Tezos users sue the IRS over cryptocurrency tax staking rules.

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The case has far-reaching consequences for proof-of-stake initiatives across the cryptocurrency sector.

On Wednesday, a Nashville couple sued the Internal Revenue Service, requesting the return of thousands of dollars they paid the government as a result of receiving tokens for maintaining the Tezos network.

Given that additional blockchains, including Ethereum, are transitioning to a Tezos-style system—a concept known as proof-of-stake that distributes tokens to individuals who own an existing quantity of them and use them to update the blockchain—the case has significant consequences for the entire crypto industry.

In their legal claim, filed in Tennessee federal court, Joshua and Jessica Jarrett claim they paid $3,293 to the IRS in 2019 after receiving 8,876 Tezos tokens. The couple then sought a refund on the grounds that the tokens, which they received for lending computer power to the Tezos network, should not be taxed until they sell or exchange them.

What’s at stake

According to the Jarretts, current IRS rules do not allow for the taxation of cryptocurrency earned through staking. The couple claims the tokens should not count as wages or income since they did not earn them from an employer but a decentralized network. They also liken their efforts to other professions that create something.

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“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,” says the complaint.

The lawsuit’s chances of success are uncertain, owing to the fact that this is new legal territory and the IRS Revenue Code is completely silent on bitcoin treatment. While the government has released a few recommendations and has been more active in its pursuit of crypto revenue—this year, it included a crypto question on the first page of everyone’s yearly tax form—it has yet to publish regulations for newer areas of the rapidly developing crypto business, such as staking.

This week’s lawsuit is being backed by an organization called the Proof of Stake Alliance, whose board members include executives from Tezos, Polychain Capital and Coinbase-owned Bison Trails. According to a spokesperson, the groups and others decided to fund the suit out of “conviction that the improper tax treatment of new tokens will harm the blockchain industry as a whole.”

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The issue has also received attention on Capitol Hill where a bipartisan group of lawmakers sent a letter last year to the IRS, asking for network validators to be taxed when they sell tokens rather than when they receive them.

While there is universal agreement that the United States needs clearer laws on cryptocurrency taxes, the subject has struggled to gain pace as Congress and the current and past presidential administrations have been consumed with the epidemic and the economic impact. This might be why the Proof of Stake Alliance has gone to the courts for help, however given the glacial pace of litigation, it’s doubtful the Nashville court would deliver a ruling this year.

Meanwhile, the issue of taxing proof-of-stake networks has also received scholarly attention. In a 2020 paper distributed by Coin Center,  a pair of University of Virginia academics make a similar argument to the Jarretts: “Our findings support the taxation of block rewards at the time of their disposition, not acquisition, which is the tax treatment accorded to other newly created property.”

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