Is Cryptocurrency “Property” for U.S. Income Tax Purposes?

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Our firm has written extensively on the topic of cryptocurrency.  Indeed, we have even designated an entire resource page on our website to this always interesting and constantly evolving topic.  You can find it here.  And, additional Insights on cryptocurrency can be found here.

Because cryptocurrencies are so new, it may not surprise you to learn that there is little authoritative guidance on the proper federal tax treatment of cryptocurrency transactions.  Indeed, the first guidance from the IRS was released only in 2014 through its issuance of Notice 2014-21, 2014-16 I.R.B. 938 (the “Notice”) in the Internal Revenue Bulletin.  In that Notice, the IRS indicated that it would treat virtual currency as property (and not money) for federal income tax purposes.  But, significantly, this guidance constitutes only the IRS’ unofficial position on this issue—it would not necessarily bind a federal court.  See BMC Software, Inc. v. Comm’r, 780 F.3d 669, 676 (5th Cir. 2015) (providing no deference to an IRS notice); but see Esden v. Bank of Boston, 229 F.3d 154, 169 n.19 (2d Cir. 2000) (concluding that an IRS notice can be “entitled to respect” under Skidmore if it constitutes a “body of experience and informed judgment”); see also Chevron U.S.A., Inc. v. Nat. Res. Defense Council, Inc., 467 U.S. 837 (1984) (federal courts must give deference to an agencies interpretation through its promulgation of regulations).

Because cryptocurrency is so ubiquitous now, we can certainly expect more federal tax court cases on cryptocurrency taxation.  And, we may not have to wait too much longer, given a recent court filing by taxpayers in the Middle District of Tennessee.

Jarrett v. U.S.

On May 26, 2021, the Jarretts filed a complaint against the United States in the Middle District of Tennessee.  See Jarrett v. U.S., Case No. 3:21-cv-00419.  Because this case is only at its nascent stages, the facts discussed below are taken from the facts as alleged in the taxpayers’ complaint.

According to the allegations in the complaint, Mr. Jarrett was engaged in a staking enterprise in 2019.  For those unfamiliar with the term “staking,” it generally means that an individual is participating in transaction validations on a proof-of-stake(Pos) blockchain.  Through his staking activities, Mr. Jarrett used his existing Tezos tokens to effectively create new ones.  As a result of his efforts, he produced 8,876 new Tezos tokens, which he maintained in his digital wallet.

The Jarretts filed a 2019 Form 1040 with the IRS.  On the Form 1040, the Jarretts reported $9,407 of “Other income” on Schedule C associated solely with the production of the new Tezos tokens.  Later, however, the Jarretts filed an amended return seeking a refund of all the taxes paid, backing out the $9,406 of previously-reported income.  Because the Jarretts never received a response from the IRS, the Jarretts filed a refund suit in the Middle District of Tennessee against the United States.

The Pleadings

Both the Jarretts’ and the United States respective pleadings are interesting.  In the initial paragraph of the Jarretts’ complaint, they assert that “federal income tax law does not permit the taxation of tokens created through a staking enterprise.”  In this regard, the Jarretts attempt to compare Mr. Jarrett’s actions of creating Tezos tokens as similar to those of a baker or writer:

Like a baker who bakes a cake using ingredients and an oven, or a writer who writes a book using Microsoft Word and a computer, Mr. Jarrett created property.  Like the baker or the writer, Mr. Jarrett will realize taxable income when he first sells or exchanges the new property he created, but the federal income tax law does not permit the taxation of the Jarretts simply because Mr. Jarrett created new property.

In support of their claims, the Jarretts cite to well-known Supreme Court tax decisions such as Eisner v. Macomber, 252 U.S. 189 (1920) and Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955).  In arguing that there must be a realization event to constitute a taxable transaction, the Jarretts also cite to dictionary meanings of the term “realize” in their complaint.  See also I.R.C. § 1001.

In their complaint, the Jarretts also asserted in paragraph 30 that “[v]irtual currency is property for purposes of U.S. federal tax law.”  Interestingly, the United States disagrees.  Specifically, on August 27, 2021, the United States filed its Answer and responded to paragraph 30 with “the United States denies that virtual currency is in all instances property for purposes of U.S. tax law.”  Although the United States does not elaborate, the question in many tax practitioners minds is “how so,” particularly in light of the IRS’ seemingly contradictory conclusion in the Notice.

Parting Thoughts

The Jarrett case is one every tax practitioner should be watching closely.  To the extent the United States tips its hand that virtual currency is not always property for federal tax purposes, it will provide important insights in various contexts, including tax planning and tax enforcement.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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