Baking tezos: what the Jarrett vs US case got wrong about taxation
Published: September 22, 2022
Summary
What is the Jarrett vs US case?
In short, Josh Jarrett argues that the 8,876 tezos tokens awarded to him for staking (a.k.a. baking) in 2019 should not be taxable income to him until they are sold. This would effectively defer the taxation until a later time, rather than rendering them tax-free. You can read all of the public case materials at the Proof of Stake Alliance website.
The case of Jarrett vs US caused a big flurry of news in the crypto universe back in February 2022 when the IRS decided that they no longer wanted to pursue the issue and sent a refund check to Jarrett for the disputed taxes. The internet rushed to the incorrect conclusion that the IRS had ruled that staking rewards are not taxable. Many crypto holders were confused why they were receiving a Form 1099-MISC from some centralized crypto exchanges reporting their staking rewards to the IRS.
What is the basis of the Jarrett arguments?
The details of the arguments are laid out in a very detailed brief [fn1] dated July 31, 2020 (“the Brief”) which is 52 pages long and submitted by Jarrett’s counsel, Abraham Sutherland. For the sake of brevity, I summarize the argument into the following points that are specifically relevant to this blog post:
Jarrett created the new tezos tokens from his own investments in equipment, WiFi, electricity, software knowledge, etc.
Jarrett did not receive the tezos tokens “from another” (another individual, entity, counterparty, known someone, etc).
Jarrett did not find the tezos tokens (like a treasure), as they were not previously owned or possessed by any other tangible party.
The baking, validation, or endorsement rewards are credited to Jarrett by the Tezos blockchain protocol which is controlled by no one, cannot be edited or changed, has no agency or discretion, and uses complex mathematical equations to make the network operate in a trustworthy way.
Jarrett’s new tezos tokens should therefore be treated like a new painting by the artist or wheat harvested by the farmer and only taxed at the time that they are sold rather than at the time they are created.
What did Jarrett get wrong in the case?
Jarrett did receive a payment of tezos from another party that previously possessed it in the amount of 2,581 tezos tokens (aka XTZ). Jarrett did not bake, validate, or endorse all 8,876 tezos tokens referenced in the Brief. Approximately 2,581 of the tezos tokens received in 2019 were received as rewards from other unrelated bakers through delegation. The remaining 6,295 were baking, validation, or endorsement rewards of Jarrett’s “own creation” (i.e. delegating his original tezos tokens to himself). This information can be found on the public address of Jarrett’s tezos wallet, including a second address belonging to him where the 2,581 delegation rewards were primarily credited by the baker’s with names Airfoil, Flippin’ Tacos, and Crypto Delegate [fn2].
The Jarrett brief argues that “receipt from someone else” is what matters in examining the taxation of staking rewards. By applying Jarrett’s own arguments and analysis of the law to these facts, the 2,581 tezos tokens received from another tangible party (the baker/Delegate, rather than the Tezos protocol itself) should be taxable at the moment earned and where the taxpayer has dominion and control over the asset (so generally when it enters their wallet address).
Disclaimer
In order to solely explore the concept of “received from someone else / another party”, I do not set out to explore or analyze in this blog the:
Merits or completeness of the law that is analyzed and applied in the Jarrett case with regards to the 6,295 staking rewards earned by Jarrett in his capacity as a baker after June 2019.
Application of the law or analysis to staking of other crypto or digital assets outside of tezos.
Valuation or dilution concepts and how they might apply to delegation issues.
Merits of the policy proposals from Senators Lummis and Gilligrand regarding full taxation deferral of both staking and mining rewards until the time of sale.
A number of these issues are analyzed in an article by Omri Y. Marian titled Law, Policy, and the Taxation of Block Rewards [fn3]. In the article, Omri lays out why deferral of taxation has no basis in good tax policy but also shows how Jarrett would have ultimately paid more taxes under a deferral method. This is why many tax professionals are left puzzled by the public support of the issue. Instead, this blog post explores an area of Jarrett’s activities which was entirely silent in the Brief with the exception of mentioning that Jarrett delegated his staking before setting up his own node.
