Taxable Talk

Let’s say you really want the IRS to change how it treats an issue that impacts you.  So you file a tax return including that item (as the IRS wants it done), adding $9400 of income and $2000 to your tax.  Then you file an amended return (a “Claim for Refund”) removing the item.  The IRS doesn’t timely process the return/refund (which is typical), so you file a claim in District Court.  The IRS then issues the refund, but you don’t cash the check because you want this dispute to be heard in court.  Is the matter moot?

That’s what was heard in the US District Court for the Middle District of Tennessee in the case of Jarrett v. United States.  I wrote about the case earlier this year, and noted that it was quite likely the Jarretts wouldn’t like the result.  And that’s what happened last month when Judge William L Campbell, Jr. dismissed the lawsuit.

The problem for the Jarretts is simple: Once the IRS refunds the money, what are you arguing?  You asked for a refund and received it!  That you would like the court to decide is nice, but, “The Court does not provide advisory opinions.”  So the Jarretts are out the money to hire attorneys, and we (taxpayers and tax professionals) don’t know with certainty how staking should be taxed.

It’s not as if the Court didn’t recognize the problem here:

Plaintiffs also argue that a decision on whether Tezos tokens created through “staking” are taxable income is of significant public importance because there are other taxpayers who engage in the same activity. The Court is not persuaded that the existence of an unanswered tax question, which is unquestionably of interest to the group of taxpayers who create Tezos tokens, provides an exception to mootness in this case…The Supreme Court has long recognized the problems presented by Congress’ decision to require taxpayers to challenge adverse tax decisions on a backward-looking basis, i.e. after taxes have been paid or assessed.

Unfortunately, the issue is moot for the 2019 tax year (the year in question) but not for 2020, 2021, or 2022:

The Court finds no reasonable expectation that Plaintiffs will be subject to the same action again. As stated above, the instant controversy was limited to whether Plaintiffs were entitled to a refund of taxes paid for the 2019 tax year. This particular issue is not capable of repetition as any subsequent claim for refund would necessarily apply to a different tax year (“The tax amounts in dispute and the nature of the claim for a refund are specific to each individual tax year.” Moreover, as this is the Jarretts’ first suit to seek a refund after paying income tax on Tezos tokens, it is premature to speculate the Jarretts’ tax refund claims will repeatedly evade review. [citation omitted]

Eventually, there are likely to be one or more court cases that are precedential impacting cryptocurrency (which would be a good thing), but this is not going to be such a case: “Plaintiffs’ claim for relief is MOOT.”

With NFTs (non-fungible tokens), DeFi (decentralized finance), DAOs (decentralized autonomous organizations), and staking the rage in cryptocurrency, there are a lot of questions on what this means for taxes.  Then on Friday I see headlines like, “IRS Will Not Tax Unsold Staked Crypto As Income.”  So before I move toward NFTs et. al., let’s start with this report and staking.  And even that has issues as there are many different kinds of staking.

Here, the staking involved is for Tezos.  The taxpayers  received about $9,400 of Tezos and they had to decide how it should be taxed.  The problem is that while the IRS has ruled cryptocurrency is property, and how airdrops and similar things are taxed, the IRS has not given definitive guidance on staking.  Should you use the principle that since you received $9,400 of value, you have $9,400 of income?  (In that scenario, when you sell it you will have a capital gain or loss with $9,400 of basis.)  Or should it be no income today but income tomorrow when you sell the Tezos?  (Here, you would have ordinary income of whatever you sell the Tezos for.)

The major issue in determining what to do is that it has typically taken the IRS three years to issue rulings on cryptocurrency matters.  When there is no law, regulation, or guidance, taxpayers are required to use general tax law principles. Given how the IRS has ruled on airdrops, it’s more likely than not the IRS will rule that the Tezos the taxpayer received were income when received.

Indeed, that’s what the taxpayers did on their originally filed tax return for the 2019 tax year.  The taxpayers then filed an amended return asking for a refund (based on that $9,400 not being income).  That they didn’t receive a response isn’t a surprise: It’s taking the IRS twelve months to process an electronically filed amended return; it’s taking 18 months for paper-filed amended returns.  Under the law, if you file a “Claim for Refund” (which is done by filing an amended return asking for a refund) and the IRS doesn’t respond within six months, you can file a court action in federal District Court or the federal Court of Claims.  The taxpayers filed a court case demanding the refund in District Court.

Last week, the federal government offered to give the refund.  This led to those headlines stating unsold staked crypto is not income.  Unfortunately, those headlines are anything but true today.  (It is possible they may be true tomorrow, though.)  The action by the Department of Justice could be for any number of reasons:

• The IRS doesn’t like the fact pattern of this case, and would prefer to fight a different case;
• The IRS wants to delay this issue until they have more time to study it; or
• The Department of Justice looked at the cost of fighting this case and the dollar amount of the refund, and decided it made economic sense to let the taxpayers have the refund.

Had the taxpayers accepted the refund (they did not), this would not have led to a precedential ruling that unsold staked crypto is not income.  It would have been solely related to those taxpayers and that fact pattern (the Tezos they received).  Had the taxpayers received some other crytpo via staking in 2020, they would have had to fight the IRS again.  It definitely would not have been applicable to any other taxpayers.

As I noted, the taxpayers did not accept the US government offer, so the case moves forward.  As of today, there is no trial date scheduled.  It is possible that the judge will rule in favor of the US government or the taxpayers.  Given that there is no trial date, it’s possible there will not be a ruling in this case until 2023.  If the government wins, I would expect the taxpayers to appeal (to the Sixth Circuit Court of Appeals because the taxpayers reside in Tennessee); they have stated they would like to have a precedent set.  If the taxpayers win, the US could just pay the refund amount or appeal.  If they pay, that would lead to a nonprecedential case.  It would be binding on the taxpayers and the IRS as to the fact pattern in the case, but it would not be binding on you or I.  If the US appeals, it might or might not lead to a precedential decision; not all appellate ruling are considered precedential.  Even if there is a precedential ruling, it would only be binding in Kentucky, Michigan, Ohio, and Tennessee (though other courts would likely look at the decision).

What does this mean for today?  First, the headlines that unsold staked crypto isn’t income are not true.  Everyone is still required to use basic tax principles in determining whether this kind of staking leads to immediate income (or not).  In a later part of this series I’ll look a little more in depth at staking and explain why a taxpayer win in this case might not be a win (and could be a loss for taxpayers).  We also have to consider how the doctrine of constructive receipt fits into staking.  Second, the most conservative course of action is to include staking as income (when received).  I believe it is more likely than not that’s how the court will rule.  (The taxpayers do have some tax law on their side, though; this is definitely not a slam dunk case.)  Third, until the court actually rules nothing has changed.  The IRS offer to pay the refund could have nothing to do with the case itself.  The best analysis of this case that I’ve seen is from the National Law Review; I would strongly advise anyone involved with cryptocurrency staking to peruse the linked article for a far better analysis of the matter than almost anything else I’ve seen.  Finally, anyone involved in such staking should discuss this with their tax professional.  There are some options as it relates to the 2018 tax year that fall off a cliff in April that taxpayers may want to consider.  Additionally, there are options in how this activity is treated on your tax return that you and your tax professional should discuss.

(The court case is Jarrett v. United States, No. 3:21-cv-00419 (M.D. Tenn.).)