IRS maintains its position on taxing staking of crypto assets: Interpretation of Jarrett v. United States case

Author: TaxDAO
In 2022, the Jarrett couple filed a lawsuit against the U.S. government, seeking a refund of their federal income tax. The case primarily revolves around the dispute over whether the Jarretts realized income when they generated new cryptocurrency through staking. That same year, the U.S. District Court for the Middle District of Tennessee dismissed the Jarretts' lawsuit, arguing that the refund claim had lost its practical significance since the IRS had issued a check for the full refund plus statutory interest to the Jarretts. Subsequently, the Jarretts appealed to the Federal Sixth Circuit Court, which upheld the original ruling; the case was decided on August 18 of this year. The Jarrett v. United States case reflects the differing positions of the IRS and cryptocurrency investors regarding the timing of income realization from staking cryptocurrency, which directly affects the taxable income recognition for personal income tax and, consequently, the tax amount owed. This article analyzes the case to clarify the U.S. government's approach to taxing income from staking cryptocurrency, providing a reference for tax compliance practices related to cryptocurrency assets.

Facts of the Case and Points of Controversy

1.1 Facts Established in Two Court Hearings

Joshua Jarrett claimed he overpaid his taxes for 2019 and sued the IRS for a refund. Jarrett produced Tezos tokens (a type of cryptocurrency) through a process known as "staking." Jarrett argued that the essence of staking is using existing Tezos tokens and computing power to produce new tokens, and therefore, he should only recognize income when he sells or transfers the tokens, thus incurring tax liability. However, the IRS had a different view on this process. The IRS stated that, similar to payments, wages, compensation, and other sources of income, staking involves an exchange of goods and services; when a taxpayer receives "rewards" generated from staking, it increases their total income (Rev. Rul. 2023-14). Additionally, the IRS's "Digital Asset Issues Update" classifies the receipt of "new digital assets generated from mining, staking, and similar activities" as taxable transactions. Based on this, Jarrett realized income upon receiving each token, which was included in his taxable income for that year. The timing of income recognition is crucial for calculating taxable income, and generally, delaying realization is beneficial for taxpayers. Jarrett's tax liability depended on the value of Tezos at the time he realized the income. Since 2018, the value of Tezos has fluctuated from $0.70 to over $8. Jarrett reported that his staking activities generated 8,876 Tezos in 2019, but he did not dispose of them. The IRS considered the Tezos he received as realized income at the time he produced the tokens. Although Jarrett disagreed, federal law prohibited him from contesting the tax liability in advance—he had to pay the tax first and then seek a refund from the IRS. Therefore, the Jarretts reported the tokens received in 2019 as income on their joint tax return and paid taxes on it. They subsequently requested a refund of $3,793 from the IRS, arguing that the income was not realized. Since the IRS did not respond within six months as required by law, Jarrett filed a refund lawsuit in federal district court, requesting: (1) a judgment that Jarrett is entitled to a refund for 2019; (2) costs and attorney fees; (3) a permanent injunction preventing the IRS from "treating the tokens created by the Jarretts as income." After receiving the summons, the U.S. government approved Jarrett's refund and statutory interest. On January 28, 2022, the U.S. government issued a refund check to the plaintiffs for $4,001.83, which included $3,793.00 in federal income tax refund and $208.83 in interest. The U.S. government then moved to dismiss Jarrett's lawsuit under Federal Civil Procedure Rule 12(b)(1), arguing that the refund claim had lost its practical significance since the government had already refunded the overpaid taxes and interest. Jarrett did not cash the check and continued the lawsuit; he still claimed he was entitled to a permanent injunction against the IRS, prohibiting the IRS from recognizing the tokens he would receive in the future through staking as income, instead recognizing them upon liquidation. He argued that it was necessary for those in the mining industry to have stable tax expectations through such a permanent injunction.

1.2 Points of Controversy in This Case

The central controversy in this case is whether the court still has subject-matter jurisdiction after the U.S. government issued the refund check. In other words, did the check received by Jarrett resolve the dispute between him and the U.S. government? According to Jarrett's perspective: on one hand, although he received the check, he refused to accept it (did not cash it), so he could still sue for the refund. On the other hand, even if his monetary claim lacks practical significance, his arguments for other forms of relief remain valid. The requested permanent injunction itself constitutes a dispute that needs to be resolved independently, and thus the court should hear it. However, the U.S. government argued that, under relevant provisions of the Federal Constitution and the Anti-Injunction Act, Jarrett's claims lack practical significance, and therefore the court should not rule on them.