I am not a lawyer, and this blog post does not constitute a tax or legal opinion or advice. I have no additional information other than what can be found on the public internet and the public blockchain wallet addresses. This blog contains the use of analogies, but does not aim to conclude or otherwise recommend that tezos baking/staking rewards are properly characterized as rental income under current tax law. This blog only sets out to show that a crop sharing rental income analogy would indicate that Jarrett is receiving a payment “from another party” in delegating his tezos for baking to a baker/Delegate.
My challenge to the tax lawyers is to pick this up and have a second look at taxation of staking rewards that are paid through delegations, including those from centralized exchanges (i.e. private, off-chain).
Background of Tezos Baking and Crop Sharing
Tezos Baking
For purposes of this discussion, it is useful to define a Delegate and a Delegator:
Delegate = Baker/Endorser/Validator, a party that bakes, endorses, or validates new blocks on the Tezos blockchain
Delegator = Tezos owner who delegates their tezos to a Delegate, but retains ownership of their original tezos tokens
Jarrett was a Delegator in the first half of 2019. He became a Delegate in the second half of 2019. Throughout this discussion, the word baker and Delegate can be used interchangeably.
Baking
The Brief provides a detailed account of how baking works which I will not repeat here. If you like visual diagrams, you can follow along with this great diagram at the Open Tezos website. In short, a so-called baker can stake their own tezos tokens, and the tokens of other tezos owners that have delegated staking to the baker, in a process called baking which secures new blocks on the blockchain. Becoming a baker requires a significant investment of equipment, resources (e.g. reliable WiFi), and knowledge. Bakers receive rewards from the protocol for successful block entries. Where a baker does not win the mathematical lottery to bake the next block, they may earn a smaller reward for network maintenance by endorsing or validating network events. Baking can only happen on-chain which means that it is always a public event.
There are no identifiable accounting records associated with the earning of baking rewards as they are newly created tokens from the protocol itself. Only the baker indicates a new reward in their book-keeping but there is no corresponding outgoing entry from some other party’s ledger.
Standard Delegation (On-Chain)
To become a baker requires an investment of equipment, reliable internet resources, and software knowledge among other things. As there is a resource and complexity hurdle to overcome, most tezos owners delegate their tezos tokens to a baker in lieu of running their own node. There are only 405 bakers as of today’s writing. The act of delegation can only happen on-chain and is a public event, unless the Delegator is delegating to a Custodial Delegate, discussed in the next section.
Different to baking, the payment of staking rewards by the baker/Delegate to the Delegators comes with identifiable accounting records. There is an outgoing entry in the Delegate’s wallet address record of the staking rewards and an incoming entry in the Delegator’s wallet address. In the case of delegation, the Delegator is receiving tokens that were previously possessed by another party (i.e. the baker/Delegate).
There is no protocol paying the staking rewards to Delegators that have delegated to a baker. Though bakers can automate the payments, the payment and amount is entirely at their discretion and completely editable by them [fn4]. Some bakers are untrustworthy or go out of business [fn5]. Some bakers are simply bad at making payment calculations so there are calculators for Delegators to monitor that their baker is paying them out correctly [fn6]. Because some bakers can be unreliable and frequently mask their underlying identity [fn7], more and more Delegators have been moving their delegation to centralized crypto exchanges because they will reliably pay the staking rewards and are considered trustworthy by the public. This is not the case for every public blockchain protocol as some protocols pay staking rewards on-chain automatically (e.g. Cardano and ADA staking pools) and other protocols, like Tezos, leave it up to the staking service (i.e. the baker) to pay the rewards. As such, you can see a variety of interpretations by the staking services of what they are actually paying to the Delegators:
Everstake (baker/Delegate): calls the payment of staking rewards to tezos holders a “revenue share” in their Terms. https://everstake.one/terms.pdf
StakeNow (baker/Delegate): describes that a Delegator holds “rights to participate” and “rights to vote” and that they are delegating such participation rights to the baker/Delegate. There is no mention of an exchange of a “right to new tokens”, instead the agreement mentions that the client (Delegator) receives a “right to a payment claim” against StakedNow after deduction of their fees (see section Section 4.1). https://stakenow.fi/terms-conditions/
CryptoDelegate (baker/Delegate): their website explicitly states “Any tokens that we generate and hold in our hardware wallets are property of CryptoDelegate. Token ownership transfer happens immediately upon the Tez tokens being sent and received from CryptoDelegate to the client.” https://www.cryptodelegate.com/
Most other bakers/Delegates don’t have a website, or if they do they have no terms of service or other written agreement with their clients. They just give them their wallet address for delegation and everyone hopes they get paid.
