Jarrett Leaves Unanswered Questions on Taxation of Staking Rewards

JARRETT V. UNITED STATES

In Jarrett v. United States, No. 3:21-cv-00419 (M.D. Tenn.), Joshua Jarrett engaged in staking activities where he posted Tezos tokens to contribute to the creation of new blocks of the Tezos public blockchain and, in turn, received new Tezos tokens. Despite not selling or exchanging any of the newly created Tezos tokens during the year of receipt, Jarrett reported such tokens as “other income” and then filed an amended return requesting a refund on the claim that staking income is not taxable.

Jarrett filed a complaint in Tennessee district court seeking a refund because he did not receive a timely response from the Internal Revenue Service (IRS). He argued that the newly created Tezos tokens were only taxable at the time of sale, not at the time of receipt, and asserted that the foundational basis of US tax law is that newly created property (such as creating a cake or a book) is not an accession to wealth that is “clearly realized.” Under US federal income tax principles, an accession to wealth is a requirement that is necessary for an item to be included as income.

Thereafter, the US Department of Justice Tax Division informed Jarrett that a full refund had been approved and issued a refund check that included interest. In response, Jarrett refused to accept the refund because it did not provide any assurance with respect to whether tokens created through staking activities constitute taxable income at the time of creation. On the basis that Jarrett’s claim is moot because the United States has fully refunded the federal income taxes and statutory interest demanded in the complaint, the district court granted the United States’ motion to dismiss.

THE NEED FOR IMMEDIATE GUIDANCE

With the recent upgrade of Ethereum to proof of stake and the exponential growth of digital assets involving staking rewards, taxpayers engaging in staking activities were hopeful that the Jarrett case would provide much-needed clarity on how staking rewards should be taxed. Presently, stakers are taking a wide range of positions with respect to the tax character and tax timing of staking rewards. For example, some stakers take the position that the receipt of staking rewards results in taxable income from the performance of services, while others assert that staking rewards are not taxable until they sell, exchange or otherwise dispose of the rewards.

With Jarrett’s dismissal, taxpayers continue to operate in uncharted tax waters. While recent legislative proposals have tried to bridge the gap between taxation and digital assets, including the Responsible Financial Innovation Act introduced in June 2022, which permitted cryptocurrency stakers to defer taxes with respect to such activities (including the receipt of staking rewards) until those assets were disposed of, such legislative proposals have not yet gained any traction in the US Congress. Meanwhile, the IRS continues to remain silent on the issue with the only analogous guidance (involving mining activities) implying that staking awards should be taxed as ordinary income upon receipt. As a result, taxpayers should continue to proceed with caution.

For a detailed discussion of staking and US federal income tax considerations, please see “Taxation of Virtual Currency Staking Activities.”

If you have questions about the tax implications of staking activities, please do not hesitate to contact the authors of this article or your regular McDermott contact(s).