The U.S. Internal Revenue Service (IRS) is expanding tax rules to accommodate its cryptocurrency program. At no time in fiscal history has pure creation been a taxable event. Still, the IRS seeks to tax new tokens as income when they’re created. This is a violation of traditional tax principles and problematic for several reasons.
In 2014, the IRS stated in an FAQ of IRS Notice 2014-21 that mining activities would result in gross taxable income. It is important to note that IRS notices are only guidelines and are not the law. The IRS concluded that mining is a trade or business and that 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, these guidelines are limited to Proof of Work (PoW) minors and were not published until 2014, long before staking became the norm. Its applicability to staking is particularly erroneous and inapplicable.
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A new lawsuit currently pending in federal court in Tennessee challenges the IRS’s imposition of staking rewards when they are created. Plaintiff Joshua Jarrett has embarked on the staking of the Tezos blockchain – staking its Tezos (XNZ) and contributing its computing power. New blocks were created on the Tezos blockchain and spawned newly created Tezos for Jarrett. The IRS taxed Jarrett’s newly created tokens as taxable gross income based on the fair market value of the new Tezos tokens. Jarrett’s lawyers have correctly pointed out that the newly created property is not a taxable event. That is, new goods (here, newly created Tezos tokens) are only taxable when they are sold or traded. Jarrett has the support of the Proof of Stake Alliance, and the IRS has yet to respond to Jarrett’s complaint.
In the history of income tax in the United States, newly created property has never been taxable income. If a baker bakes a cake, he is not taxed when it comes out of the oven, he is taxed on sale at the bakery. When a farmer plants a new crop, it is not taxed when it is harvested, it is taxed when it is sold at the market. And when a painter paints a new portrait, it is not taxed when it is finished, it is taxed when it is sold in a gallery. The same goes for newly created tokens. At creation, they are not taxed and should only be taxed when they are sold or traded.
Cryptocurrency is new and has many evolving terminologies with it. While it is common to refer to newly created chip blocks as “rewards”, this is a misnomer and could be misleading. Calling something a reward suggests someone else is paying for it and it sounds a lot like taxable income. In reality, no one pays a new token to a staker – this is new. Instead, staking produces a truly new property.
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Some suggest that new tokens are taxable (at inception) because there is an established market where value is immediately quantifiable. In other words, they argue that the baker’s cake is not taxable when it is created because there is no established market price that determines the value of the cake. It is true that Tezos tokens have immediate market value, but even this fact needs to 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 is often true for new properties – and not just for standardized or basic products. If the norm is whether there is an identifiable market value, then other newly created assets would indeed be taxable, including unique assets. When Andy Warhol finished a painting, there was a market value for his artwork; he was valuable in every brushstroke. However, his paintings were not taxed at creation. A newly created asset – in any context – has never been taxable, not because its value might be uncertain, but because it is not yet income. Cryptocurrency should be treated the same.
Other analogies to traditional tax principles are misplaced and simply do not match. For example, stake rewards are not like stock dividends. The IRS states in Topic # 404 Dividends that “Dividends are distributions of property that a company pays you if you own shares of that company.” So, dividends are a form of payment derived from one source – the company creates the dividend. In addition, this dividend comes from the profits and profits of the company. The same is not true for newly created tokens. With newly created properties – like staked ones – there is no other person making a payment and there is certainly no payment dependent on profit and income.
Finally, the IRS position is impractical and overstates income. Staking rewards are continuously created and user participation is high. For Cardano’s ADA and XNZ, more than three-quarters of all users have bet coins. Across the spectrum of cryptocurrency staking, the pace of newly created tokens is staggering. In some cases, there are minute-by-minute and second-by-second creations of new tokens. This could represent hundreds of taxable events each year for a crypto taxpayer. Not to mention the burden of matching those hundreds of events to historical fair market spot prices in a volatile market. Such a requirement is unsustainable for both the taxpayer and the IRS. And finally, taxing new tokens as income results in over-taxation because new tokens dilute the value of already existing tokens. This is the dilution problem and it means that if the new tokens are taxed as income, investors will be paying taxes on a clearly exaggerated statement of their economic gain.
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The IRS’s fervor taxing cryptocurrencies fosters inconsistent enforcement of tax laws. Cryptocurrency is property for tax purposes and the IRS cannot distinguish it for unfair treatment. It should be treated the same as other types of goods (like the baker’s cake, the farmer’s crops, or the painter’s artwork). It doesn’t matter that the property itself is a cryptocurrency. The IRS seems blinded by its own enthusiasm, so we must advocate for tax fairness.
This article is for general information purposes and is not intended to be and should not be construed as legal advice.
The views, thoughts and opinions expressed here are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Jason morton practices law in North Carolina and Virginia and is a partner at Webb & Morton PLLC. He is also a judge advocate in the Army National Guard. Jason focuses on tax defense and tax litigation (foreign and domestic), estate planning, business law, asset protection, and cryptocurrency taxation. He studied blockchain at the University of California at Berkeley and studied law at the University of Dayton and George Washington University.