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The Irs Was Just Handed a Resounding Defeat in Court!

The Irs Was Just Handed a Resounding Defeat in Court!

In the crypto world, tax season has never been simple, and this year has been no exception. The Internal Revenue Service has declared that it is tightening up its enforcement of crypto tax laws, most notably through “Operation Hidden Treasure,” which aims to uncover unreported cryptocurrency revenue. Tax law enforcement is an essential component of every well-functioning tax system.

Similarly, providing public guidance on how the government interprets tax rules is an important part of any system in which taxpayers voluntarily submit taxable income.

The IRS has yet to offer taxpayers clarification on the proper tax treatment of different crypto-related transactions, particularly for individuals who earn token rewards via staking on proof of stake blockchains.

With nearly 40 million Americans or 16 percent of all adults in the United States, having acquired cryptocurrencies in 2018, this lack of clarity is affecting an increasing number of taxpayers.

This is especially true for those working with proof of stake blockchains, a rapidly increasing aspect of the cryptocurrency ecosystem in which users can produce new tokens by staking, an ecologically friendly method of validating transactions on proof of stake networks.

Proof of stake activity increased by 571 percent between 2020 and 2021, accounting for 31% of the cryptocurrency market, with 25 of the top 100 cryptocurrency networks using this consensus mechanism.

Because the IRS has yet to release guidelines on the proper tax treatment of staking incentives, many proof-of-stake stakers and staking businesses are taking a cautious approach. Those taxpayers report the value of reward tokens as income at the time they are created, rather than when they get money from selling them.

Staking prizes as income at the time of production would be in violation of more than a century of tax law. The artist, for example, does not get money when their painting is finished.

Instead, money is made when the artwork is sold. Similarly, a farmer earns money only when his or her crops are sold, not when they are harvested. When a stalker issues reward tokens as part of their efforts to protect a blockchain, the same applies.

Aside from being against the law, taxing staking rewards based on their creation rather than disposition is a terrible policy that risks discouraging participation in a developing technology that has ramifications for American competitiveness.

If staking rewards are taxed as income at the time of formation, entities that participate in staking as a service generate tens of thousands of reward tokens per hour and potentially have millions of taxable events per year.

Recordkeeping, accounting, and paying taxes on each token at the time it is issued create a massive administrative overhead that could dissuade the great majority of business participants in the United States from participating.

In addition to the administrative overhead that taxing reward tokens at the time of creation imposes on the taxpayer, this treatment has other negative consequences for the taxpayer.

If a speaker is required to recognize gain on the staking reward at the time of formation, the staker must sell the newly produced tokens, set aside—but not stake—a portion of the validator’s tokens, or set aside other liquid assets to pay the tax owed on the reward tokens. Each of these alternatives has drawbacks.

First, because the protocol’s security is dependent in part on the amount of staked tokens, compelling the staker to sell those tokens makes the protocol less secure.

Second, if the staker must set aside other liquid assets (such as cash) to pay taxes, those liquid assets have effectively been invested in the protocol. Third, due to the infancy of the technology, it is very uncommon for tokens linked with a proof of stake network to have significant price fluctuations over the course of a year.

Fourth, there may not be a liquid market for the tokens, or even a market at all, in order to sell them. Taxing the token’s worth at the time of creation might quickly turn into a tax on fictitious income.

When it comes to receiving appropriate tax treatment on staking prizes, taxpayers who want to prevent this unfair treatment have few, expensive, and time-consuming choices.

Josh Jarrett, a previous customer of mine, illustrated this when he sued the United States for a tax refund in an attempt to get a court ruling that incentive tokens should only be deemed income when they are sold.

Jarrett, the owner of a Tennessee SmartGym and a Tezos staker, created 8,876 XTZ tokens by validating transactions in 2019. Despite the fact that he did not sell or exchange these tokens, he chose to be prudent and pay income tax on the value of these tokens when they were created.

He filed a refund claim for this tax in 2020, claiming that he had not received income from the creation of reward tokens and that they should only be deemed income when they are sold, as is the case with any newly generated property.

His refund request was neither accepted nor denied by the IRS. Jarrett sued the United States in the United States District Court for the Middle District of Tennessee six months later, seeking a refund and a declaration that staking awards would not be taxed as income at the time they were created.

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The US Department of Justice informed Jarrett in December 2021 that it would be asking the IRS to issue the refund in an attempt to settle the case. The government’s intention was simple: by issuing the refund case, it could claim that it had supplied Jarrett with the remedy he sought and that there was no more issue to resolve because he had gotten the result he wanted by filing the lawsuit.

As a result, the government is attempting to utilize the provided refund to avoid a potentially binding court finding that staking awards are only taxed at the time of disposition. Jarrett tried to refuse the return, but his lawsuit may be dismissed as moot.

The existing tax picture for stakeholders is untenable, as taxpayers are forced to choose between prejudicial tax treatment on the one hand, and a multi-year administrative and legal process on the other, in order to get fair treatment.

This is disappointing since one approach for the government to foster the responsible expansion of blockchain technology in the United States is to provide adequate and equitable tax treatment for all staking rewards.

The research and experimentation tax credit, the deductibility of home mortgage interest, favorable tax treatment for depreciable property used in a trade or business, and capital gains for funds invested in opportunity zones are just a few of the provisions in the Internal Revenue Code designed to encourage or discourage certain activities.

Each of these Code provisions exists because the United States wants to support a specific behavior as a matter of policy.

Proof of stake methods consume far less energy than proof of work protocols and provide a fertile ground for technical advancement. Because the security of proof of stake protocols is dependent in part on the number of tokens staked in the network,

the US may encourage this budding business to grow deeper roots in this nation by taxing reward tokens in the same manner that the IRS handles all other newly generated property.

For the benefit of American innovation, it’s past time for the US to handle proof of stake properly.

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