Overview
On October 10, 2024, Joshua and Jessica Jarrett filed a complaint against the United States asserting that cryptocurrency tokens created through staking are new property and should not be treated as income. Jarrett, et al. v. United States of America, Docket No. 3:24-cv-01209 (M.D. Tenn. Oct. 10, 2024). This position challenges Internal Revenue Service (IRS) Revenue Ruling 2023-14, which concludes that staking rewards are includible in a taxpayer’s gross income in the tax year in which the taxpayer gains “dominion and control” over the staking rewards.
In this article, we consider the tax implications arising from this case, which may impact taxpayers who are engaged in crypto staking activities.
In Depth
BACKGROUND
For those that have been following recent developments in the taxation of crypto and crypto staking, the Jarretts may seem familiar. Last year, the same couple argued before the US Court of Appeals for the Sixth Circuit regarding the same issue: whether the receipt of staking rewards generates taxable income at the date the rewards are received.
Jarrett initially sued the IRS in 2022 for a refund in connection with his 2019 tax year, claiming that he overpaid his 2019 taxes because his payment included amounts for taxes arising in connection with the creation of certain Tezos crypto tokens. Jarrett v. United States, No. 3:21-cv-00419, 2022 BL 349876 (M.D. Tenn. Sept. 30, 2022). Jarrett argued that the tax was inappropriate because he had created new tokens by staking existing tokens that he owned. Accordingly, he should have owed tax on the tokens only upon sale or transfer, rather than upon creation. Before the parties reached oral argument, the government granted Jarrett’s refund request and directed the IRS to schedule an overpayment. The government then moved to dismiss the case (claiming that the full refund resolved the dispute), which the district court sustained.
Refusing to accept or cash the refund check, Jarrett appealed to the Sixth Circuit, claiming that the refund claim remained a live dispute. Jarrett v. United States, No. 22-6023 (6th Cir. 2023). While it did not impact the Sixth Circuit’s decision, the IRS formalized its position on the taxation of staking rewards shortly after oral arguments were completed, releasing Revenue Ruling 2023-14. The Sixth Circuit affirmed the district court’s ruling, concluding that the IRS refund check mooted the prior case.
TREATING TOKENS CREATED FROM STAKING AS NEW PROPERTY
Last week’s complaint (now relating to Jarrett’s 2020 tax year) features similar facts to the prior case and takes a similar tax position on staking rewards. Jarrett created new Tezos tokens in 2020 by staking his existing Tezos tokens. The complaint contends that the newly created tokens should be treated as new property and, under the realization requirement, should not be taxable as income until transferred or otherwise disposed of. The complaint also provides various illustrative analogies between the new tokens and other forms of new property that are not taxed upon receipt, including comparisons to vegetables grown by farmers, manuscripts drafted by Stephen King, and widgets manufactured in a factory (highlighting that in each case such property is not subject to tax until sold).
In addition to the realization requirement, the complaint also discusses the dilutive effect of the staking rewards, asserting that the creation of new tokens also offsets the economic gain from the newly created tokens to the extent that the new tokens diminish the value of existing tokens. This is highlighted in the comparison between staking rewards and stock received pursuant to a stock split. Accordingly, the complaint contends that the taxation of the new tokens would result in overtaxation to the extent that the new tokens diluted the value of the existing tokens.
The Jarretts have requested several forms of relief from the district court. Among other requests, the Jarretts have requested that the district court grant a judgment that the disputed federal income taxes were erroneously assessed, an order awarding a refund for amounts paid for their 2020 tax year, and a permanent injunction against the IRS preventing it from treating tokens created by the Jarretts as income.
CONCLUSION
Because the US previously chose to refund the applicable taxes to the Jarretts rather than litigating to a dispositive decision, this case presents the Jarretts with a second chance to challenge the IRS’ published position regarding the taxation of staking rewards. Of course, revenue rulings generally represent the IRS’ interpretation of existing tax law and are not binding on the courts. Accordingly, a ruling in Jarrett’s favor may drastically alter the taxation of crypto staking rewards and could even result in deferred taxation on tokens rewarded in connection with taxpayer staking activities. We expect this case will be closely followed by taxpayers engaged in crypto staking activities.
If you have questions about the tax implications of staking activities, please contact the authors of this article or your regular McDermott contact(s).
