Crypto Tax Update:
What advisors need to know about the Jarrett et al v. United States of America settlement
The following article is for informational purposes only and does not constitute investment or tax advice. Onramp Invest encourages crypto investors to work with a tax accountant proficient in the nuances of cryptoasset transactions in compliance with up to date IRS guidance.
Oversight of the evolving crypto and DeFi landscape is a common area of concern and confusion for many in the investment space. With taxes typically seen as a pillar of the broader financial planning process, ongoing guidance and rulings from the IRS in regard to crypto-related activity by investors should be top of mind for financial advisors who want to assist crypto-owning clients with remaining compliant on their tax forms moving forward.
Much has been written on Twitter and elsewhere in regard to the recent settlement between the IRS and the Nashville couple (Jessica and Joshua Jarrett) who filed a complaint in court that they should not have to pay taxes on unredeemed rewards from staking on the Tezos blockchain network. The following post unpacks what this settlement could mean for the space and provides an overview of the tax precedents in place prior to this event.
Before going any further, we should put the underlying economic activity in context. Staking is the process by which cryptoasset holders commit those assets to support a blockchain network in return for rewards. Staking rewards are typically offered at a variable rate, representing a percentage return on the overall cryptoassets pledged/committed by the asset holder. Staking rewards differ from network to network and, as with loaning assets in the traditional world, also consider the time period over which assets are pledged. These rewards are not always issued in the same cryptoasset that is staked, and there is of course some risk in the underlying protocols. As a result of this risk, stakers are heavily incentivized to work for the network by validating transactions properly (as well as maintain a certain amount of ”up-time” where they are validating transactions or they risk losing some or all of their stake). More loosely, staking can also refer to committing cryptoassets to lending protocols in order to earn rewards or interest.
Setting the Scene
In early February of this year, in a US District Court in Tennessee, the IRS made an offer to settle with Jessica and Joshua Jarrett of Tennessee in a dispute arising out of his 2019 tax return. Mr. Jarrett had initially reported in good faith his staking rewards from the Tezos blockchain ecosystem as “other income” on his 2019 return. In the time allotted to do so, and after receiving tax advice, he amended his return which resulted in money being owed to him from the IRS. After not receiving a response from the IRS for nearly a year, Mr. Jarrett filed a complaint in the district court seeking a refund from the government.
Finally, on February 3, 2022, after initially disputing his case the Department of Justice made an offer of settlement and directed the IRS to issue a tax refund based on the amended return. The result of the case has received a lot of attention from both the crypto and advisor community but, although it is a win for Mr. Jarrett financially, it is not necessarily an indication of the ultimate position of the IRS in regards to staking activities.
One critical distinction to make is that this particular scenario is related to “unredeemed” rewards. The plaintiff never took possession of the staking rewards. Had they done so and sold them, the prevailing opinion would be that those rewards should be reported as income, dividends, or property received in kind based on the specific nature of the transaction.
In Jarrett v. USA, the Jarretts asserted that “federal income tax law does not permit the taxation of tokens created through a staking enterprise.” They argued that staking activity is similar to that of a baker who produces property, and that the taxable income will occur upon the sale or exchange of the newly created property. To finish the analogy, a baker is not taxed when they bake a cake, but rather when they sell it.
This is a perfect example of a taxpayer defending their “reasonability test” (more below) in a novel economic case not covered by the existing tax code. For a deeper tax dive, see supreme Court tax decisions Eisner v. Macomber, 252 U.S. 189 (1920) and Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955). In their pleading, the Jarretts also cited dictionary meanings of the term “realize.”
So… What Does This All Mean?
To begin with, this is a win for the cryptoasset ecosystem. However, it is certainly not a statement from the IRS that income from staking is tax free, which is how many are portraying it. The fact that they did not redeem or sell the rewards is critical.
Individual and corporate tax filing elections are often based on IRS precedent resulting from formal court cases. The tax code itself lays out guidelines for what is clearly allowed and what is clearly not allowed, but as usual there is a spectrum of “it depends” between the two.
Here we get into a little understood aspect of professional tax preparation: a lot of what is allowed or disallowed specifically by the IRS is determined by legal precedent. In this way, the “realistic tax framework” for individual taxpayers is more similar to case law than absolute rules. Like the body of laws in the US, a lot of it is clarified by legal precedents without updating the underlying legislative language.
As a general statement, the better CPAs and tax preparers out there help their clients 1) take what is absolutely allowed, 2) avoid what is absolutely forbidden, and most crucially identify areas where they are entitled to deductions and credits based on a “reasonability test” as laid out in the tax code or by legal precedent. The main takeaway here is that you can and should take taxable deductions and credits that you, in conjunction with your tax advisor, feel that you or your business are entitled to.
The test for this is simple – “Am I willing to stand up in court and declare that I fully believe, based on my best interpretation of the nearest applicable tax code and legal precedents, that I or my business was entitled to take those benefits based on a reasonable interpretation of the relevant guidance.”
Some key points in regards to Jarrett v USA: It is not a binding precedent as it settled out of court. The IRS is still likely to take the same position with future taxpayers as they did with Jarrett. That said, it is impossible to know if the IRS settled because they agreed with the plaintiff or if the “juice wasn’t worth the squeeze.”
That being said, it is good news. A taxpayer in the exact same situation as Jarrett is likely (consult your tax advisor!) best served taking the same approach, since although no precedent was set it certainly seems that the IRS was unwilling to proceed. Please note that this only applies to scenarios that closely resemble this situation.
Investors and their tax advisors should interpret the tax code and IRS legal precedents in good faith and only pursue beneficial elections if they are prepared to defend them. A lot of cryptoasset guidelines are likely to be set by legal precedent as opposed to the formal amendment of the tax code by the IRS.
The more complex your cryptoasset holdings, strategies, and transactions are the more complex the tax decisions will be. A trusted, competent, compliant tax advisor, be it CPA, lawyer, or tax preparer, is a critical member of your financial team. For more straightforward cryptoasset allocations, an advisor familiar with the cryptoasset space is a powerful resource. Many professionals are simply not fluent or willing to become so in regards to cryptoassets. This is not a knock on them, but it is a good nudge to find a provider with more tacit knowledge of your particular financial situation. If you own a Ford for 15 years and have an incredible mechanic, when you buy a Ferrari you probably will need to find a new mechanic. This is not a bad thing for you or the mechanic, it’s just what happens.
In summary, although not a decisive win for the taxable status of staking rewards, it is still a crucial victory for the space.It shows that the IRS is open to determining the tax status of cryptoasset economic activity. As with much of the regulatory landscape, tax provisions in relation to cryptoasset transactions will continue to evolve as the space does. Onramp Academy curates timely updates specifically for financial advisors that enable them to provide best in class service to their clients in any market environment. Forward thinking advisors have the ability to provide value to crypto-owning clients when it comes to ensuring compliance with up to date IRS guidelines. Check out our 2021 Cryptoasset Tax Guide in Onramp Academy to learn more about the tax implications of participation in the crypto ecosystem.