Analysis of the Tax Legal Relationships in the Case

2.1 Whether the Court Has Subject-Matter Jurisdiction Over Jarrett's Refund

2.1.1 District Court's Ruling Subject-matter jurisdiction refers to the court's power to adjudicate specific types of matters and provide the requested remedies. A court must have jurisdiction to issue a valid judgment on a claim. The U.S. government argued that, according to Article III of the Constitution of the United States, judicial power is limited to "cases" and "controversies," and since there is no longer a controversy regarding the refund, the court lacks the corresponding subject-matter jurisdiction. The district court accepted this view and stated that when a court cannot provide any effective remedy to the prevailing party, the case loses its practical significance. Since the U.S. government had completed the refund process, the court could not grant relief by satisfying Jarrett's refund request. Regarding Jarrett's argument that "they have the right to refuse the refund and seek judicial determination," the court found that Jarrett incorrectly relied on the Campbell-Ewald v. Gomez case to support this argument. In that case, the defendant made a settlement offer, which was insufficient to terminate the case. In contrast, in this case, the U.S. government issued a check directly to Jarrett, rather than making an offer; whether Jarrett deposits the check does not affect the existence of the controversy. Thus, the district court concluded that there was no longer a controversy regarding the refund claim and denied their jurisdiction.

2.1.2 Federal Circuit Court's Ruling The Federal Circuit Court stated that they adopted a "fresh perspective" to review the district court's ruling of lack of practical significance, focusing on whether the government sufficiently demonstrated that the case had lost its practical significance. After extensively examining previous case law and Supreme Court cases, the circuit court acknowledged that the defendant's relief "offer" does not provide the plaintiff with complete relief, but actual payment does. The circuit court further stated that there is no reason to determine the validity of the check based on how Jarrett handles it; Title 26 U.S. Code § 6611(b)(2) states that "the IRS's obligation to pay interest and the refund check terminate simultaneously," regardless of whether the taxpayer accepts the check. At the same time, the circuit court also denied the similarity between the Campbell-Ewald case and this case. During the appeal process, the IRS issued Rev. Rul. 2023-14, which stated that the income from staking should be recognized when control over the tokens is obtained. The circuit court concluded that this ruling had no impact on the 2019 tax liability.

2.2 Whether Jarrett's Request for a Permanent Injunction Constitutes an Independent Controversy

2.2.1 District Court's Ruling Regarding the controversy over the permanent injunction, the court found that two regulations excluded Jarrett's request for "prospective relief." The first is that federal tax lawsuits brought under the Internal Revenue Code (IRC) are excluded from declaratory relief under Title 28 U.S. Code § 2201(a). The second is that the Anti-Injunction Act prohibits lawsuits "for the purpose of restraining tax assessments or collections." On the other hand, the plaintiff's lawsuit is based on Title 26 U.S. Code § 7422, which is a "civil action for refund," and this lawsuit is necessarily retrospective rather than prospective. Claims under this provision "are for the recovery of any internal revenue tax alleged to have been erroneously assessed"; this means that Jarrett cannot bring a lawsuit that only involves anticipated tax relief. Furthermore, Jarrett argued that their lawsuit falls under the "exception to lack of practical significance," but the court countered that this exception does not apply in this case. There are two types of "lack of practical significance" exceptions: (1) voluntarily ceasing the challenged conduct; (2) harm that can recur but evades review. Regarding the first situation, the court stated that the U.S. government's refund action is not a "voluntary cessation" because the government did not change its tax rules and regulations but merely refunded Jarrett's taxes. As for the second situation, the court stated that the "capable of repetition" principle only applies when the plaintiff can reasonably show that they will again be affected by the alleged unlawful conduct. Since the question of whether the Tezos created by Jarrett constitutes taxable income "will never have a definitive conclusion," any subsequent refund requests would be based on different tax years, and thus the circumstances in question "cannot recur." Therefore, the district court concluded that it should not have jurisdiction over the tax injunction.

2.2.2 Federal Circuit Court's Ruling Regarding the permanent injunction, the Federal Circuit Court's overall stance is that regulations confirm retrospective applicability. They determine the appropriateness of previously assessed and previously paid taxes, rather than addressing future tax years. In this regard, the circuit court's reasoning is similar to that of the district court, stating that "a judgment that is only beneficial for tomorrow would violate the prohibition against declaratory judgments in tax cases." Another important point made by the circuit court is that after the refund request itself is dismissed, merely anticipated relief cannot support a refund case. The court's reasoning on this point is relatively weak, citing the Christian Coal case to illustrate that "in the absence of an actual refund request, the court lacks jurisdiction to hear a lawsuit containing only prospective claims."

The U.S. Taxation Attitude Toward Cryptocurrency Assets

Although the legal relationships in this case are relatively straightforward, they reflect the attitudes of federal courts and the IRS toward cryptocurrency taxation, particularly the overall regulatory direction of the IRS. Based on the analysis of the case facts and legal reasoning, this article attempts to interpret the possible viewpoints of federal courts and the IRS on cryptocurrency taxation.

