Recovering political scientist now mostly focused on crypto.

On Feb. 3, 2022, Josh Jarrett, a Tennessee “smartgym” owner and a “baker” (who ensures transactions in a block are correct) on the Tezos blockchain, announced he was rejecting the U.S. government's offer of a $4,000 tax refund for income taxes he paid on his cryptocurrency staking rewards. The offered refund was an attempt by the government to settle a lawsuit Josh brought against the Internal Revenue Service in May 2021. Declining the refund, Josh decided to push forward with his lawsuit.

In looking for clarity about his own tax bills, Jarrett might provide much needed clarity for the staking industry. The Internal Revenue Service has not been clear if staking rewards – the tokens generated from securing a proof-of-stake (POS) blockchain – should be treated as income or property, an important classification for accounting purposes. We at the Proof of Stake Alliance (POSA), see this as an issue of public importance, given staking’s growing role in the larger crypto industry.

This article is part of "Mining Week."

The government, in offering a refund on taxes Jarrett paid on his XTZ rewards, attempted to settle his lawsuit. Jarrett is intent on taking the dispute to trial, which might set landmark policy for the crypto industry, as POS becomes the dominant consensus mechanism securing cryptocurrency.

The government has since asked the court to dismiss Jarrett’s lawsuit, arguing the offered refund resolves any dispute between the parties. But Jarrett disagrees. In a brief filed last week, Jarrett reiterated the public importance of this case and the need for it to continue. Coin Center also recently filed an amicus (friend of the court) brief in the case, arguing that “by attempting to moot this important case, the IRS is increasing uncertainty for thousands if not millions of already confused taxpayers.”

While the offered refund, motion to dismiss and Jarrett's refusal are certainly noteworthy procedural developments, it’s important to highlight what actually matters in this case: Josh’s position – that staking rewards should be taxed at the time they are sold, not the time they are created. This is the correct legal and policy position for the tax treatment of staking rewards. Though the particular case may not set legal precedent that could impact all stakers, the legal and policy arguments made should serve as a clarion call for the industry.

U.S.-based blockchain innovators are hampered by uncertain tax policy, a fact that will remain true until the court confirms and regulators adopt a saner/consistent position regarding the status of staking rewards.

Jarrett argues in his lawsuit that staking rewards, created by the staker at the time of validating transactions, should be taxed consistent with more than 100 years of tax law. That is, at the time of sale rather than the moment of creation.

When individuals bake loaves of bread, paint works of art, extract oil from a well or gold from a mine, they never pay taxes on the value of the item at the time the property is created, but when they realize income from its sale.

There are a few good reasons why this makes sense: It streamlines the process for paying taxes, lessens the administrative burden on both the taxpayer and the government and is ultimately most equitable. Paying taxes on assets when sold is not tax avoidance. Without this treatment, some stakers would have taxable events every few seconds.

Besides, if staking rewards are treated as income, who issues the 1099 form? Whose expense is it? Are blockchains employers?

Instead of acknowledging this as the appropriate legal treatment, the government first ignored Jarrett’s claim for a refund, then opposed his claims in court and offered him a refund and asked the court to dismiss the suit. The government’s recent call to dismiss Jarrett’s lawsuit represents one of two things:

1) recognition that Jarrett’s legal position regarding staking rewards is correct

2) an attempt to prevent the court from resolving the question at the center of Josh’s case: How should his staking rewards be taxed?

If it’s the former, then it is hoped clear guidance from the IRS will be forthcoming. Assuming it’s the latter, however, this would be another unfortunate instance of the IRS doing everything in its power to prevent the court from ruling and weighing in on fair and appropriate tax policy for a growing part of our economy.

While the IRS has failed to act on staking rewards, the world has continued to move to blockchain and blockchain has started to shift to proof-of-stake. Staking is already a multibillion-dollar industry and America is home to some of the largest and fastest-growing players in the staking ecosystem. Staking is also performed by individuals throughout the U.S., including Josh Jarrett, who help secure the protocols they participate in and get exposure to the upside of these protocols through staking rewards. Many of the largest U.S-based crypto exchanges have also started facilitating staking for their retail customers, bringing staking to millions more individuals and making the country an integral part of securing proof-of-stake blockchains.

The Proof of Stake Alliance (POSA), along with prominent crypto advocates and tax law experts, are spotlighting Jarrett’s case because it highlights the foundational principles of blockchain innovation: crypto – or digital assets – are digital property.

Or as Coin Center so aptly put it, “Starving taxpayers of clear policy statements while simultaneously expanding enforcement of unclear rules will erode taxpayer faith in the rule of law, reduce tax compliance and tax revenue because of the costs inherent in determining a correct approach, and subject thousands of taxpayers to potential criminal liability without reasonable attempts to make them aware of those liabilities and how they can be avoided."

Without unequivocal confirmation that staking rewards are taxed like all other created property, America could lose its foothold as a home for a growing staking ecosystem, which drives blockchain innovation and job creation. It’s time for the courts, Congress or the IRS to make clear that staking rewards should receive the same tax treatment as any other type of created property. There’s a lot more at stake than Josh Jarrett’s tax refund.

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Recovering political scientist now mostly focused on crypto.