The IRS’ crypto tax guidance is a slow creep toward rationality

In 2022, the crypto world was captivated by a lawsuit that wasn’t about Coinbase, Ripple or Grayscale. It was about Joshua and Jessica Jarrett, two Tennessee taxpayers who took on the IRS over Tezos tokens created through staking. Instead of choosing a position, the IRS demurred, sent a refund, and the case was dismissed. 

This left the crypto community, eager for regulatory guidance, in limbo. Fast forward to July 31, 2023, and the IRS has released new guidance on staking rewards. 

Spoiler alert: It’s a mess. 

The IRS’s new stance is inconsistent with current tax laws and burdens staking providers.

Why is this so complicated? 

Well, as with all things crypto, staking is anything but straightforward. At times, staking can feel like mining — you validate a few blocks, and suddenly, a coin is deposited into your wallet, ready for immediate use. That certainly feels like income. 

But more often than not, unlocking those staking rewards is a Herculean task. You might have to unstake your assets, wait out a period or even navigate a vesting schedule. In these cases, labeling it as “’instant income” is a tough sell.

The IRS’s misguided approach

The IRS has decided that staking rewards should be included in gross income the moment the taxpayer controls them. But remember, these revenue rulings aren’t law; they’re more like “strong suggestions.” 

The IRS’s opinion is just that — an opinion. And it’s one that courts, especially the Tax Court, don’t necessarily have to follow. So, before you start calculating how much you owe Uncle Sam for your staking rewards, remember that this isn’t set in stone.

The art of taxation: Why creating value isn’t the same as earning income

Tax law is like a Rubik’s Cube — complicated but solvable. The IRS’s broad definition of gross income comes with caveats. You’re not taxed for creating value; you’re taxed when that value is realized through a sale or exchange. This principle is rooted in case law and IRS rulings that have stood the test of time. 

For instance, if you’re an artist and you create a painting, you’re not taxed on the value of that painting when you finish it. You would be taxed on any income you earn from selling the painting. Wouldn’t the same hold true for digital assets? The IRS doesn’t think so.

Let’s delve into the IRS’s glaring omissions. The ruling is mum on whether tokens received from staking are “newly created property” for which the taxpayer is the original owner, which could land them in the bucket of nontaxable self-created property.

The ruling does make a passing mention that “validation rewards typically consist of newly created units of cryptocurrency.” However, this statement is conspicuously absent from the IRS’s core arguments. It’s like saying, “We know it, but we won’t admit it.”

The IRS also conveniently sidesteps key elements of landmark cases. Take the US Supreme Court case Commissioner v. Glenshaw Glass Co., which defines income as “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” The IRS ruling acknowledges “accessions to wealth” and “complete dominion,” but is eerily silent on the “clearly realized” part.

Read more from our opinion section: Yes, crypto is ready for Wall Street

Moreover, the IRS disregards a century of case law supporting the non-taxability of self-created property. They can’t just ignore Supreme Court rulings like Eisner v. Macomber, which established that income isn’t taxable until realized, or Anschutz v. Commissioner, which reinforced that a taxable event occurs upon sale or exchange, not creation.

The unbearable weight of staking taxes

Locked rewards aren’t taxable until you can use them, but the IRS’s guidance would create an administrative nightmare and force stakers into financial gymnastics just to pay their tax bills. 

If you declare your staking rewards as immediate income, you’re cornered into unenviable choices: Liquidate your new tokens, compromising network security; halt some staking, reducing your holdings; divert other investment funds; or, heaven forbid, evade taxes (don’t do it). And let’s not forget the phantom income menace — owing taxes on tokens that have tanked in value by tax season. You could be taxed on “ghost money.”

A missed opportunity for the IRS

The IRS’s guidance leaves us with more questions than answers. From slashing penalties to the tax obligations of foreign stakers, the IRS has a lot more explaining to do. 

Should slashing penalties be considered ordinary losses if rewards are ordinary income? The IRS is tight-lipped. Do foreign stakers owe US income tax if they delegate staking to US nodes? Could this be considered a “US trade or business?” Will the standard 30% withholding tax apply to these foreign stakers? How will liquid staking assets like Lido’s stETH be treated? Many argue they should qualify for capital gains treatment. Until these questions are answered, the tax landscape for staking remains as clear as mud.

The IRS had a golden opportunity to craft nuanced regulations for this complex area of tax law. Instead, they’ve given us a one-size-fits-all approach that fits no one. This issue is far from settled and is likely headed for the courtroom unless Congress steps in. 

The IRS’s guidance is a half-baked attempt that could stifle innovation and burden an emerging industry. It’s time for a more thoughtful approach.

Start your day with top crypto insights from David Canellis and Katherine Ross. Subscribe to the Empire newsletter.

Explore the growing intersection between crypto, macroeconomics, policy and finance with Ben Strack, Casey Wagner and Felix Jauvin. Subscribe to the Forward Guidance newsletter.

Get alpha directly in your inbox with the 0xResearch newsletter — market highlights, charts, degen trade ideas, governance updates, and more.

The Lightspeed newsletter is all things Solana, in your inbox, every day. Subscribe to daily Solana news from Jack Kubinec and Jeff Albus.