Polygon Advisory Group LLC

On the evening of February 2, news broke that the IRS had agreed to refund Joshua and Jessica Jarrett a little over $3,000 in taxes paid on Tezos (XTZ) staking rewards earned in 2019. The Jarretts filed suit against the IRS back in May 2021 in the Middle District of Tennessee after filing and paying their 2019 taxes. Almost immediately, crypto channels on social media erupted jubilantly in celebration of the fact that staking income is no longer taxable. They were wrong.

A few essential points to get out of the way quickly:

1. The case was filed in US District Court, not Tax Court.

2. The IRS attempted to settle the case by issuing the Jarretts the refund they had sued for, and the Jarretts rejected the settlement.

3. There was no decision regarding the taxation of staking rewards, and thus no precedent has been set.

4. Nothing has changed.

To understand the importance of the Jarrett case and its potential ramifications on the taxation of staking income, let’s examine the issue.

What is staking?

Staking refers to the process of locking up crypto assets to participate in a blockchain’s consensus mechanism, thereby validating transactions. In exchange for using the investor’s coins to validate these transactions and add them to the blockchain, the network rewards the holder of the coins.

In practice, the staking rewards earned by an investor are generally looked at in one of two ways:

As interest income, similar to interest paid on cash held in bank accounts. This is the most commonly held opinion.

As compensation for the service of aiding the blockchain in validating transactions.

How are staking rewards taxed in the US?

The IRS holds no definitive position that deals specifically with the taxation of staking rewards. Instead, we must analyze staking income based on the tax concepts involved, always adhering to the general principle given in IRS Notice 2014-21 that crypto is considered property for purposes of US taxation.

In our tax practice, we have long held the idea that staking rewards are recognized as income on receipt, measured as the fair market value of the asset received as a staking reward. The following explains why:

Section 61 of the Internal Revenue Code defines gross income. First, we will look at §61(a)(4), which states that interest received is included in gross income. It follows that if we consider staking rewards to be de facto interest payments, those rewards should be included in the earner's gross income.

If we instead consider staking rewards to be payment for services, we will look at §61(a)(1), which says that compensation for services is included in gross income. Generally speaking, compensation for services is paid in cash (i.e. a paycheck). However, staking rewards are paid in crypto. No matter, §83(a) tells us that property transferred in connection with the performance of services should be included in income at its fair market value, less any amount paid.

So, whether you consider staking rewards to be interest or to be payment for providing service to the network, the rewards are considered to be income when earned. Beyond adding to the amount due to the IRS, the recognition of staking income has two main tax attributes in that it assigns a basis to the rewarded coins in the amount of income recognized and begins the holding period for capital gains treatment on the sale of the coins at a later date.

Back to the Jarret Case

Lawyers for the Jarretts argued that staking rewards should be seen not as compensation or interest, but as newly created assets like a farmer’s crops or an artist’s painting. While this argument will eventually be decided through the Courts or legislation, I don’t believe this argument has merit. As a side note, treating staking rewards as newly created property would have negative tax consequences in the long run. Farmers and artists recognize ordinary income (not capital gains) on the sale of their inventories, and both are subject to self-employment taxes.

The IRS attempting to pay the Jarretts their refund was a smart move. Had the Jarretts accepted, for the bargain price of $3k, the IRS would have dodged having the issue of whether staking rewards are taxable being decided by a District Court.

Instead, the case will now move to trial sometime in the Spring of 2023. The IRS has effectively bought itself time to either A) wait for guidance/legislation or B) catch another taxpayer with unclaimed staking income and bring the case to Tax Court, where a decision would set a federal precedent. So, for the time being, the Jarrett case has done nothing to change the way staking rewards are taxed in the US.

The more significant issue is the lack of official guidance around crypto as a whole and the ability of a small-time, somewhat frivolous lawsuit to make such big waves. Social media and some crypto websites are already festooned with posts and articles saying staking rewards are not taxable because of the Jarrett case. Those posts are wrong, but until we have clear legislation, regulations, and guidance around these common crypto practices, not many people will understand why.