An important crypto tax case has emerged in the U.S. District Court in the Middle District of Tennessee, (Jarrett v. U.S.). In the Jarrett case, the taxpayers owned a certain cryptocurrency and engaged in staking activities, and the IRS then taxed their staking rewards as ordinary income. The taxpayer in this case contributed his cryptocurrency coins (property for tax purposes) and his computing power to a decentralized node of computers in an effort to validate transactions and obtain more coins through the staking process. They obtained newly minted coins as a reward for staking. In effect, they obtained property of the same type.
Through staking, the taxpayers argue that the creation of new blocks on the blockchain, which result in new coins being minted, are not taxable income until such time as the new coins are sold or exchanged. That is, the mere receipt of the newly minted coins is not an accession of wealth and is thus not taxable income. They claim this is true because the newly minted coins were simply the “creation” of new property. They claim it is akin to a baker who creates a new cake or an author who creates a new novel. The creation of a thing is not taxable income. Instead, income must “come in” from some thing; it must be “derived” from some “source”. Taxable income is not the creation of something, like the newly minted coins. There is a certain new creation process in staking and that process results in the creation of newly minted coins. It is a subtle nuance but an important one.
But let’s consider another “property” example – where the contribution of property creates new property of the same type, and consider whether, in this example, the IRS would tax the creation of new property as ordinary income.
Three Galiceño horse owners come together for a common cause and decide to clone Galiceño horses, the rarest breed of horses in the world. Each owner owns one Galiceño and each owner also holds a key research tool involved in the cloning process. The full cloning process, however, only works if all three owners contribute their horses and their key research tools. The three owners find a state-of-the-art bio research facility capable of cloning. Each Galiceño owner contributes his horse and his key research tool to the common lab to undergo the experimental cloning procedure. The experiment is a great success and it produces six cloned Galiceños, all of the exact same type as the original Galiceño horse. Each owner gets two new Galiceños for their participation and contributions in the experiment.
In this hypothetical, let’s assume the three Galiceño owners are U.S. taxpayers. Then each taxpayer is an owner of a piece of property for tax purposes (horses are property). Each owner then contributes his property and special research tool (intellectual property) to a common facility in hopes of producing new property (new Galiceños) – of the exact same type as the original contribution of property (the original horse). Their contribution of property results in the creation of new property (a newly cloned Galiceño). For tax purposes, in this hypothetical, the IRS would not tax the Fair Market Value of the newly cloned horse as ordinary income. Instead, the taxable event occurs when the new property (the cloned horse) is bought or sold.
The same tax result should be true of the newly minted coins in the Barrett case. It makes no difference that cryptocurrency is generally used as currency because the IRS does not treat cryptocurrency as true currency. Instead, it determined that cryptocurrency is property for tax purposes. So, any example of a certain type of property creating new property of the same or similar type would apply. The hope is that the Court will see through the wide indiscriminate tax net throw at cryptocurrency by the IRS. One that is entirely too broad and illustrates a general misunderstanding of cryptocurrency processes.