Lawsuit Challenging Taxation Of Cryptocurrency Tokens Generated Through Staking Dismissed As Moot – Fin Tech – United States – Mondaq

To print this article, all you need is to be registered or login on Mondaq.com.

The early dismissal of a federal lawsuit that could haveresolved whether certain cryptocurrency tokens can be taxed asfederal income feels like business as usual for an industryaccustomed to uncertainty. At issue in this taxpayer-initiatedlawsuit was whether cryptocurrency tokens generated through thestaking process are properly taxed as income. Resolution of thisissue was poised to make a significant effect on the digital assettax scheme, particularly after Ethereum - the world's secondlargest cryptocurrency by market cap - recently transitioned to aproof-of-stake consensus protocol.

Plaintiffs, two Tennessee taxpayers, engaged in a cryptocurrencystaking operation involving Tezos, a cryptocurrency that uses theproof-of-stake mechanism to validate transactions. Transactionvalidators for proof-of-stake platforms must first"stake" or pledge as collateral a number of their owntokens as their "buy in" to be chosen as a validator. Ifchosen, the staker-validator then uses their computing power tovalidate transactions, or blocks of data, that are added to ablockchain. Successful validators are rewarded with thecryptocurrency tokens that are created when the new blocks of dataare validated and added to the blockchain.

In 2019, Plaintiffs' Tezos staking efforts created 8,876 newTezos tokens. When tax season arrived, Plaintiffs initiallyreported $9,407 in "other income" from the new Tezostokens on their 2019 tax returns. Later claiming that the new Tezostokens were not subject to federal taxation as income, Plaintiffsrequested a nearly $4,000 refund from the IRS.

According to Plaintiffs, the creation of Tezos tokens throughthe proof-of-stake validation process was no different from a bakerbaking a cake where that freshly baked cake is considered newproperty, not income subject to taxation. Not until Plaintiffs soldthose new tokens - just like the baker selling the cake - wouldthey be subject to federal income tax based on that realized gain,or so Plaintiffs argued.

The Government initially rejected Plaintiffs' claim thattokens generated through staking were not income and denied therefund request. But as the court case progressed, the Governmentchanged its tune and agreed to issue a full refund - every pennyPlaintiffs requested - to resolve the case. The Government did notexplain why it decided to issue the refund or whether tokensgenerated through staking are indeed taxable.

Determined to secure a judgment that the newly created tokenswere not income for tax purposes, Plaintiffs rejected the refund.From Plaintiffs' perspective, if they accepted the refund forthat year, they would be forced to fight with the IRS every yearover whether the tokens they generated that year from staking weretaxable.

Plaintiffs tried to reject the refund "offer," but theGovernment issued it anyway and then moved to dismiss the case asmoot. The Government argued the case was moot becausePlaintiffs' complaint only raised whether the denial of refundin tax year 2019 was proper. Because the Government issued a fullrefund to Plaintiffs for tax year 2019, the issue (refundeligibility for 2019) was moot and incapable ofrepetition.As the Government saw it,Plaintiffs' lawsuit did not actually implicate the broaderpolicy question of whether tokens generated through staking aretaxable as income.

The Court agreed with the Government's position, rejectingPlaintiffs' contention that a live issue remained or that thisissue would reoccur every year that Plaintiffs continued to engagein staking. The Court also disagreed with Plaintiffs (supported byan amicus brief from Coin Center) that the issue was of significantpublic importance needing judicial resolution.

Barring an appeal in this case, those who had hoped forclarification on this issue remain disappointed. What is certain isthat the Government was careful not to leave too many clues aboutwhether it has changed its position on whether tokens generatedthrough staking were taxable income. Buried in a footnote in theGovernment's motion to dismiss, it noted that "the grantof a refund for one taxpayer for one year is neither a prospectivenor universal statement of IRS policy about the many individualitems reported on a tax return for any given year." Thisappears to respond to a statement from the "Proof of StakeAlliance" that the IRS's decision to issue a refund inthis case was an indication that it no longer considered tokensgenerated through staking as income.

This case was also particularly significant because thepopularity of proof-of-stake protocols is on the rise, due at leastin part to the perception that they are more energy efficient thanproof-of-work consensus protocols (e.g., Bitcoin). But how the IRSwill treat tokens generated from staking remains unclear. In 2014,the IRS issued guidance that cryptocurrency "mining" ortokens issued to validators who successfully validate transactionson proof-of-work platforms (no staking required) were income.See IRS Notice 2014-21 ("when a taxpayer successfully'mines' virtual currency, the fair market value of thevirtual currency as of the date of receipt is includible in grossincome") (https://www.irs.gov/pub/irs-drop/n-14-21.pdf).Interestingly, absent from the Government's answer toPlaintiffs' complaint or in its motion to dismiss was anyforceful argument leveraging this older guidance for the point thatany tokens created or received from validating blockchaintransitions are taxable income, whether or not those tokens aregenerated through a proof-of-work or proof-of-stake protocol.

We may not get our answer unless and until Plaintiffs file arefund request next tax season!

The content of this article is intended to provide a generalguide to the subject matter. Specialist advice should be soughtabout your specific circumstances.

POPULAR ARTICLES ON: Technology from United States

Continued here:
Lawsuit Challenging Taxation Of Cryptocurrency Tokens Generated Through Staking Dismissed As Moot - Fin Tech - United States - Mondaq