By Merritt Francis

 

In prior blog posts, I’ve written on blockchain technology, its future implementation into the private and public sectors, and NFTs.[1]  Blockchain technology is a decentralized, distributed ledger that records transactions.  It may be helpful to think of blockchains like a bank ledger, where computers record the transactions rather than individuals. Blockchains are “decentralized” because there is no central authority for data stored on them; transactions are recorded by a peer-to-peer network run by participant “nodes”.  Blockchains are “distributed,” because all transactions are viewable by the public.  Once a transaction is recorded on a blockchain, it is unmodifiable.

Transactions are recorded on a blockchain by participant “nodes,” which are computers completing consensus algorithms, allowing the transaction to be recorded on the blockchain.  Once an individual submits a transaction on a blockchain, the transaction is only recorded once a participant node satisfies the blockchain’s respective consensus algorithm.  There are two main examples of consensus algorithms blockchains use today: proof of work (PoW) and proof of stake (PoS).  I will first explain the PoW and PoS consensus algorithms, then proceed to examine the tax consequences Joshua Jarrett found himself in by engaging in a PoS blockchain.

PoW (Proof of Work) Consensus Algorithms

Bitcoin and Ethereum, two widely adopted blockchain technologies, employ a proof of work (PoW) consensus algorithm.[2]  Under a PoW consensus algorithm, participant nodes (crypto miners) download and run the full chain through a mathematical function.  Once a node has satisfied the PoW consensus algorithm, it’s rewarded by “mining” a block, which is the act of adding valid blocks onto the blockchain.  For example, the hash for Bitcoin block #660000, mined on December 4, 2020, is 00000000000000000008eddcaf078f12c69a439dde30dbb5aac3d9d94e9c18f6.  The block reward for that successful hash was 6.25 BTC.[3]

PoW makes it extremely difficult to alter any aspect of the blockchain, since such an alteration would require re-mining all subsequent blocks.  Unfortunately, however, PoW is bad for the environment because it uses up an immense amount of computing power.  Ethereum’s PoW consumes 73.2 TWh (terawatt-hour) annually, which is the energy equivalent of a medium-sized country like Austria.[4]  Tesla suspended vehicle purchases using Bitcoin due to climate change concerns.[5]  Elon Musk elaborated on the decision in a tweet, saying “Cryptocurrency is a good idea on many levels and we believe it has a promising future, but this cannot come at great cost to the environment.”[6]

PoS (Proof of Stake) Consensus Algorithms

In response to the PoW blockchains’ negative externalities, the proof of stake (PoS) consensus algorithm was created as an environmentally friendly alternative.  PoS “doesn’t rely on expensive hardware using vast amounts of electricity to compute mathematical puzzles,” like bitcoin’s PoW system.[7]  Under a PoS consensus algorithm, owners of a cryptocurrency offer their coins to nodes as collateral, and those nodes have a chance to validate new blocks.[8]  Offering coins as collateral to participant nodes is the process of “staking” your cryptocurrency.[9]  Coin owners with staked coins become “validators,” which entitles them to cryptocurrency rewards for each new block its node validates.[10]  This is what happened in Jarrett v. United States.[11]

Jarrett v. United States of America

During 2019, a Nashville couple, Joshua and Jessica Jarrett, received 8,876 tezos (XTZ) in staking rewards.  The tezos coins were worth $9,407 when the Jarretts received them, and they reported $9,407 as income and paid the related taxes.[12]

On July 31, 2020, the Jarretts filed an amended tax return demanding a $3,793 refund from the IRS.  Under IRS Notice 2014-21, virtual currencies are considered property for federal tax purposes.[13]  And, pursuant to § 1001(a) of the IRC (Computation of gain or loss), the gain from the sale or other disposition of property shall be the excess of the amount realized over the adjusted basis.[14]  As such, the Jarretts argued the virtual currency they received as staking rewards did not amount to taxable income because property is only taxed when it is sold or dispossessed, rather than when the property is created.[15]

The United States Department of Justice ordered the IRS to issue a $3,793 refund to the Jarretts, which they received on February 14, 2022.  The Jarretts, however, refused to accept the refund because the IRS failed to acknowledge the true rationale for issuing the refund.[16]

The rationale behind issuing the refund would provide precedent for other stakers to properly file their income taxes in the future.  So, the Jarretts sought a formal ruling from the United States District Court for the Middle District of Tennessee.  In response, the United States filed a motion to dismiss arguing the Jarretts’ action was moot because the United States fully refunded the claimed overpayment.[17]

In its February 28, 2022 motion to dismiss, the United States stated that “Mootness is ‘the doctrine of standing set in a time frame: The requisite personal interest that must exist at the commencement of the litigation (standing) must continue throughout its existence (mootness).’”[18]  Because the Jarretts received a full refund, as the United States argues, the Jarretts’ action for a refund is moot.

Taxpayers who engage in staking their cryptocurrencies will likely have to continue to speculate as to how the IRS will approach taxing staking rewards.  One thing is clear: it is time for the I.R.S. to release guidance on the matter.

 

[1] Merritt Francis, You Bought a JPEG File for $69.3 Million – What Are You Allowed To Do With It?, Richmond J. L. Tech. (2021), https://jolt.richmond.edu/2021/10/20/you-bought-a-jpeg-file-for-69-3-million-what-are-you-allowed-to-do-with-it/; Merritt Francis, Blockchain as Best Practice: The Benefits of the Criminal Justice System Implementing Blockchain Technology, Richmond J. L. Tech. (2021), https://jolt.richmond.edu/2022/01/06/blockchain-as-best-practice-the-benefits-of-the-criminal-justice-system-implementing-blockchain-technology/.

[2] Jake Frankenfield, Proof of Work (PoW), Investopedia (July 22, 2021), https://www.investopedia.com/terms/p/proof-work.asp.

[3] Id.

[4] Proof-Of-Work (POW), Ethereum (Mar. 28, 2022), https://ethereum.org/en/developers/docs/consensus-mechanisms/pow/.

[5] Lora Kolodny, Elon Musk says Tesla will stop accepting bitcoin for car purchases, citing environmental concerns, CNBC (May 12, 2021), https://www.cnbc.com/2021/05/12/elon-musk-says-tesla-will-stop-accepting-bitcoin-for-car-purchases.html.

[6] Id.

[7] Rachel-Rose O’Leary, The Creator of Proof-of-Stake Thinks He Finally Figured It Out, CoinDesk (Sept. 13, 2021, 4:21 AM), https://www.coindesk.com/markets/2018/09/07/the-creator-of-proof-of-stake-thinks-he-finally-figured-it-out/.

[8] Id.

[9] Id.

[10] Id.

[11] Jarrett v. United States of America, Docket No. 3:21-cv-00419 (M.D. Tenn. May 26, 2021).

[12] Id.

[13] I.R.S. Notice 2014-21.

[14] I.R.C. § 1001.

[15] Jarrett, Docket No. 3:21-cv-00419.

[16] Id.

[17] Id.

[18] Id.

Image source: https://sftaxcounsel.com/taxation-of-crypto-staking/

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