3.1 Overall Attitude of Federal Courts

On July 26, 2023, during the oral arguments in the circuit court, the Chief Justice acknowledged that if the government needs more time to establish a position on tricky or novel issues, allowing the government to delay (consider) the case has certain benefits. However, less than a week after the oral arguments, the IRS issued Rev. Rul. 2023-14, clearly stating that they disagreed with Jarrett's position. Jarrett quickly pointed this out to the appellate court, insisting that they had the right to a hearing on their case and to seek injunctive relief, as they might be subject to similar taxes in the future. The federal courts generally hold a conservative attitude toward cryptocurrency taxation; they did not legally confirm the timing of income realization from staking but instead refused to conduct a corresponding hearing on jurisdictional grounds. The district court stated, "The plaintiff requests the court to provide advisory opinions on whether they are entitled to a refund under current tax law, but the court does not provide advisory opinions." Regarding the IRS's Rev. Rul. 2023-14, the court noted that "this may imply that similar refunds obtained by Jarrett may not be approved in the future," but it did not evaluate the tax ruling. Considering the Chief Justice's earlier remarks, the court believes that cryptocurrency taxation remains an emerging field, and legally confirming the timing of income realization is evidently premature.

3.2 IRS's Views on Related Issues

3.2.1 Timing of Income Recognition from Staking The IRS clearly opposes Jarrett's view, asserting that income from staking should be recognized when control over the tokens is obtained. This involves a timing issue. The IRS assessed taxes for the 2019 tax year, while Jarrett filed his lawsuit in 2022, and the IRS's Rev. Rul. 2023-14 was issued on July 31, 2023; in other words, the IRS only clarified the timing of income recognition from staking in 2023. Nevertheless, the IRS has consistently maintained since at least 2019 that income from staking should be recognized when control over the tokens is obtained. Since the IRS's tax rulings do not have legal effect, to avoid the potential risk of the tax ruling being denied by the court, the IRS adopted a strategy of denying jurisdiction in this lawsuit, allowing them to avoid substantial judicial review of the timing of income recognition from staking. The IRS's litigation strategy was successful, as Jarrett's lawsuit did not legally challenge the Rev. Rul. 2023-14 or the IRS's previous tax practices. This means that for the foreseeable future, the IRS is likely to continue using the "control over the tokens" standard to determine the timing of income recognition from staking.

3.2.2 Possible Direction of Taxation on Staking Income As mentioned in the previous section, although the IRS's tax ruling does not have corresponding legal effect, it serves as guidance for taxation, allowing the IRS to collect taxes under similar circumstances according to the same standard; moreover, the IRS believes that different tax causes may arise in each tax year due to varying circumstances. Therefore, even investors who received refunds or did not recognize income from staking tokens in previous years due to non-liquidation must be vigilant: in future tax years, income from staking is likely to be recognized when control over the tokens is obtained. However, since the Rev. Rul. 2023-14 is based on only two cases and there are currently few precedents in practice, we recommend that investors communicate further with professionals to determine their future tax strategies.

3.3 Discussion of Other Legal Issues in This Case

3.3.1 Jurisdiction Issues The Jarrett v. United States case provides an important precedent for jurisdiction in refund cases. On one hand, it confirms that once the IRS issues a refund check, the refund dispute ceases to exist; this means that taxpayers find it difficult to request the court to conduct substantial reviews of the IRS's tax provisions through litigation. Jarrett claimed in his appeal that the government could strategically mail refund checks and suspend refund lawsuits for various reasons at any time. Undoubtedly, the IRS can use this strategy to evade substantial review of controversial tax policies and effectively implement them. However, the court held a different view, stating that satisfying all citizen demands in individual lawsuits may be a strategy of the government, but such a strategy typically does not raise concerns about government abuse of power. The government must pay full refunds and interest to achieve a non-controversial purpose, and this must occur in the context of public opinion arising from the lawsuit that prompted the government's concession. This means that the IRS's strategy still incurs corresponding costs and is subject to public scrutiny and other forms of oversight. These limitations prevent the IRS from abusing power and require it to operate within its limits.

3.3.2 Nature of Refund Lawsuits On the other hand, this case further confirms the "retrospective" nature of refund lawsuits, making it seem difficult for the court to recognize the litigation strategy of seeking a permanent injunction for future taxes through a refund lawsuit in this context. In fact, one of Jarrett's purposes in filing the lawsuit was to challenge the IRS's timing of income recognition (reflected in Rev. Rul. 2023-14) and to assert that the timing of income from staking should be recognized at the time of "liquidation." Unfortunately, the court did not support Jarrett's request. Through the analysis of the Jarrett v. United States case, this article attempts to clarify the U.S. government's approach to taxing income from staking cryptocurrency, providing a reference for tax compliance practices related to cryptocurrency assets. This case reflects the federal court's conservative attitude toward cryptocurrency taxation, as it did not legally confirm the timing of income recognition from staking and refused to conduct a corresponding hearing on jurisdictional grounds. At the same time, the IRS's new tax ruling highlights the uncertainty and complexity of cryptocurrency taxation and showcases the future development and trends of cryptocurrency taxation, which warrant close attention from investors.