For those bakers/Delegates that do have T&Cs on a published website, almost all of them make it clear that the baker/Delegate does not hold custody of any client (Delegator) funds/crypto (the “original” staked tezos tokens as opposed to the newly created tezos tokens). With the exception of CryptoDelegate, most of them are silent as to the custodial vs non-custodial relationship of the newly created tezos tokens. The use of “revenue share” or “profit sharing” language by the baker/Delegate makes sense in this context as the bakers/Delegates would not want to be viewed as holding “in trust” the newly created tezos tokens on behalf of their client (Delegator) as this would create a custodial relationship. For non-tax regulatory reasons, the bakers/Delegates certainly want to stay away from any custodial relationship with their clients. As such, it makes sense that the bakers/Delegates view themselves as the creator of the new tezos tokens/property holding legal title and ownership until they pay the rewards to the Delegator.
From a technical perspective, you can delegate directly from your private wallet on-chain to the centralized exchanges like Kraken, Binance, and Coinbase but you won’t earn any rewards that way [fn8]. The protocol doesn’t decide that, the exchanges do for regulatory reasons. In order to earn staking rewards and properly delegate to one of these exchanges, you must open a customer account at the exchange, go through KYC/AML procedures, and deposit your tezos tokens into the custodial wallet of the exchange. This is discussed in the next section about Custodial Delegation.
Exchanges “Custodial Delegation” (Off-Chain)
Though similar in concept to Standard Delegation discussed in the previous section, Custodial Delegation means that a Delegator must deposit their tezos in the custodial wallet of a centralized exchange after passing KYC/AML checks. The exchange then provides the services (or subcontracts them to another party) of baking and credits the rewards to the internal ledger account of their customer. This means that the transactions are considered off-chain in that the public cannot view the internal (customer) records of the exchange. The public only sees one big pool of tezos for the exchange when viewing the public tezos baking records. Though this delegation through an exchange generally occurs off-chain, new products are constantly being developed so this could evolve.
Though this type of delegation is private, there are still identifiable accounting records just like with Standard Delegation. Those accounting records are just not visible to the public blockchain but they do exist. The exchange creates the new tokens through baking, the rewards have an outgoing entry from the exchange records into the sub-records of the customer, and the customer has a corresponding incoming entry for the rewards in their customer account with the exchange. Exchanges have different methodologies for paying rewards to their customers/Delegators:
Some exchanges pay rewards based on whatever the network reward is, minus the baking fee retained by the exchange (usually between 10-25%).
Other exchanges pay a fixed reward (listed on their website and regularly adjusted) and will pay that amount regardless of the baking reward earned by the exchange (the exchange might earn more or less than what they pay to their customer). It is also typical that the exchange pays the reward rate listed on their website even if that customer’s specific assets were never used in the baking/staking process.
For the remainder of this discussion, I will only focus on Standard Delegation for simplification because Jarrett did not delegate to any exchanges in 2019 [fn9]. That being said, I have not found a compelling argument to view Standard Delegation different than Custodial Delegation. What is important is the legal agreements in place (if any) and rights to the newly created assets.
Staking on Other Blockchain Protocols
It is important to note that different crypto assets operate staking under varied protocol designs and therefore must be assessed independently of each other. For example, staking of ADA on the Cardano blockchain can be done through a delegation mechanism called a “staking pool operator” (akin to the baker/Delegate). However, Cardano rewards from delegation are automatically delivered to the Delegator by the protocol (after deduction of fees/profits owed to the staking pool operator). The staking pool operator never takes possession or legal title/ownership to the rewards before disbursing them to Delegators. As such, Cardano staking rewards earned through on-chain delegation could have a basis in being treated the same as the on-chain staking rewards earned by the staking pool operator themselves but delegation through a centralized exchange may not. Further analysis would be needed to explore these possibilities.
