In a US District Court complaint filed May 26, 2021, a married couple is seeking a refund of taxes they paid on cryptocurrency tokens the husband created, asserting that current law does not permit the treatment of created property as taxable income. They argue that instead an eventual sale or exchange of such tokens is the activity that results in the taxable event.1 The taxpayers’ argument challenges one of the fundamental guiding principles the IRS has asserted with respect to cryptocurrency, dating back seven years. In Notice 2014-21 (the Notice), the IRS first provided taxpayers with guidance relating to cryptocurrency.2 While relatively brief in analysis and substance, the Notice provided that for US federal income tax purposes, cryptocurrency should be treated as property, with general tax principles applying, including, e.g., that tokens received in exchange for mining are income to the recipient upon receipt. In the complaint, the taxpayers assert they did not receive the tokens at issue as compensation, but rather created them, like a baker who bakes a cake, and that they should not be taxed immediately on the creation of new property. While this case, like many implicating cryptocurrencies, is highly factual involving an intricate understanding of the relevant technologies, it will be interesting to see whether the court slices a narrow ruling limited in application, or serves up the whole cake and tackles income realization in the context of cryptocurrency creation. Either way, a ruling in favor of the taxpayers would be more than just food for thought – it would be a rejection of longstanding IRS cryptocurrency guidance with the potential for far-reaching effects.
Overview of the claim
At the heart of this claim is an understanding of how blockchain technologies work and the creation of cryptocurrencies occur. The units of cryptocurrency at issue in this case are Tezos tokens. Cryptocurrencies, like Tezos coins, use cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. A blockchain is a particular cryptographic data structure that transmits data in blocks that are connected to each other in a chain. There are two primary methods for users to validate cryptocurrency transactions: mining and staking. Mining is the process by which computers create new blocks in the chain that validate cryptocurrency transactions and maintain the distributed ledger. Miners are rewarded for the “validation service” by the issuance of new units of cryptocurrency. Staking involves the validator pledging some of its tokens to prove the validity of the transactions reported in the particular block on the chain. Both methods, mining and staking, can result in the miners and validators receiving newly created cryptocurrency tokens.
The taxpayer in this case alleges that his staking enterprise resulted in the creation of new blocks on the Tezos public blockchain, which in turn resulted in the creation of new Tezos coins. Further, the taxpayer alleges no person, as defined by the Internal Revenue Code, paid the newly created Tezos coins to him. Because the taxpayer neither sold nor exchanged any of the new Tezos coins received as a result of his staking enterprise, the taxpayer alleges he has yet to realize any income. The taxpayer compares his situation to that that of a “baker who bakes a cake using ingredients and an oven, or a writer who writes a book using Microsoft Word and a computer.” The taxpayer believes that the new Tezos coins he created as a result of his staking enterprise should be treated in a similar manner to such other created property and that as a result, he should not realize income until he sells or exchanges the new property he created.
Eversheds Sutherland perspective
Not unlike most transactions implicating cryptocurrencies, and potentially due to the lack of comprehensive guidance specific to this new technology provided to date by the IRS, the taxpayers in this case seek to rely on dated, albeit well-respected, caselaw to apply long-standing tax principles to this new technology. The taxpayers cite to the Supreme Court’s decisions in both Eisner v. Macomber3 and Commissioner v. Glenshaw Glass,4 for the propositions that income must involve a “coming in,” and that income includes an accession to wealth that is “clearly realized” in order to be treated as income. The taxpayers allege these principles must be interpreted in their favor, e.g., that created property “goes out” from the taxpayer rather than “comes in” and created property is not “realized” wealth.
Depending on one’s view of cryptocurrency technology, tokens resulting from “validation services” may be considered created by the validator, or issued to the validator. As noted by the taxpayer, a question arises as to “who” would be issuing such new coins and whether that “who” is a person under current tax law. It will be interesting to see how the court addresses these fundamental questions regarding the nature of crypto technology and to which traditional activities the parties engaging in crypto activities are more analogous for tax purposes, service providers or creators of new property. If the latter, the IRS may need to revisit its entire recipe collection with respect to the tax treatment of such technology.
It should be noted that, currently, a few cryptocurrency exchanges, including Coinbase, do treat newly created cryptocurrencies received in connection with staking activities as income to the taxpayer, which is consistent with the IRS guidance in the Notice. Coinbase, on its user help webpage, specifically addresses staking activities and states that US customers subject to US tax reporting “are required to report their earnings from Staking rewards” and that Coinbase will send a Form 1099-MISC to all US customers that earn over $600 in staking rewards.
Thus, in addition to taxpayers who are acting as miners and validators, the outcome of this case could also impact the US tax reporting obligations of cryptocurrency exchanges, and prompt the IRS to issue new and different guidance on this issue across the board.