What Happened

A recent disclosure in the U.S. District Court for the Middle District of Tennessee is causing speculation as to what position the IRS may take on the taxable status of tokens created through proof-of-stake consensus mechanisms. The case, Jarrett v. United States, Case No. 3:21-cv-00419 (M.D.Tenn. filed May 26, 2021), was brought by a Tennessee couple seeking a tax refund after declaring $9,407 worth of Tezos tokens as income in their 2019 tax returns. The Jarretts’ claim that they created these particular tokens by staking other tokens and using their own computing power to validate transactions on the Tezos network. The complaint alleges that the new tokens were not taxable income because the IRS does not generally treat the creation of new property as a taxable event. A February 3, 2022 filing in the case seems to indicate there could be credence to that argument, as it was revealed that the IRS offered to issue the Jarretts their refund in exchange for the case’s dismissal.

Are Newly Created Tokens Taxable?

The Jarretts’ argument is simple, even if the architecture underlying proof of stake mechanisms is complex. Generally, the IRS does not tax newly-created property. For example, an artist who combines paint with a canvas to create a new work does not suddenly have an increase in declarable income once the piece is finished. Any proceeds from a subsequent sale would be considered income, but there is nothing about the original work that is “derived” from a “source” such that it could be classified as income under 26 U.S.C. § 61(a). Similarly, a gold miner is not taxed by the IRS until the miner disposes of the gold produced.

The Jarretts argue that their creation of new tokens via staking and validating transactions with computing power is likewise non-taxable. Like the new artwork (or, as Jarrett put it in his Complaint, like a newly-baked cake), newly created tokens should not be taxable until they are sold or exchanged for something of value.

The merits of this argument remain undetermined. The IRS’ offer to settle may imply it believes the Jarretts have the better interpretation of this principle’s applicability. In its August 27, 2021 Answer to the Jarretts’ Complaint, however, the agency repeatedly denied that the Jarretts created new Tezos tokens. It is unclear how the IRS is defining “creation” and whether its understanding of staking evolved between the agency’s August Answer and December settlement offer.

Would This Mean All Tokens Gained Through Staking Are Untaxable?

Even if the IRS (or the court) ultimately agrees with the Jarretts and finds that their newly-created Tezos tokens are not taxable, people engaged in staking should still pause and consider the nuances such a decision may have. A potentially crucial component of the Jarretts’ allegations is that the tokens were created by staking Tezos and using the Jarretts’ own computing power. As alleged, this means the Jarretts’ staked their tokens and also provided the physical computing power required to act as an actual node validating transactions on the Tezos network.

This contrasts from the far more common situation where individuals “stake” their tokens in a pool controlled by another party that in turn validates transactions through its own servers. In these situations, who is actually “creating” the tokens becomes less clear. In some cases, there may even be terms and conditions governing the transactions that affect the staker’s claim to “created” tokens. As a result, the IRS may view the taxable nature of these arrangements differently. Other situations, such as those where a staker receives previously-created tokens (for example, on platforms that distribute fees collected on its network to stakers) would almost certainly result in transfers constituting taxable events. If, however, those tokens are distributed in the same manner as newly-created tokens, accounting headaches would likely ensue.

What’s Next?

The Jarretts’ appear intent on litigating this matter in court since they have rejected the IRS’ offer to settle. One thing is for certain—we won’t have an answer by this year’s tax filing deadline. If you have a similar situation to the Jarretts, you should consult with your tax advisor in order to explore your specific reporting options. Briefing on the actual merits of the case is not due until August 19, 2022. This case will be important to watch as it could have implications for the IRS’ longstanding position that tokens obtained through proof of work (“mining”) processes are taxable at the time they are created.