Blog post by R. Joseph Ritter, Jr. CFP® EA
A client recently made me aware of a federal court case involving cryptocurrency taxation. This post will review how the case may impact the future of cryptocurrency taxation.
In Jarrett v. USA, the taxpayers correctly reported their cryptocurrency transactions on their tax return but then requested a refund. Their rationale for the refund was that they disagreed with how the IRS viewed the reporting of cryptocurrency transactions. Once the relevant time period passed for the IRS to respond and no refund was forthcoming, the taxpayers sued. In response, the IRS issued a refund check.
Ultimately, the case was dismissed because the taxpayers had received the requested relief. Then, the Jarretts appealed, and their appeal was dismissed as well. Jarrett v. United States, No. 22-6023 (6th Cir. Aug. 18, 2023)
Both cases were dismissed because the judges ruled that the Jarretts had obtained the requested relief – a refund. The reason the Jarretts continued to push the case on appeal is that they wanted the court to rule on tax regulation. Unfortunately, because the IRS issued a refund and the judges ruled that they obtained the relief requested in court, no ruling on the regulation itself will be forthcoming.
So, where does this leave us? Essentially nothing has changed for cryptocurrency taxation after the Jarrett ruling.
What did the Jarretts want? The Jarretts were staking cryptocurrency, and they believed coins produced from staked cryptocurrency should not be taxed until converted into cash. While the government may tax transactions in currency issued by the U.S. Treasury, the United States Internal Revenue Code extends to accessions of realized wealth. And the tax code revolves around the timing of that income, or when income is realized. This was the whole argument of the Jarretts, beyond requesting a refund.
Tacitly, the fact that the IRS issued the refund might give the appearance that the IRS was admitting the tax regulation would not survive in litigation. However, the IRS has since issued a clarifying Revenue Ruling further outlining their position. We would not encourage reporting cryptocurrency transactions differently from an IRS Revenue Ruling.
What does the IRS say? The position of the Internal Revenue Service is that cryptocurrency is an asset similar to publicly traded securities. Notably, the IRS is not alone. The Securities and Exchange Commission, for example, is now suing cryptocurrency exchanges, such as CoinBase, for failing to register as a securities exchange. In other words, multiple branches of the government deem cryptocurrency as a security or an asset rather than a medium of exchange (currency).
Just yesterday, the Securities and Exchange Commission’s Hester Pierce gave a video interview in which she signaled that additional regulations are coming which “are not looking good” for cryptocurrency.
An alternative currency would compete with the U.S. Treasury and Federal Reserve. Thus, an alternative currency brings the potential of undermining the role of the dollar in the economy. Added to that, because it is not a fiat currency, the government’s currency regulators are not providing any oversight and may not be able to. This, then, seems to give rise to why the Department of Justice and SEC are intervening with litigation and regulation.
This is where an analogy would be helpful. Let’s say you purchase 100 shares of stock in Widget Company. This is an asset which you own, similar to staked cryptocurrency. Widget Co. declares a dividend. We understand that dividends paid in cash represent realized ordinary income. But what happens if Widget Co. pays the dividend with fractional shares of stock in Widget Co.? In the eyes of tax regulation, there is no difference between paying a dividend in cash or fractional shares. Income is realized at the time the dividend is issued.
To avoid double taxation, the amount of income realized becomes your basis in the fractional shares received by way of the dividend. When the fractional shares are sold, the difference between the sale proceeds and your basis represents capital gain or loss.
This is how the IRS also views cryptocurrency. Coins produced in staking are realized income, and the amount of income becomes the basis in those coins. Upon a future sale or conversion of the coins, basis is subtracted from the proceeds to determine capital gain or loss. This approach avoids double taxation on the original realized income.
While capital gains tax will likely be changing after 2025, we should note that the lowest capital gains tax bracket is zero, so it’s possible to be taxed on the ordinary income but avoid capital gains tax. It is also possible for high net worth individuals to be taxed on capital gain at a lower rate than their ordinary tax bracket. If the Jarretts had their way, these two forms of potential tax savings would be eliminated. This makes their argument a bit confusing, unless their end goal was to have cryptocurrency be deemed a cash equivalent or an alternative to the dollar. We here at Somerset Tax Partners, LLC don’t see that happening.
The federal government seems to be presenting a unified front against cryptocurrency competing with the dollar. Until further tax regulation comes to light, cryptocurrency should be reported on your tax return as property, not as a cash equivalent.