Farm Leases, Rent, and Crop Sharing
The taxation of agricultural structures has one of the longest histories within the tax code amongst various industries especially when compared to more recent technologies like cloud-computing and blockchain. It therefore provides a great deal of analogies and case law to review. Crop sharing is a method of rent paid by tenant farmers (operators) to landowners in lieu of cash payment [fn10]. In the US, it broadly falls under two models:
Fixed rate: the tenant farmer/operator pays the landowner a fixed rate of rent each year, though it may be slightly adjusted for weather conditions and harvest projections on a periodic basis. In general, the tenant farmer/operator takes on the risk of a bad harvest and benefits from the gains from a bumper harvest.
Harvest/production rate: the tenant farmer/operator pays the landowner a percentage rate of harvest in rent each year, such as 20-25%. In general, the tenant farmer and landowner are sharing in the risks and rewards of harvest production.
In the absence of a contract indicating otherwise, the annual crops produced legally belong to the tenant farmer/operator under the laws of most US states and regardless of the model chosen. There are a handful of states where that is less clear. The landowner will usually have preferential rights to the crops by way of a landowner lien in the case of a tenant farmer/operator bankruptcy. In case the tenant farmer/operator ends the tenancy with the landowner, the tenant farmer/operator is usually entitled to come back to the property to collect their crops. This is called the “doctrine of emblements”.
Following the arguments of the Jarrett’s, I will later analogize the baker/Delegate of tezos to the tenant farmer/operator and the Delegator to the farm landowner/landlord.
Why didn’t I choose an analogy like creating art paintings or other analogies used in the Brief? Because there are no available tax law cases involving artists paying their landlord to use their property in exchange for payment in art paintings. While the creation of art paintings may work for the analogy of Jarrett operating his own node, it does not work in an analysis of the delegation process. Owners of land giving rights to use their land to tenant farmers/operators in exchange for a percentage of their crop is a standard industry practice in agriculture.
Detailed Analysis
What is income? The Brief and Jarrett’s arguments
Taxation of crop sharing arrangements
Rewards by Delegators are payments received from another party and not created property
Taxation of tezos delegation rewards akin to crop sharing
What is income? The Brief and Jarrett’s arguments
The often quoted case in the Jarrett Brief (amongst many) is that of Eisner v. Macomber, 252 U.S. 189 (1920) which discusses the definition of income and how it is derived. There is a reference that for income to be derived, there must be a “coming in” which Jarrett argues means a payment from one party to another and not the creation from nothing. Though the Jarrett Brief mentions in short passing that Jarrett delegated his staking before launching his own node in June 2019, it makes no further mention of this delegation and how it is alike, or not, to the creation of new tokens as a baker. Below I quote or paraphrase a series of points made in the Jarrett Brief before applying the same points to the concept of delegation. Page number references are to the pages of the PDF itself rather than the numbering of the Brief:
Page 7: a statement is made that Jarrett did not receive the tokens from another party as interest, dividends, or any other type of payment.
Page 9: references Commissioner vs Glenshaw Glass Co., 348 U.S. 426 (1955) and that in the case of the craftsman and the truffle hunter, both have become wealthier “assuming clear ownership and control of the tokens and truffles”. It leaves doubt as to who has become wealthier when ownership and control of the new tokens (or truffles) is not clear.
Page 9: further discusses the “culmination of the taxpayer’s investment of labor and/or capital” results in income realization at the time of the truffles or tokens sale or exchange. The discussion spills to page 10 about found treasure being income at the time of undisputed possession. Being found means that the treasure previously had an owner. They argue that Jarrett’s tokens are not treasure as they did not have a previous owner.
Page 12: references that Jarrett initially delegated his tokens “to others” with no mention of who the others were. It mentions in the footnote being a Delegator is a suitable option when you have insufficient tokens to stake or do not have the equipment/investment/interest to operate on your own. It mentions that Jarrett bought his own equipment in June 2019 and began maintaining his own staking node as a baker (Delegate).
