How a Tiny Tennessee Court Case May Shape the Future of Digital Assets: A Dispute over a $3,800 Tax Bill Could Have Billions of Dollars in Consequences

In 2019, Joshua Jarrett of Nashville engaged in a small-scale virtual currency staking enterprise using a home computer. Jarrett owned a few hundred thousand tokens in Tezos, a proof-of-stake (POS) platform that allows randomly selected users to generate new tokens by validating blockchain transactions. In essence, this staking process lets validators use tokens they already have (and a relatively small amount of computing power) to obtain additional tokens.

Over the course of a year, Jarrett generated just under 9,000 new Tezos tokens. Jarrett then reported these tokens on his federal income tax return and was assessed $3,793 in taxes. That’s where the issues began.

The IRS’s View of Virtual Currency

Since 2014, the US Internal Revenue Service (IRS) guidance has expressly treated all forms of virtual currency as commodities (property). IRS Notice 2014-21 states: “For federal tax purposes, virtual currency is treated as property…. Under currently applicable law, virtual currency is not treated as currency that could generate foreign currency gain or loss[.]” In effect, this means that most owners of virtual currency do not incur tax liability until their holdings are actually sold, and the resulting income or loss is determined at the time of the transaction. While mark-to-market method taxpayers may incur tax liability based on fluctuations in the value of virtual currencies that they continue to hold, accrual and individual cash-method taxpayers such as Jarrett generally do not. Rather, much like the sale of a car, or a piano, or a loaf of bread, the tax obligation is tied to a realization and recognition event, which usually occurs when the asset is transferred from one person to another at a profit or loss.

The IRS has treated the receipt of newly “mined” virtual currency as property received for the performance of services. In answer to FAQ No. 8 in its 2014 guidance, the IRS wrote that “when a taxpayer successfully ‘mines’ virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.” The IRS did not further define what it meant by the term “mine.” But in common usage, “mining” generally refers to virtual currency created via proof-of-work (POW) consensus mechanisms (i.e., those in which “miners” compete to earn block rewards by being the first to solve a complex mathematical problem). The term is not as often associated with the type of POS validation processes in which Jarrett participated.

A Case to Watch: Jarrett v. the United States of America

Which leads to the question now pending in the U.S. District Court for the Middle District of Tennessee: Can Jarrett be taxed for new tokens that he generated through staking but has not yet transferred or sold? Jarrett argues, “no.” As his lawyers put it: “Like a baker who bakes a cake using ingredients and an oven, or a writer who writes a book using Microsoft Word and a computer, […] Mr. Jarrett will realize taxable income [only] when he first sells or exchanges the new property he created[.]” On the other hand, the IRS likely believes that tokens obtained through staking should be treated the same as tokens “mined” via POW, as taxable income akin to a payment received in exchange for validating transactions on the blockchain. This dispute forms the basis of the lawsuit Jarrett filed in 2021, seeking a $3,793 refund from the IRS.

Throughout the case so far, surprisingly, the Justice Department lawyers tasked with defending the IRS have had some difficulty articulating its bases for taxing Jarrett’s tokens. In its August 2021 answer to the complaint, the government denied that “virtual currency is in all instances property for purposes of U.S. tax law.” That denial raised eyebrows among many observers, particularly given its apparent contradiction of the IRS’s own 2014 guidance. The government has not since articulated the circumstances in which it views virtual currency as property received for the performance of services. In general, this would be a beneficial answer for the crypto community because the value of the tokens received is likely to be small when received. When the tokens are then later sold or exchanged, future gains could be treated as long-term capital gains. In other words, it's better to have a small amount of ordinary income today and significant amounts of long-term capital gains in the future.

Hoping to avoid an adverse decision that might limit its ability to tax staking activities as full ordinary income transactions in the future, the IRS recently offered to refund Jarrett the full amount of his claim in exchange for dismissing the case. On February 3, 2022, however, Jarrett announced that he was turning down the IRS’s offer and would seek a final court decision instead. “Until the case receives an official ruling from a court, there will be nothing to prevent the IRS from challenging me again on this issue,” Jarrett said in a statement. “I need a better answer.”

The upshot is that US District Judge William L. Campbell, Jr., of the Middle District of Tennessee, will now decide—as a matter of first impression—exactly how POS-based virtual currencies ought to be treated for federal income tax purposes.

The Potential Stakes

Industry groups like the Proof of Stake Alliance have rallied to support Jarrett’s cause, and the case has come to be seen as an important bellwether for the government’s treatment of POS and virtual currencies as a whole.

In the past year, POS consensus mechanisms have skyrocketed in popularity; the reported market capitalization of the top 30 POS tokens was almost $600 billion at the end of Q3 2021. Ethereum, the second most popular virtual currency in the world, has announced plans to fully transition to POS before the end of 2022. Large exchanges have set up “staking pools” to allow individuals to combine their resources and engage in shared POS staking activities. The tax treatment of staking, therefore, is likely to have consequences worth billions of dollars for investors, exchanges and the government. Of particular significance, more favorable tax treatment for POS validation could give it a leg up in the ongoing competition against POW-based currencies and tokens, including Bitcoin.

Thus, what began as a simple dispute over $3,793 is now likely to have reverberations throughout the multi-billion-dollar virtual currency industry. A trial in the Jarrett case is currently scheduled for March 2023. With apologies for the pun, the stakes could not be higher.