Social media has been abuzz with rumors that this case set a potential precedent. However, that’s not entirely accurate.
In 2021, a couple filed a lawsuit against the IRS seeking a refund of taxes they paid for Tezos network staking rewards they earned that year.
News recently broke that the couple and the IRS settled the lawsuit, and the couple is now set to receive their claimed refund; social media was abuzz with rumors that a potential precedent had been set.
However, that isn’t entirely accurate.
What rewards are at issue in the case?
It’s helpful to identify the type of rewards at issue in the case. Staking is a term that gets used in various ways with respect to cryptocurrency.
Per the court filings, the taxpayers received rewards from validating transactions on the Tezos network, commonly referred to as baking. The rewards at issue relate to newly-issued coins received from operating a baking node on the Tezos network.
It’s not clear if the rewards also included transaction fees collected in conjunction with baking a block; or if any of the rewards related to delegating rather than baking.
The issue in the case concerns whether the rewards were taxable upon receipt. The IRS has offered to concede the case, but the couple isn’t accepting the concession.
In light of the IRS’s offer, it seems logical to conclude that the IRS agrees the rewards aren’t taxable upon receipt, but we shouldn’t jump to any conclusions.
What is the couple’s argument?
The taxpayers contend that an individual baker on the Tezos network creates the new coins issued in return for baking a new block as opposed to receiving new coins as a reward.
The argument is intended to fit within an exception to general tax rules imposing tax on property received.
The exception excludes property created by an individual from being taxed until the property is sold. Think of an artist who created a new painting; they can’t be taxed on their new work until someone has purchased it.
There isn’t a clear reason why the creation argument wouldn’t apply equally to new units received in return for mining a new block on a proof-of-work (PoW) protocol.
What’s potentially wrong with the couple’s argument?
But the creation argument doesn’t seem to address other aspects of participating in baking on the Tezos network.
In conjunction with the newly-created coins issued for baking a block, a baker may also receive fees from users. The fees don’t represent newly-created coins, and thus would fall outside the creation argument.
Tezos provides for the issuance of newly-created coins to endorsers of a block that has been baked. But it isn’t clear how the creation argument would apply to these coins because the endorser is not the one baking, or creating the block.
Finally, Tezos permits the delegation of tez (XTZ) from non-bakers to bakers, so the bakers can meet the staking requirement. These delegators often receive some return from the bakers who are receiving the delegated units. That return doesn’t represent newly-created coins and also falls outside the creation argument.
The court filings here are very basic and don’t provide details about whether the couple was involved solely in baking or these other activities as well.
Why is the couple refusing to settle?
Legally, the couples’ lawsuit seeks a refund of taxes. By conceding the case, the IRS is choosing to give the couple what they asked for; the concession also allows the IRS to avoid the actual question without directly addressing how the staking rewards should be taxed.
Based on recent court filings, the couple doesn’t want the money. They are trying to push the case forward, so the court can issue a legal ruling on the proper tax treatment. That strategy, however, might not work.
Will the couples’ strategy work?
Most likely not.
Typically, courts only conduct trials and make decisions when they are necessary to resolve a dispute between parties. Here, the dispute between the parties, as framed by the couples’ initial court filing, is whether they’re entitled to the refund. If the IRS now agrees to give them the refund, the court is likely to dismiss the case since there’s no longer a dispute.
Alternatively, the couple could seek to change their initial request to keep the case alive. It’s not clear if that strategy would work but we will just need to see what happens next.
The bigger question is whether this concession actually means anything with respect to the IRS position on staking rewards.
What is the impact of the IRS’s staking concession?
Assuming the case gets resolved based on the IRS’s concession, there will be questions about what this actually means for other crypto investors.
The resolution would be a settlement between parties; it wouldn’t be a determination or ruling from the court. The court didn’t make a ruling on the issue, so the case provides no legal precedent for the tax treatment of staking rewards.
What is the IRS’s view on staking rewards?