Page 12: a statement is made that the design of Tezos is such that it is “not operated or maintained by a single person or entity….because, in short, that person could cheat”. Network maintenance, participation, and other concepts are discussed on the following pages in order to explain how trust is created when no single person or entity can be trusted.
Page 15: restates that tezos reward tokens are created or discovered at some point, and are not paid to the staker “by some other person or entity”; they are created, not earned.
Page 28: discusses how a “corresponding accounting entry of some other identifiable party” can lend a clue about compensation and mentions that there is no such party with the Jarrett facts.
Page 28: acknowledges that “receipt from somewhere else” is what matters in examining taxable compensation.
Page 29: offers a footnote in relation to wheat farming, referencing IRC Treas. Reg. 1.61-4 and the deferral of taxation for landowners in receipt of crop share rental payments.
Page 30: mentions that tezos stakers (the bakers/Delegates) don’t work together, they instead compete with each other.
Taxation of crop sharing arrangements
Before exploring this topic we first have to define a few terms:
Is it income? Yes, unless there is a specific exclusion.
Is it realized income? E.g. legal title or enjoyment of benefits has crystallized for the recipient.
Is it recognized income? This is the moment of taxation and is a question of timing.
It follows then that an item of income cannot be recognized if it is not yet realized. This is illustrated in Strong v. Commissioner, 91 T.C. with the following excerpt (emphasis by me added in purple brackets):
Just as the harvesting of a crop is not a taxable event to the crop's raiser, neither is the birth of offspring a taxable event to the true, initial owner of the offspring by virtue of this owner's unrestricted rights in the dam. Cf. Tatum v. Commissioner, 400 F.2d 242, 246-247 (5th Cir. 1968), affg. 46 T.C. 736 (1966). [No taxable events exist in these instances because the harvesting and birth do not represent realization events]. Cf. Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955); 1 B. Bittker J. Eustice, Federal Taxation of Income, Estates and Gifts, par. 5.2 (1981).
As the discussion of this blog is solely focused on the new tezos tokens received by Jarrett as a Delegator from the baker/Delegate, I will focus the remainder of this text about crop sharing arrangements on the landlords specifically, and not on the tenant farmers/operators.
Treas. Reg. § 1.61-4(a) allows crop sharing landlords to pay tax at the time the crops are sold or otherwise reduced to a money equivalent, regardless of whether or not the crop shares are viewed as rent under state law. This is consistent with the arguments presented in the Jarrett Brief (discussed above). Tatum v. Commissioner, 400 F.2d confirms that rent received by a landlord in the form of crop shares is indeed income, and is indeed realized income, but is simply not yet recognized as taxable income. The recognition of taxable income is simply deferred (emphasis by me added in purple brackets):
Although there is no distinction in the essential income nature of crop rents as against rent in any other form, Treas. Reg. § 1.61-4(a), (b) accords to share-crop landlords the privilege of waiting until the crop shares are reduced to money before recognizing the income. This accounting procedure is a rule of administrative convenience, made necessary by the absence of cash with which to pay the tax prior to a sale and by difficulties in abstract valuation of farm products, but this rule of deferred reporting of income has no bearing on the underlying question whether potentially taxable income exists. Because recognition is deferred the unsold (or uncontributed) crop shares occupy a special position in tax nomenclature — they are best described as "potential income assets." See Estate of Davison v. United States, 292 F.2d 937, 155 Ct.Cl. 290 (1961). [The shares are income items, but because recognition is postponed until they are reduced to money or its equivalent they are not immediately taxable. Crop shares have also been termed "deferred but realized income."] Eustice, Contract Rights, Capital Gain, and Assignment of Income — The Ferrer Case, 20 Tax L.Rev. 1, 40 (1964).
Tatum v. Commissioner, 400 F.2d, further distinguishes that rent received by a landlord in the form of crop sharing is not farming income, it is rental income which may be eligible for deferral of taxation recognition under Treas. Reg. § 1.61-4(a).
