Crypto staking rewards and their unfair taxation in the US

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The United States Internal Revenue Service (IRS) is expanding tax regulations to align with its cryptocurrency agenda. At no point in tax history has pure creation been a taxable event. However, the IRS tries to tax new tokens as income at the time they are created. This is a violation of traditional tax principles and is problematic for several reasons.

In 2014, in an FAQ on IRS Notice 2014-21, the IRS stated that mining activities would result in gross taxable income. It is important to note that IRS notices are guidelines only, not the law. The IRS concluded that mining is a trade or business and the fair market value of the mined coins is immediately taxed as ordinary income and subject to self-employment tax (an additional 15.3%). However, this guide is limited to proof-of-work (PoW) miners and wasn’t released until 2014 – long before staking became mainstream. Its applicability to staking is particularly misguided and inapplicable.

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A newly filed lawsuit, now pending in federal court in Tennessee, denies IRS taxation of taxing rewards as they arise. Plaintiff Joshua Jarrett participated in the Tezos blockchain – he unplugged his Tezos (XNZ) and contributed his computing power. New blocks were created on the Tezos blockchain, resulting in newly created Tezos for Jarrett. The IRS taxed Jarrett’s newly created tokens as gross taxable income based on the market value of the new Tezos tokens. Jarrett’s attorneys correctly pointed out that newly created property is not a chargeable event. This means that new property (here the newly created Tezos tokens) is only taxable if it is sold or exchanged. Jarrett has the support of the Proof of Stake Alliance and the IRS has yet to respond to the Jarrett complaint.

A taxable income

In US income tax history, newly created wealth was never taxable income. When a baker bakes a cake, it is not taxed when it comes out of the oven, but is taxed when it is sold in the bakery. When a farmer grows a new crop, it is not taxed when it is harvested, but when it is sold in the market. And when a painter paints a new portrait, it is not taxed when it is finished, but taxed when it is sold in a gallery. The same goes for newly created tokens. They are not taxed when created and should only be taxed when sold or exchanged.

Cryptocurrency is new and there are many evolving terminologies that come with it. While it is common to call newly created blocks of tokens “rewards”, it is a misnomer and could be misleading. Calling something a reward suggests someone else is paying for it, and it sounds very much like taxable income. In fact, nobody pays a staker a new token – it’s new. Instead, staking really creates newly created property.

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Some suggest that new tokens be taxable (when created) as there is an established market where value is instantly quantifiable. In other words, they argue that the bakery cake is not taxable when it is made because there is no set market price that determines the value of the cake. It is true that Tezos tokens have an immediate market value, but again this fact should be put in context: prices can vary from market to market and not all markets are accessible to everyone. But the existence of a market price often applies to new real estate – and not just to standard or mass-produced products. If the standard is whether there is an identifiable market value, then other newly created properties would in fact be taxable, including unique properties. When Andy Warhol completed a painting, there was a market value for his work of art; it was worth every stroke of his brush. However, his paintings were not taxed when they were created. Newly created wealth – in no context – was never taxable, not because its value would be uncertain, but because it is not yet income. Cryptocurrency should be treated equally.

Other analogies to traditional tax principles are out of place and just don’t fit together. For example, staking rewards are not like stock dividends. The IRS, in Issue 404, Dividends, states that “Dividends are distributions of assets that a company pays you when you own shares in that company.” Dividends are thus a form of payment that comes from one source – the company creates the dividend. In addition, this dividend comes from the company’s profits and earnings. The same does not apply to newly created tokens. With newly created wealth – as with staking – there is no other person who makes a payment and certainly no profit and income-related payment.

Oversteer

After all, the IRS position is impractical and overrates income. Staking rewards are created continuously and user participation is high. Over three quarters of all users have used coins for both Cardanos ADA and XNZ. Across the spectrum of cryptocurrency staking, the pace of newly created tokens is staggering. In some cases, new tokens are created every minute and every second. This could add up to hundreds of taxable events each year for a crypto taxpayer. Not to mention the burden of matching those hundreds of events in a volatile market with historical fair market prices. Such a requirement is untenable for both the taxpayer and the IRS. And ultimately, taxing new tokens as income leads to over-taxation as the new tokens dilute the value of the existing tokens. This is the dilution problem and means that when new tokens are taxed like income, stakers are paying taxes on a demonstrably exaggerated representation of their economic gain.

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The IRS’s eagerness to tax cryptocurrencies encourages inconsistent application of tax laws. Cryptocurrency is owned for tax purposes and the IRS cannot weed it out for unfair treatment. It must be treated in the same way as other types of property (such as the baker’s cake, the farmer’s harvest, or the painter’s artwork). It shouldn’t matter that the property itself is a cryptocurrency. The IRS seems to be blinded by its own enthusiasm, so we need to stand up for tax justice.

This article is for general informational purposes and is not intended and should not be construed as legal advice.

The views, thoughts, and opinions expressed herein are those of the author alone and do not necessarily reflect the views and opinions of Cointelegraph.

Jason Morton practiced as a lawyer in North Carolina and Virginia and is a partner at Webb & Morton PLLC. He is also an Attorney General in the Army National Guard. Jason focuses on tax defense and litigation (foreign and domestic), estate planning, business law, asset protection, and cryptocurrency taxation. He studied blockchain at the University of California, Berkeley and studied law at the University of Dayton and George Washington University.