There’s no specific IRS guidance on staking. However, the IRS guidance on mining supports that there could still be tax implications for staking activities of this nature because of its similarity to mining.
If you follow and apply IRS Notice 2014-21, the guidance on mining income, a staking reward is taxable as ordinary income at its fair market value on the date you receive it.
Even if this case doesn’t provide legal precedent, it may provide some insight into the IRS’s current position on the issue. The question is whether the IRS’s concession is an indication of its view on taxing this type of staking reward.
Until the IRS releases a formal statement or guidance on the issue, there’s no way to know if it has actually changed its position. The Department of Justice (DOJ) hasn’t formally filed anything with the court on behalf of the IRS.
Why did the IRS decide to make a concession?
A court filing on behalf of the couple shows the IRS authorized the issuance of the refund and nothing more despite the couple’s apparent requests for an explanation.
Although the filings are silent on the issue, a deeper inspection of the court filings and prior IRS guidance may provide some insight.
The amount at issue is just under $4,000. It’s possible the DOJ and the IRS are settling the case purely for its nuisance value. The case was pending in federal District Court. Given the amount at issue, it wouldn’t be surprising if the court nudged the parties toward settlement rather than incurring legal expenses that far outweigh the amount at issue.
Has the IRS changed its position on the taxation of staking rewards?
Again, the IRS has no formal guidance on staking rewards.
Although it has been slow to issue crypto guidance, the IRS has indicated guidance is in the works and it’s actively pursuing compliance efforts. It’s possible the concession is a strategic step to pave the way for issuance of guidance or pursuit of a different legal case where more money is at stake and the facts are more in the IRS’s favor.
The IRS’s silence, by itself, could indicate that its position hasn’t changed. Existing guidance expressly states mining rewards are taxable upon receipt. There’s no reason the treatment of staking rewards should be any different, particularly in light of the legal argument being pursued by the taxpayers.
If the IRS now agreed with the couples’ creation argument in this case, it would need to formally rescind or revise the existing guidance relating to mining.
Regardless, if the IRS were changing its position, it’s unlikely that would happen without the IRS issuing a clarifying statement to explain how the creation argument applies to distinct activities related to staking rewards.
Ultimately, unless the IRS makes a formal statement about the issue in the near future, it seems more likely that the concession was nothing more than a strategic step in its broader plan for guidance and compliance on these issues.
Should you examine your staking rewards for potential refund opportunities?
Before you decide you’re entitled to any refunds, you may want to consult a tax professional.
If you earned staking rewards from a proof-of-stake (PoS) protocol and treated them as taxable upon receipt, you might be entitled to a refund if you didn’t sell those units during that same tax year. The tax code, however, places a time limit on your ability to seek a refund of those taxes. The time limit is generally three years from when the return was filed.
Should you file a refund claim?
Filing a refund claim at this point might not have any effect because the IRS can refuse to grant the refund. Or, if it does grant the refund, it may still end up examining your claim and decide you need to repay the refund. Without additional clarity from the IRS, it’s difficult to know whether the expense of filing an amended return is worthwhile. One benefit of filing the refund claim is that it preserves your right to the refund even after the time limit has expired.
You can always delay your claim until you’re close to the end of the three-year time period. This approach provides some additional time for the issue to be resolved, so you can determine whether filing a refund claim is appropriate. However, you need to be careful because you don’t want to inadvertently miss the deadline.
Should you file a protective refund claim?
You can file what is known as a protective claim for refund. IRS guidance permits a taxpayer to file a protective refund claim when the treatment of an issue is unsettled or may change in the future.
A protective refund claim preserves your right to the refund, but sits on hold with the IRS until the issue is resolved. This approach gets your claim filed with the IRS, but reduces the risk of it being granted and then needing to be repaid at a later date.
Final thoughts
Each of these options should be weighed carefully. Please consult a tax professional before taking action.
Filing a refund claim isn’t an easy task. The IRS would likely require specific documentation as evidence for which units were created and not taxable upon receipt. It’s also likely you’d need to provide information reporting on which units were disposed of and when they were disposed.
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