Bates Research | 03-17-22
Will a Current Lawsuit Redefine Cryptocurrency as Property for Tax Purposes?
A determined litigant is hoping to define, or redefine, a type of cryptocurrency through a lawsuit against the Internal Revenue Service. The cryptocurrency involved is Tezos, one of several cryptocurrencies that rely on “proof of stake” as the validation method for additions to a blockchain. This matter is significant, as Tezos has a unit value of about $4 and a market value of about $8 billion. Tezos is one of the currencies available for use in smart contracts—self executing contracts where the parties can verify performance without an intermediary.
Trust in Smart Contracts?
Smart contracts seem most useful in transactions along a blockchain. Like crypto itself, a smart contract is another piece of complex computer programming. In traditional contracts, elements of trust enter at most stages from concept through execution. For instance, a party to a contract must trust the initial intention of the other party to complete the transaction, the ability of that party to complete it, that the subject of the contract exists, and that the subject is as specified in the contract.
The verification process in blockchain, whether by proof of work or proof of stake, establishes or eliminates these elements of trust. There must be consensus for a transaction to be recognized on the blockchain. The irreversibility of a blockchain transaction may resolve the need to prove trust for completion. But smart contracts, and the blockchain features that underlie them, may require further development to be useful in general commerce. With certain transactions, there are too many legal requirements requiring written agreements to allow them. For example, a sale of real estate can’t be self-executing even if crypto is involved.
Is a New Crypto Token Income or Property for Tax Purposes?
The current litigation, Jarrett vs. United States of America, may have emerged as the result of a mistake. The plaintiff, Mr. Jarrett, participated in the Tezos blockchain and, in so doing, validated transactions through proof of stake. As a result, he produced 8,876 new Tezos tokens. When he filed an IRS 1040 form in 2019, he and his wife reported $9,047 in other income attributable to the production of the new tokens. Later, the Jarretts filed an amended return and sought a refund of the $9,047.
The IRS resisted the refund, prompting the Jarretts to file suit in Federal District Court. The plaintiffs argue that there can be no income from this staking transaction until there is a sale. They liken the tokens to loaves of bread (conveniently, producers of Tezos are called “bakers”) arguing that income can only result from a sale. More specifically, they argue that the tokens are property under the tax code.
The IRS disagreed with that analysis, but after initial pleadings and motions, they proposed to settle the case by offering a full refund and interest. The agency was probably shocked when the Jarretts refused to accept the settlement offer. The Jarretts refused because the IRS would not concede that the Tezos tokens, and any other virtual currency, are property for purposes of the tax law. In its Answer to the Complaint, the government stated: “the United States denies that virtual currency is in all instances property for purposes of U.S. tax law.” Analysts note that if crypto isn’t property, what else could it be?
Is Crypto the New Phlogiston?
In 18th century science, phlogiston was postulated as an undetectable substance released during combustion and used to explain the oxidation process. Crypto could be like phlogiston in that it is a mysterious substance that is undetectable but converts one substance into another. Following the IRS's position, a court may find that the mysterious substance converts property into income. Most likely, if sense prevails, a court will find that crypto is not like phlogiston.
The Jarretts continue to litigate to resolve the definitional uncertainty. If their Tezos are not property, yet can produce taxable income immediately, smart contracts must take that into account. The elimination of uncertainty may require some form of government regulation. But resolution of the uncertainty will require answers to several questions that affect smart contracts and tokens, including transaction timing, taxation rates and—perhaps more challenging—valuations of the tokens involved.
About the Author
Bates Consulting Expert Paul Nelson has 45 years of experience with the regulatory and legal compliance issues facing banks and other financial services providers. Paul’s background includes five years as a Senior Attorney and Acting Regional Counsel with the Comptroller of the Currency and serving as a General Counsel of the U.S. House Banking Committee. His areas of expertise include Corporate Governance, Trusts, AML, Banking, and Nonbank Financial Services Providers Regulation, Legislation.
Bates Group’s MSB, FinTech and Cryptocurrency practice offers guidance and services for Money Services Businesses and Non-Banking Financial institutions, fintech and cryptocurrency firms. Our crypto subject matter experts work directly with firms and counsel to design and implement policies to ensure they are AML-compliant. Our MSB and AML Teams help obtain and maintain Money Transmitter Licensing, and they also engage clients with BSA/AML/OFAC Program Development, Risk Management, Training, Advisory Services, and Independent Reviews.
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