A US-based cryptocurrency association is suing the Internal Revenue Service to force it to clarify rules over tax payable on tokens acquired by staking.
The outcome could have a major impact on the future of crypto in the US and beyond.
The clarity – and changes – the lawsuit seeks would make it dramatically easier for US taxpayers to adopt crypto without having to hire a specialist to calculate tax liability at the end of the year.
“If you are a crypto investor, many accountants may not want to put their name on your tax returns,” said Brian Rachmaciej, a Chicago-based tax attorney who specialises in cryptocurrency.
“It’s not just the complexity, but also the uncertainty, because the rules are not clear. The IRS issued guidance, but guidance is not the same as established tax code.”
The suit was brought by a Tennessee couple and is backed by the Proof of Stake Alliance (POSA).
The couple paid tax on more than 8,000 tezos tokens they accumulated in 2019 by providing proof of stake for tezos, but then filed an amended tax return asking for a refund, arguing the tokens had been taxed incorrectly as income when in fact they were “created property”.
When the IRS did not respond to the refund request, the couple filed a lawsuit, funded in part by POSA.
The IRS responded to the lawsuit – but by simply sending a refund without clarifying its position. The couple rejected the offer, insisting the IRS clarify its position or continue on to court so a judge can rule on the matter.
POSA points out that current IRS guidance from 2014 is out of date, is not based on actual law but rather the IRS’s incorrect interpretation of tax law, was designed for crypto mining and not staking, and unfairly treats crypto acquired through staking as though it were regular income.
IRS ‘Applying 1930s Laws’
“The IRS is applying tax law from the 1930s to crypto, and that just doesn’t work,” said Rachmaciej. “The IRS is out of touch with crypto, where it is and, most importantly, where it’s going.”
The lawsuit comes at a pivotal point in crypto’s evolution as the sector moves away from the established “proof of work” model used to verify ownership to a “proof of stake” standard.
Solana, Avalanche and Tezos all use proof of stake, while Ethereum, the second-largest crypto in the world, has announced it will soon switch to proof of stake.
The problems with proof of work are many, and are why many are moving to proof of stake. Proof of work is very computing-intensive and is generally undertaken by large operators, which comes with some problems.
First, it centralizes the process, potentially exposing it to risk. When China banned crypto mining in 2018, most operators moved next door to Kazakhstan, which by 2021 became home to about one-fifth of the world’s bitcoin mining operations.
When political turmoil hit, mining operations were shut and the hashrate at major crypto mining pools (groups of miners in different locations that team up to produce bitcoin) fell 14% over a two-day period, according to data from mining firm BTC.com. Slowing computer capacity could slow transaction settlement.
Proof of work is also far more energy-intensive as the way in which it is rewarded incentivises throwing huge amounts of computing power to solve more equations more quickly. The more computers you use, the more equations you can solve, the more crypto you generate – and also, the more electricity you consume.
At its peak, crypto mining in Kazakhstan was eating up about 8% of the nation’s total electric supply.
Calls for Clear Tax Guidance
Proof of stake works differently and does not incentivize using more computing power to solve problems. It can be done on smaller scale, is more decentralised, less energy intensive and less vulnerable to disruption.
These are just some of the reasons the crypto world is moving to the proof of stake model and why getting the tax clarity is so important.
Another is that anyone who holds a proof of stake crypto will automatically accumulate more tokens, as every owner becomes part of the proof of ownership chain – and therefore also automatically accumulates complex tax liabilities. Holders of bitcoin do not face this problem, only those who mine it do.
“The IRS has never issued guidance that specifically addresses staking rewards,” said Alison Mangiero, acting executive director of POSA. “We want to bring awareness to the legal argument that staking rewards are created property and should be taxed as such.”
The effort is getting some high-level support: In August 2021, four members of the Congressional Blockchain Caucus sent a letter to the IRS commissioner asking for clear guidance on proof of stake tax, saying in a statement that “currently, taxpayers are not given guidance for how participating in “staking” should be treated, which could result in unintentionally dissuading participation in this new technology.”
Indeed, if merely owning a crypto creates a complex tax situation many accountants do not even want to deal with, that would slow its adoption.
• Neal McGrath
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