In an effort to gain clarity on the taxation of proof-of-stake rewards, a “baker” on the Tezos blockchain system made what some might consider the ultimate sacrifice: He declined a refund offered by the Internal Revenue Service.
The IRS offered to refund Joshua Jarrett the amount of tax he paid on tokens he received for his staking activity. He sued for a refund in federal district court, arguing that the property that is created by a staking reward is akin to bread baked by a baker, that should only be taxed when it is sold.
Because blockchains do not have central recordkeepers, they rely on participants to validate transactions and achieve consensus, according to the Proof of Stake Alliance, an industry association: “Different blockchains have implemented different mechanisms to achieve this consensus. Proof-of-stake blockchains achieve consensus when token holders temporarily commit or ‘stake’ their tokens to a staking protocol and then are chosen at random to validate and create new blocks of transactions. In creating new blocks, ‘stakers’ also create new tokens, incentivizing token holders to help keep the network decentralized and secure.”
Proof-of-stake protocols permit even those with small token holdings to validate transactions, which also expands the number of those who are able to earn rewards for validating transactions.
“Most of the early cryptocurrencies like Bitcoin and Ethereum used proof of work to validate transactions,” according to Kell Canty, CEO of crypto-reporting platform Ledgible. “The newer ones use other means. Ethereum will be transitioning to proof of stake later in the year.”
In a letter from Assistant Attorney General David Hubbert to Jarrett’s lawyer, David Forst, the Justice Department stated that it authorized and directed the IRS to schedule a full refund in the amount of $3,793, plus statutory interest for the 2019 tax year. Forst’s response rejected the proffered refund.
“The draft stipulation suggests that, in the Department of Justice’s view, the proffered refund brings the parties’ dispute to an end. Particularly after our recent call, we cannot share that view,” said Forst.
According to Forst, there were no guarantees that the IRS wouldn’t similarly tax the Jarretts in subsequent tax years, or even in 2019 itself. “The IRS will also apparently not provide any assurances with respect to the sole issue that gave rise to this litigation — whether tokens created through staking a particular cryptocurrency constitute taxable income at the time of their creation,” he continued. “As the question will arise for the Jarretts again in subsequent tax years, they would remain at risk even if they accepted the proffered refund. Therefore, the Jarretts reject the proffered refund and intend to continue vindicating their rights in court.”
In response to the lawsuit, Ledgible announced reporting options for staking rewards.
“As there still remain differing positions around how staking rewards are taxed, Ledgible wants to ensure our users are fully supported in how they decide to report staking activity to the IRS,” said Canty. “This new change will allow tax filers and professionals the ability to toggle staking rewards income reporting as treatment evolves.”
Near the end of 2021, proof-of-stake tokens represented 30% of the total crypto market, according to Canty: “If Ethereum completes its move to proof of stake, PoS chains would be nearly half of the crypto market cap.”
