When Are Staking Rewards Taxable?

In a surprise reversal of its position that staking rewards are taxable at the time of receipt, the IRS has offered to settle with a Tezos staker who claims rewards are only taxable when sold. This case, Jarrett v. United States, involves the staking of Tezos tokens.  This IRS decision has caused confusion because it appears to be a tactical move, not a change in policy, much less a binding precedent. Before discussing how stakers might respond, it’s worth understanding more about the case and staking income.

Staking Income

 In the Tezos public blockchain, holders of Tezos tokens are entitled to “stake” their tokens, earning new Tezos token rewards. The participants in the “proof of stake” employ their Tezos tokens to validate transactions, create new blocks on the Tezos public blockchain (which create records of transactions and ownership of Tezos) and earn rewards. To participate in this process, the holders of Tezos use software on their computer to operate a “node” and validate new blocks. Alternatively, if a user does not wish to operate a node, users delegate their tokens to someone else who, in exchange for a fee, operates a node and stakes the holder’s Tezos on the holder’s behalf. In contrast to Bitcoin mining, rewards in Tezos staking are allocated in proportion to the number of Tezos staked rather than in proportion to computing power.

Taxation of Staking Income

 Although the IRS has offered no guidance on staking income, its position can be concluded from rulings on mining income and hard forks. Notice 2014-21 announced that the fair market value of mining rewards is taxable on the date of receipt. Revenue Ruling 2019-24 ruled that new cryptocurrency received as part of a “hard fork” (when an existing cryptocurrency splits into two competing versions) is taxable income when the taxpayer exercises “dominion and control” over that new cryptocurrency. 

 Whenever a taxpayer receives “new” cryptocurrency, whether through mining, a hard fork, or airdrop, the IRS has treated this receipt as a taxable event. The taxpayer has income equal to the fair market value of the new cryptocurrency when the taxpayer exercises control.  The IRS views staking rewards in the same way: taxable on receipt.

Jarrett: Staking Rewards are … not Income

 In 2020, a Tennessee couple filed an amended tax return claiming a refund of all their 2019 tax paid in relation to their Tezos staking income. When the IRS denied their refund claim, the Jarretts went to court. Although the amount at stake was modest – a mere $3,793 – the case had an outsized significance. The Proof of Stake Alliance, an organization formed to promote proof of stake technology, sponsored the case hoping to establish a judicial precedent.

The taxpayers claimed that staking income is taxable only when the staking rewards are sold. Instead of income, staking rewards represent property that the taxpayers created through their own efforts, similar to a cake that a baker bakes or a writer’s book. Just as a baker is taxed only when the baker sells a cake and an author is taxed only on book sales, the “bakers” of Tezos should not be taxed on earning Tezos rewards but only at the time of selling those rewards.

IRS Settlement Offer

Recently, the IRS offered to settle the taxpayers’ claim by issuing a full refund. The IRS decision to grant a refund is not an official pronouncement of IRS policy. Even after granting a refund to the taxpayers, the IRS may deny other claims on amended returns. Thus, merely issuing a refund to the taxpayers does not establish an IRS policy or any authority or precedent upon which other taxpayers can rely.

Not satisfied with a mere refund in their quest for a precedent, the Jarretts are now attempting to continue the case by turning down the IRS offer. It’s unclear if the court will agree with the IRS that the refund resolves the case, or if the court will allow the case to continue. The case is set for bench trial on March 7, 2023 so it may take a long time until we learn the outcome.

 Why did the IRS settle? It was likely its fear of losing, its concern over devoting too many government resources to a small case limited to a single year, or some combination of the two. Unfortunately, in settling, the IRS elevated its own strategic calculations over clarity of tax policy.

Whatever the reason, the IRS concession does not signal a change in IRS policy. From the IRS’s perspective, staking rewards remain taxable when received. Unfair or not, stakers who adopt the position that staking rewards are taxable only when sold can expect an audit or for their amended return to be denied.

Stakers Sometimes Prefer to be Taxed On Receipts, not Sales

At first blush, taxing staking rewards at the sale rather than receipt seems like a win for stakers. Yet the IRS position will sometimes result in stakers paying less tax on their rewards!

This is because if the rewards are only taxed when sold, they will be taxed as ordinary income. If stakers are taxed on receipt of rewards but hold tokens after they are earned, any gain on those tokens at the time of sale is taxed as capital gain.

Compare how rewards are taxed under the IRS position versus what the Jarretts’ position in this example: 

• On January 1, 2022, Sue earns 100 Tezos worth $4 each, for $400. Sue immediately sells 50 Tezos for $200, the same price she earned the Tezos. On June 1, 2023 Sue sells her remaining 50 Tezos at $300 each, for $15,000.

With the IRS position, at the highest tax bracket, Sue pays $148 in income tax when she earns the 100 Tezos (37% of $400). Sue pays her tax from the $200 of proceeds from the sale of 50 Tezos, which generates no gain or loss.  When she sells the remaining 50 Tezos she has $14,800 of gain ($15,000 - $200) and because it is long-term capital gain she pays $2,960 in income tax (20% of $14,800). She pays a total of $4,108.

With the Jarretts’ position Sue only pays tax when she sells. She pays $74 when she sells 50 Tezos on January 1, 2022 (37% of $200) and she pays $5,550 when she sells the remaining 50 Tezos on January 1, 2025 (37% of $15,000). Here, she pays $5,624.

For Sue, the tax with the Jarretts’ position is so much higher because the proceeds from the sale of 50 Tezos on January 1, 2025 is not taxed at the preferential rate for long-term capital gain.

What Should Stakers Do?

The IRS decision to offer a refund to the Jarretts openly invites all stakers to file an amended return claiming staking rewards are only taxable on sale. This is urgent for stakers who may be facing a statute of limitations on filing an amended return, which is fast approaching for tax returns filed for the 2018 tax year.

But it’s not clear that stakers should take this opportunity. Instead, stakers should ask: Am I better off filing an amended return? If so, when should I file? And what position should I take on my next tax return?

When filing an amended return, stakers pay tax on their staking rewards on their original return, hoping to recover this tax when they file an amended return. With this position, stakers need to fund their tax liability generated on receipt of the staking rewards. This undermines what is arguably the main benefit of the Jarretts’ position: that stakers need not sell staking rewards as they are earned to fund their tax liability.  

As significant as the IRS decision appears at first blush, it may not offer much practical help to stakers. However, stakers need to know the significance of this decision and assess how it may affect their future operations and accrued tax liability.