Brief commentary on recent cases, rulings, notices, and related federal tax guidance.
Jarrett Case Raises New Questions on How to Report Cryptocurrency “Staking” Rewards
While the IRS has not specifically addressed the taxation of staking rewards, they have indicated a willingness to treat these rewards in the same manner as mining rewards, which are taxable when received. While the Jarrett case indicates that a one-size fits all approach to taxing crypto rewards may not be appropriate, nothing in the case, so far, provides a strong authority on how staking rewards should be taxed. If you have received staking rewards, you should consult with your tax advisor in order to explore your specific reporting options and obligations.
In 2014, the IRS took the position that “when a taxpayer successfully ‘mines’ virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.” Mining a cryptocurrency, through the proof of work consensus mechanism, is the process of solving a complex algorithm in order to verify transactions and add new data to the blockchain. By being the first to solve the algorithm, the miner is rewarded with a certain amount of the cryptocurrency for the computational effort it took to validate the transactions.
The proof of work system was broadly adopted as the consensus mechanism for many cryptocurrencies, especially at the time the IRS took their position on mining rewards. Recently, however, another consensus mechanism called “proof of stake” has been gaining popularity. Under this system, a cryptocurrency holder is required to “stake” their cryptocurrency to be eligible to win the right to become a “validator” or “forager” and validate transactions for the blockchain. Alternatively, a cryptocurrency holder could stake their holdings in favor of a third party validator who becomes responsible for performing the validation if selected. The system selects one eligible validator to verify and add the new data to the blockchain. If successful, the validator receives the rewards. If the validator proposes invalid transactional data, however, the validator’s staked cryptocurrency, or a portion thereof, will be destroyed. This risk of loss adds complexity to the proof of stake system and ensures correct validations.
Reporting Positions for Staking versus Mining Rewards
While the IRS has yet to provide specific guidance regarding the taxation of staking rewards, taxpayers have taken various positions on the matter. The Jarrett v. U.S. case, currently making its way through the U.S. District Court, is causing speculation as to which position is correct. Jarrett argued that new tokens granted as a staking reward were created through the use of his own computing power to validate transactions. Thus, like a newly created piece of art or a newly baked cake, the created tokens should not be taxable until they are sold or exchanged for something of value.
The IRS disagrees with this position. In line with the tax treatment applicable to mining rewards, the IRS argued that Jarrett received the tokens as payment for successfully validating new transactions for the blockchain. Thus, those tokens were taxable on receipt. In a sudden change of course, however, the IRS issued Jarrett a refund and moved to dismiss the case. The IRS has not explained the reason for the refund.
A Proactive Approach
If the case is ultimately dismissed, the issuance of a refund should not be seen as the IRS’s acquiesce of Jarrett’s argument nor authority to claim that staking rewards are not taxable on receipt. The IRS can still continue to take the position that staking rewards are taxable on receipt. Moreover, even if the IRS ultimately agrees that Jarrett’s staking rewards are not taxable on receipt, that does not mean that all staking rewards will not be taxable on receipt. The complexity of the proof of stake system may mean that taxpayers earn staking rewards in situations that vary widely from the nuances in this specific case. The differences in these situations may mean that some staking rewards are taxable on receipt while others may not be. If you have received staking rewards, you should take a proactive approach and consult with your tax advisor in order to explore the reporting options and obligations relative to your specific circumstances.
New Passthrough Reporting Requirements (and Exceptions) for Foreign Items
The global economy has become increasingly integrated over the years, leading to an ever-increasingly complex sprawl of tax provisions governing international commerce. Recently, the IRS imposed a new filing obligation on passthrough entities and certain individuals in order to reduce the complexity of tax return preparation, substantiation, and filing. In theory, this is a welcome change, but the scope of filing obligation may catch some unaware. Fortunately, the IRS has extended some grace to taxpayers in 2021, but there are actions that taxpayers should take now and in the future to ensure compliance, including:
- Verifying the filing status of partners by requesting updated Forms W-8 or W-9;
- Reviewing past business activity to see if any information is required to be reported on the new forms; and
- Updating governing documents, such as partnership agreements, LLC agreements, and shareholder agreements, to ensure they permit or mandate a process to facilitate the exchange of relevant owners information.
Beginning in tax year 2021, certain partnerships, S corporations, and individuals filing Form 8865 will be required to include new Schedules K-2 and K-3 with their tax returns to report items of “international tax relevance” to the IRS and (in the case of partnership and S corporations, to their owners). The intent of the new schedules is to provide uniformity and clarity for taxpayers in reporting foreign transactions and business activity attributed to them from passthrough entities, with the ultimate goal of improving efficiency.
The filing obligation is fairly straightforward in the case of a partnership or S corporation conducting business activity abroad, but the filing obligation also applies to partnerships or S corporations without foreign-source income or non-U.S. assets if they have partners or shareholders that may claim a foreign tax credit (sourcing information will be relevant for those claiming the foreign tax credit), or if they have foreign partners (undocumented partners are presumed foreign).
Relief provisions permit transitional relief in 2021 for certain taxpayers (News Release IR-2022-38) and penalty relief (Notice 2021-39) for those who attempt to comply with the new requirements in good faith, but fail to fully comply. Non-filing relief applies to partnerships without foreign partners, without foreign activity of any type, without foreign activity reported in 2020, and without knowledge of any partner or shareholder request for such information. Good-faith efforts to comply include the steps taken to obtain information from partners and steps taken to adapt governing documents to facilitate information sharing. In short, taxpayers cannot throw up their hands and pretend the obligation doesn’t exist, but they can expect the IRS to extend grace and to be reasonable if the taxpayer is likewise acting reasonably.