Crypto staking rewards and their unfair taxation in the US

Published at: July 11, 2021

The United States Internal Revenue Service (IRS) stretches the tax rules to fit its cryptocurrency agenda. At no time in tax history has pure creation been a taxable event. Yet, the IRS seeks to tax new tokens as income at the time they are created. This is an infringement on traditional tax principles and problematic for several reasons.

In 2014, the IRS stated in an FAQ within IRS Notice 2014-21 that mining activities would result in taxable gross income. It is important to note that IRS notices are mere guidances and are not the law. The IRS concluded that mining is a trade or business and the fair market value of the mined coins are immediately taxed as ordinary income and subject to self-employment tax (an additional 15.3%). However, this guidance is limited to proof-of-work (PoW) miners and was only issued in 2014 — long before staking became mainstream. Its applicability to staking is especially misguided and inapplicable.

A newly filed lawsuit now underway in federal court in Tennessee challenges the IRS’s taxation of staking rewards at their creation. Plaintiff Joshua Jarrett engaged in staking on the Tezos blockchain — staking his Tezos (XNZ) and contributing his computing power. New blocks were created on the Tezos blockchain and resulted in newly created Tezos for Jarrett. The IRS taxed Jarrett’s newly created tokens as taxable gross income based on the fair market value of the new Tezos tokens. Jarrett’s attorneys correctly pointed out that newly created property is not a taxable event. That is, new property (here, the newly created Tezos tokens) is only taxable when it is sold or exchanged. Jarrett has the support of the Proof of Stake Alliance, and the IRS has yet to answer the Jarrett complaint.

A taxable income

In the history of the United States income tax, newly created property has never been taxable income. If a baker bakes a cake, it is not taxed when it comes out of the oven, it is taxed when sold at the bakery. When a farmer plants a new crop, it is not taxed when harvested, it is taxed when sold at the market. And when a painter paints a new portrait, it is not taxed when completed, it is taxed when sold at a gallery. The same holds true for newly created tokens. At creation, they are not taxed and should only be taxed when sold or exchanged.

Cryptocurrency is new and there are a lot of evolving terminologies that go along with it. While calling newly created token blocks “rewards” is commonplace, it’s a misnomer and could be misleading. Calling something a reward suggests that someone else is paying for it and makes it sound a lot like taxable income. In actuality, no one is paying a new token to a staker — it’s new. Instead, staking produces truly new-created property.

Some suggest that new tokens are taxable (at creation) because there is an established market where value is immediately quantifiable. Said differently, they argue that the baker’s cake is not taxable upon creation because there is no established market price that determines what the cake is worth. It is true that Tezos tokens have an immediate market value, but even this fact should be put into context: Prices can vary across marketplaces and not all markets are accessible to everyone. But the existence of a market price is often true about new property — and not just for standardized or commodity products. If the standard is whether an identifiable market value exists, then other newly created property would indeed be taxable, including unique property. When Andy Warhol completed a painting, there was a market value for his artwork; it had value with every stroke of his brush. Yet, his paintings were not taxed upon creation. Newly created property — in any context — has never been taxable, not because its value might be uncertain, but because it isn’t income yet. Cryptocurrency should be treated the same.

Other analogies to traditional tax principles are misplaced and they simply don't match up. For example, staking rewards are not like stock dividends. The IRS states in its Topic No. 404 Dividends that “dividends are distributions of property a corporation pays you if you own stock in that corporation.” Thus, dividends are a form of payment derived from a source — the corporation creates the dividend. Further, that dividend comes from the corporation’s profits and earnings. The same is not true for newly created tokens. With newly created property — like those through staking — there is no other person originating a payment and there is certainly no payment dependent on profits and earnings.

Overtaxation

Finally, the IRS position is impractical and overstates income. Staking rewards are continuously created and user participation is high. For both Cardano’s ADA and XNZ, over three-fourths of all users have staked coins. Across the spectrum of cryptocurrency staking, the pace of newly created tokens is staggering. In some instances, there are minute-by-minute and second-by-second creations of new tokens. This could account for hundreds of taxable events each year for a crypto taxpayer. Not to mention the burden of matching those hundreds of events to historical fair market spot prices in a volatile market. Such a requirement is unsustainable for both the taxpayer and the IRS. And ultimately, taxing new tokens as income results in overtaxation because the new tokens dilute the value of the tokens already in existence. This is the dilution problem and it means that if new tokens are taxed like income, stakers will pay tax on a demonstrably exaggerated statement of their economic gain.

Related: Tax justice for crypto users: The immediate and compelling need for an amnesty program

The IRS’s fervor to tax cryptocurrencies promotes an inconsistent application of the tax laws. Cryptocurrency is property for tax purposes and the IRS cannot single it out for unfair treatment. It must be treated the same as other types of property (like the baker’s cake, the farmer’s crops, or the painter’s artwork). It should not matter that the property itself is cryptocurrency. The IRS appears blinded by its own enthusiasm, therefore we must advocate for tax fairness.

This article is for general information purposes and is not intended to be and should not be taken as legal advice.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Jason Morton practices law in North Carolina and Virginia and is a partner at Webb & Morton PLLC. He is also a judge advocate in the Army National Guard. Jason focuses on tax defense and tax litigation (foreign and domestic), estate planning, business law, asset protection and the taxation of cryptocurrency. He studied blockchain at the University of California, Berkeley and studied law at the University of Dayton and George Washington University.