Keyword: blockchain

Against the backdrop of rapidly evolving blockchain technology, the IRS has oftentimes been slow to update its related tax guidance, leaving participants in the blockchain ecosystem uncertain about their tax obligations. Perhaps nowhere is this lethargy more pronounced than in the context of the consensus mechanisms that drives the entire blockchain network. Whereas, traditionally, coins rewarded pursuant to proof-of-work mechanisms have been treated as payment for services, an alternative class of consensus mechanisms, called proof-of-stake, may just be different enough to result in deferred taxation. Whether this is true is the subject of a recent legal claim that may, once resolved, shed light on the tax treatment of the increasingly popular proof-of-stake consensus mechanism.

Proof-of-Work Taxation

In 2014, an IRS Notice stated that a person that mines new blocks in a blockchain through a proof-of-work consensus mechanism must include any virtual currency received in connection with such activities in the miner’s gross income at the virtual currency’s fair market value. The ruling had an immediate impact on blockchains, such as Ethereum and Bitcoin, that depend on miners to add new data or ‘blocks’ to the chain. Through the proof-of-work consensus mechanism, miners are challenged to be the first to identify the missing number needed to solve a staggeringly complex hashing algorithm. For the lucky few who succeed, thousands of dollars’ worth of Ether or Bitcoin are awarded and—according to the IRS—taxable on receipt.

In the years following the IRS’s ruling, however, the taxation of mining has been complicated by the gradual adoption of an alternative consensus mechanism referred to as proof-of-stake. Under this method, miners—now typically called validators—are required to “stake” their holdings of a blockchain’s native coin in order to be eligible to win the right to add a new block to the chain. The more coins that a validator stakes, the greater the chance that they will be selected by the blockchain’s validation algorithm to add a new block to the chain. If the selected validator proposes an invalid block, however, the validator’s coins (or portion thereof) will be destroyed. This risk of loss in proof-of-stake validation adds a layer of complexity that is not present under the proof-of-work model, which simply involves the payment of virtual currency in exchange for the use of raw computational power to solve the mathematical puzzle. In addition, token holders will often stake their holdings to allow a third party, a validator, to use their tokens to validate the transaction as part of the proof-of-stake consensus mechanism. A welcome feature of proof-of-stake validation is that it requires considerably less energy than proof-of-work validation.

Whether this new feature is enough to challenge the taxability of any tokens or coins generated by the validation process has remained an open question that has only recently been publicly considered by the IRS.

The Jarretts—Answers at Last?

Sometime in 2019, Joshua Jarrett decided to participate on the Tezos blockchain as a validator. Jarrett staked his holdings in the native coin—Tezos—and as luck would have it, he won the right to propose new blocks on the Tezos chain. In return for validating the next block on the Tezos chain via the proof-of-stake consensus mechanism, Jarrett received 8,876 Tezos coins and dutifully paid $3,293 in federal taxes on the gain reported on his and his spouse’s joint federal income tax return.

A year later, the Jarretts had a change of heart and sought a $3,293 refund by filing an amended tax return. The Jarretts took the belated position that the coins were not taxable, using the “creation of an asset” theory. They argued that “new property—property not received as payment or compensation from another person but created by the taxpayer—is not and has never been income under U.S. federal tax law.” The Jarretts further reckoned that “[l]ike the baker or the writer, Mr. Jarrett will realize taxable income when he first sells or exchanges the new property he created, but the federal income tax law does not permit the taxation of the Jarrett’s [sic] simply because Mr. Jarrett created new property.”  The IRS denied the Jarretts’ refund claim, and the Jarretts filed a refund suit in the Middle District of Tennessee. Had the Jarretts taken the position on their original return that the reward was not taxable upon receipt, the IRS would have had been required to assess the unpaid tax. If the Jarretts wanted to challenge the assessment, they would have had to do so in the Tax Court. The IRS (and often many taxpayers) prefers to litigate technical issues in the Tax Court because of the court’s technical expertise.

The government countered that Joshua Jarrett never created new Tezos coins. Rather, in line with the tax treatment applicable to proof-of-work, the government argued that “Jarrett exchanged Tezos tokens for goods and/or services during 2019.” As such, Jarrett received the coins as payment for successfully proposing new blocks to the Tezos chain, and those coins were indeed taxable on receipt.

In something of an about-face, at the start of 2022, the government relented and offered to refund the Jarretts, as they had initially requested. However, unwilling to accept the government’s offer, the Jarretts have since elected to press on in order to force a definitive ruling on the taxability of virtual currency generated from proof-of-stake consensus mechanisms. The case is scheduled for trial in March 2023, and a final ruling may not take place until then.

Nonetheless, the Jarretts’ case is important to the blockchain industry as many chains have adopted, or are in the process of migrating toward, a proof-of-stake consensus mechanism, including Ethereum. The government’s initial concession appears to provide some basis to argue that perhaps an alternative tax treatment is appropriate, but the IRS may simply want to identify a taxpayer that did not report the tokens as taxable, assess a deficiency and force the taxpayer to sue in Tax Court. Blockchain participants, however, will have to wait for a firmer, and much needed, answer.