participants ("miners") compete in an energy-intensive process using computers ("nodes") to solve complex mathematical problems to mine the next block and receive incentive fees ("mining rewards") for their work, usually in the form of the native token for a given blockchain.
• In a Proof of Stake consensus mechanism (also known as “staking”), a newer and less energy-intensive alternative to Proof of Work, miners/computing power are replaced with “validators” (users who agree to “stake” their own tokens), who propose and vote on new blocks and receive incentive fees (“staking rewards”) for validating legitimate transactions.

In Jarrett v. U.S., Plaintiff Jarrett has argued before a federal district court that he should not be “double taxed” both when he obtains Tezos cryptocurrency tokens as staking rewards, and also when he sells the tokens.  Jarrett has claimed that his unsold staking rewards are not taxable "income" because they constitute "new property" that he created, and therefore, like a baker baking a cake, or an author writing a book, only the sale of those tokens should be a taxable event. 

Recently, the IRS offered Jarrett a refund (with statutory interest) on taxes he paid for his unsold Tezos staking rewards.  Jarrett rejected the offer in favor of proceeding to trial because the IRS only offered a discrete refund for his 2019 Tezos staking rewards but did not take a position on the underlying issue – whether tokens created through staking constitute taxable income at the time of their creation.

If the court sides with Jarrett, this favorable tax treatment could help promulgate Proof of Stake and increase participation in staking.  Furthermore, such a ruling could also be construed to extend to mining rewards, which, pursuant to IRS Notice 2014-21, are currently subject to the same “double taxation” that Jarrett disputes for staking rewards.

Trial is scheduled for next month.