Introduction:
There is a raging debate on social media about whether the activity of cybercurrency
staking is similar to a baker who creates a cake using raw ingredients and is not taxed until the
cake is sold, or whether staking involves personal services and the taxpayer is receiving assets
(new coins) as compensation, in which case, receipt of the coins is immediately taxable.
The Controversy:
The current controversy involves a Tennessee Federal District Court case, Jarrett v. US in which a taxpayer who paid taxes on “staking rewards” (new coins he received for his activities), sued for a refund claiming his actions were comparable to the baker making a cake. IRS agreed to pay the refund and has moved to have the case dismissed. Many commentators, without the slightest clue as to how IRS operates, have erroneously concluded that staking is akin to making a cake, because IRS decided to issue a refund in the Jarrett case and have the case dismissed
Potential Reasons for the Refund:
First, the amount in controversy involved a refund claim of $3,000 and is would cost the government probably ten times, if not twenty or thirty times the refund claim the litigate the matter. More importantly, IRS is working on the issue of how to tax staking activities and has not reached a conclusion. The issue involves potential hundreds of millions, if not billions in future tax revenue and, logically, IRS did not want a federal judge (who may or may not have substantial federal tax experience) making a potential adverse decision that would cause massive confusion, before it establishes a position on the matter. Thus, the issuance of a $3,000 refund should not be considered definitive win for those participating in staking.
Based on current law, staking income should be realized when there is payment for the services, in the form of an asset, whether a virtual asset or otherwise. In the Jarrett case, the taxpayers received Tezos tokens worth approximately $9,000, so they received property with an ascertainable value for work performed and taxpayers should be taxed upon receipt of the coins.
Taxpayers’ Argument:
Taxpayers’ claim that newly created property is not an accession to wealth that is clearly realized — the making a cake analogy– so they should not be taxed until the coins are sold. Taxing them when the coins are received is analogous to taxing a baker when the cake is finished and for sale, whether or not someone buys it. But were taxpayers actually making the Tezos coins? They reviewed and validated new blocks within an existing block chain, but did not actually create the Tezos coins in the sense that a baker creates a cake or an author writes a book.1 They were paid for their services with coins.
The” Central” Issue:
The core question is the value of the asset when received. In many cases, the asset’s value is zero, in which case the taxpayer does not have income when the asset is received (the taxpayer has a zero basis in the asset). When the asset has an ascertainable fair market value upon receipt, the asset should be immediately taxable; thus, if the asset’s value is $10 when received, taxpayer has $10 in compensation income and a $10 basis in the asset for determining future gains or losses. In Jarett’s case, the coins were worth $9,000 upon receipt, so they should be taxed on that amount as ordinary compensation income.
Conclusion:
It will be interesting to see whether IRS decides that staking is like making a cake or is just another form of payment for personal services.
1 Of course, they had a small role in the creation of the coins, but the same can be said of an auto assembly-line working making a car. If the worker received a car as payment, could the worker claim the car is not taxable under the “making a cake, writing a book” rationale?