IRS faces increased legal scrutiny over taxation of crypto staking rewards

Tezos blockchain staker Josh Jarrett and his partner Jessica have once again sued the Internal Revenue Service (IRS) for the tax imposed on the tokens they earned from staking.

In the lawsuit filed before the United States District Court Middle District of Tennessee, the couple wants the court to decide how crypto block rewards would be treated for tax purposes.

According to the Jarrets, block rewards should be treated as property, which would make them taxable upon sale. However, the IRS’s current guideline describes them as income, which imposes tax obligations on the staker immediately after the tokens come into their possession.

This is not Josh Jarrett’s first lawsuit against the IRS.

In 2021, the couple challenged the IRS’s treatment of their 2019 Tezos block rewards after paying tax on the 8,876 Tezos tokens they earned through staking that year. Interestingly, the IRS refunded the tax paid, eventually leading to the dismissal of the case in September 2024 by the court, which considered it moot since a refund had been issued.

With the new lawsuit, the Jarretts are not simply asking for a refund of the tax paid on the Tezos block rewards they earned in 2020; they are also asking for a permanent injunction that will restrain the IRS from treating block rewards as income. If the court grants this injunction, it would overturn the IRS’s 2023 policy, which mandates that tax agencies should treat block rewards as income when earned.

Coin Center backs the Jarretts in IRS lawsuit

The crypto advocacy group, Coin Center also supports the new lawsuit. According to the think tank, this lawsuit is crucial to ensure a fair policy in how the IRS treats block rewards. It noted that the agency has always treated the new property as taxable after the sale but is refusing to apply the same principle to block rewards.

It said:

“The IRS’s policy is illegal because block rewards are new property and therefore not themselves “income.” Rather, any payment later received for those tokens when they are sold is income. The IRS’s policy results in unfair overtaxation, compliance problems, and the stifling of innovation.”

In its statement, the center noted that strict tax laws on block rewards could discourage many Americans from using cryptocurrencies and blockchain technology. They impose a significant burden on anyone who stakes cryptocurrencies, forcing them to track their block rewards for taxes that might not reflect the current financial reality since the token has yet to be sold.

This could create a “compliance nightmare” that punishes decentralization by overtaxing an individual for a newly created property. The center made reference to its earlier analysis showing the IRS’s over-taxation of Jarrett blocks rewards.

Interestingly, the group noted that Congress is already deliberating on the issue with a new bill introduced to the House that will clarify when taxes should be paid on tokens. However, it noted that the legislation might have to wait until the next Congress, which is a long time off, hence why it supports Jarret’s efforts.

US regulators see increasing involvement in crypto-related lawsuits

The new lawsuit against the IRS joins the increasing number of litigation against regulators due to a lack of clarity on multiple issues in the crypto sector.

Beyond the IRS, derivatives exchange Bitnomial recently sued the Securities and Exchange Commission (SEC) for claiming that its yet-to-be-listed XRP futures are under its jurisdiction as securities.

According to the company, the court has already ruled that Ripple XRP is not an investment contract or security. Therefore, only the Commodity Futures Trading Commission (CFTC) should have a say on the product.

While the various lawsuits highlight how regulators and crypto stakeholders have resorted to the court for clarity, the US agencies have also secured significant financial victories from some of the lawsuits. So far, the regulators have recorded $32 billion in settlements from crypto companies.