IRS Taxation of Staking Rewards

As a team, we have been focusing on virtual asset taxation from a US perspective  - https://htj.tax/?s=crypto+irs

The IRS has not issued any clear guidance on the taxation of staking rewards. In 2014, the IRS issued Notice 2014-21, which provides that cryptocurrency is treated as property for federal tax purposes, but Notice 2014-21 and subsequent Revenue Ruling 2019-24 and frequently asked questions do not provide any further guidance on the tax treatment of staking rewards. This absence of guidance has produced widespread interest in a case before the Middle District of Tennessee, Jarrett v. U.S., which centers on the tax treatment of staking rewards.

Jarrett v. U.S.

In 2019, Joshua Jarrett engaged in staking, by which he used his existing Tezos tokens to contribute to the creation of new blocks on the Tezos public blockchain. This resulted in Jarrett’s creation of staking rewards in the amount of 8,876 new Tezos tokens. Jarrett and his wife, Jessica, reported the value of the staking rewards on their 2019 jointly federal income tax return as ordinary income and paid the related taxes.

In July 2020, the Jarretts filed an amended tax return, asserting that their staking rewards were not income subject to tax and requested a refund from the IRS in the amount of $3,793. The IRS did not at first respond to the request for a refund, which allowed the Jarretts to sue for a refund in May 2021. The Jarretts’ complaint asserted that federal income tax law does not permit the taxation of tokens created through a staking enterprise and that tokens created through staking are only taxable upon the sale or exchange of the tokens.

In December 2020, the Jarretts received a letter from the U.S. Department of Justice notifying them that the IRS had been authorized to provide the Jarretts a full refund, plus interest. The Jarretts rejected the refund offer because the IRS did not provide a reason for the refund and left open the issue of whether the creation of tokens through staking is a taxable event.

A trial in the Jarrett case is scheduled for March 2023. But in a conference on Feb. 10, 2022, counsel for the United States reported they intend to move to dismiss the case on mootness grounds. If the judge does not grant the motion to dismiss, the case can proceed to the merits of the issue.

The IRS’s refund offer has generated considerable speculation about the taxation of staking rewards. But the offer is not a concession as to the tax treatment of staking rewards and cannot be relied on as precedent by other taxpayers in similar positions. Taxpayers engaged in staking should consult their tax advisors before taking a position on their staking rewards in their tax returns.

What Is Staking?

Like a lot of things in crypto, staking can be a complicated idea or a simple one depending on how many levels of understanding you want to unlock. For a lot of traders and investors, knowing that staking is a way of earning rewards for holding certain cryptocurrencies is the key takeaway.

How does staking work?

If a cryptocurrency you own allows staking — current options include Tezos, Cosmos, and now Ethereum (via the new ETH2 upgrade) — you can “stake” some of your holdings and earn a percentage-rate reward over time. This usually happens via a “staking pool” which you can think of as being similar to an interest-bearing savings account.

The reason your crypto earns rewards while staked is because the blockchain puts it to work. Cryptocurrencies that allow staking use a “consensus mechanism” called Proof of Stake, which is the way they ensure that all transactions are verified and secured without a bank or payment processor in the middle. Your crypto, if you choose to stake it, becomes part of that process.

This is where it starts to get more technical. Bitcoin, for instance, doesn’t allow staking. To understand why, you need a little bit of background.   Cryptocurrencies are typically decentralized, meaning there is no central authority running the show. So how do all the computers in a decentralized network arrive at the correct answer without having it fed to them by a central authority like a bank or a credit-card company? They use a “consensus mechanism.”

Many cryptocurrencies — including Bitcoin and Ethereum 1.0 — use a consensus mechanism called Proof of Work. Via Proof of Work, the network throws a huge amount of processing power at solving problems like validating transactions between strangers on opposite sides of the planet and making sure nobody is trying to spend the same money twice. Part of the process involves “miners” all over the world competing to be the first to solve a cryptographic puzzle. The winner earns the right to add the latest “block” of verified transactions onto the blockchain — and receives some crypto in return.

For a relatively simple blockchain like Bitcoin’s (which functions a lot like a bank’s ledger, tracking incoming and outgoing transactions) Proof of Work is a scalable solution. But for something more complex like Ethereum — which has a huge variety of applications including the whole world of DeFi running on top of the blockchain — Proof of Work can cause bottlenecks when there’s too much activity. As a result transaction times can be longer and fees can be higher.

What is Proof of Stake?

A newer consensus mechanism called Proof of Stake has emerged — with the idea of  increasing speed and efficiency while lowering fees. A major way Proof of Stake reduces costs is by not requiring all those miners to churn through math problems, which is an energy-intensive process. Instead, transactions are validated by people who are literally invested in the blockchain via staking.

Staking serves a similar function to mining, in that it’s the process by which a network participant gets selected to add the latest batch of transactions to the blockchain and earn some crypto in exchange.

The exact implementations vary from project to project, but in essence, users put their tokens on the line for a chance to add a new block onto the blockchain in exchange for a reward. Their staked tokens act as a guarantee of the legitimacy of any new transaction they add to the blockchain.

The network chooses validators (as they’re usually known) based on the size of their stake and the length of time they’ve held it. So the most invested participants are rewarded. If transactions in a new block are discovered to be invalid, users can have a certain amount of their stake burned by the network, in what is known as a slashing event.

What are the advantages of staking?

Many long-term crypto holders look at staking as a way of making their assets work for them by generating rewards, rather than collecting dust in their crypto wallets.

Staking has the added benefit of contributing to the security and efficiency of the blockchain projects you support. By staking some of your funds, you make the blockchain more resistant to attacks and strengthen its ability to process transactions. (Some projects also award “governance tokens” to staking participants, which give holders a say in future changes and upgrades to that protocol.)

What are some staking risks?

Staking often requires a lockup or “vesting” period, where your crypto can’t be transferred for a certain period of time. This can be a drawback, as you won’t be able to trade staked tokens during this period even if prices shift. Before staking, it is important to research the specific staking requirements and rules for each project you are looking to get involved with.

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