This deferral is only available in the case that the landlord meets the definition of being a farmer. Farmers are defined under Treas. Reg. § 1.175-3 and includes common industries like wheat, corn, and hog farming but excludes things like timber (emphasis by me added in purple brackets):
A taxpayer is engaged in the business of farming if he cultivates, operates, or manages a farm for gain or profit, [either as owner] or tenant. For the purpose of section 175, [a taxpayer who receives a rental (either in cash or in kind) which is based upon farm production is engaged in the business of farming. However, a taxpayer who receives a fixed rental (without reference to production) is engaged in the business of farming only if he participates to a material extent in the operation or management of the farm.] A taxpayer engaged in forestry or the growing of timber is not thereby engaged in the business of farming.
Two simple examples can be derived from this and applied in the context of Treas. Reg. § 1.61-4(a):
A landowner of a farm that harvests wheat, receiving rent in the form of wheat at a fixed amount (without reference to production), and who does not materially participate in the farm, is not a farmer.
This landowner is therefore not eligible for the taxable income recognition deferral under Treas. Reg. § 1.61-4(a) and would recognize rental income in the year they earned or received the crop depending on the cash or accrual basis of accounting that applied to them.
A landowner of a timber farm, receiving rent in the form of timber harvest sharing which is based on 20% of timber production, is not a farmer.
The outcome is the same as Example 1.
This exercise illustrates that the agricultural case law has made clear that rent received in a crop sharing arrangement is rental income, it is realized, and it is recognizable in the year earned or received unless there is a deferral that applies to them. In the case that a landowner is not a farmer, then there is no deferral available to them under Treas. Reg. § 1.61-4(a). This is then summarized in the following table:
Even in the case that a taxpayer has successfully proven that they are in the business of farming and eligible for taxable income recognition deferral under Treas. Reg. § 1.61-4(a), the recognition moment is not the obvious “moment of sale” under case law. In both Dudden v. Commissioner, 91 T.C. and Strong v. Commissioner, 91 T.C. we see an interesting analysis of “reduced to money equivalent”. In both cases, the transfer of livestock from landowner herds into breeding herds (overseen by the tenant operator) was considered a sale or reduction to money equivalent and triggered the taxable income recognition moment even though the livestock had not been sold or culled. Strong v. Commissioner, 91 T.C. elaborates (emphasis by me added in purple brackets):
Petitioners' transfers of the acquired gilts and calves to their leased breeding herds represent transfers of the animals to commercial applications from which further rental income will be realized. These transfers represent dispositions of the animals through these animals' dedication to productive use in petitioners' breeding herds. [In making the transfers, petitioners have not had to expend money to purchase breeding animals from outside sources. This money savings is then in the "nature of money" for, in a broad economic sense, petitioners now have at their disposal funds which have not had to be directed toward the purchase of brood replacements.] Accepting such, we hold that petitioners have received a "money equivalent" and must accordingly recognize income. That is, we find that at the time of the transfers in question the rental income potential reflected in the transferred gilts and calves has been fully achieved and, therefore, is recognizable and taxable.
I end this section by asking, “what if this isn’t really a crop sharing type arrangement and it’s really a profit sharing arrangement?”. Profit sharing generally means a type of joint participation in the profit earning process or partnership amongst the parties, which is not the case with tezos baking. In the agricultural context, profit sharing is generally used when the landlord is the one receiving the business income and is paying a portion back to the “grower” or “operator” which is also not the case with tezos baking. With tezos baking, it is the baker/Delegator (“grower/operator”) that is paying the Delegator (“landlord”).
Rewards by Delegators are payments received from another party and not created property
I will first summarize the points above regarding tezos baking delegation compared to the act of baking itself:
There is usually no clear written agreement as to who holds legal title/ownership to the newly created tezos tokens in the baking process, with one exception being CryptoDelegate who clearly states on their website that they own the newly created tokens. Bakers/Delegates must view themselves as the creator and owner of the newly created tezos tokens as the alternative would mean the baker/Delegate is holding custody of client assets which opens up a world of non-tax regulatory issues.
While acting as a baker/Delegate is certainly a culmination of equipment, software, and knowledge investments, the whole point of delegation is so that the Delegator does not have to make those investments.
Jarrett’s tokens, while not “found”, did have a previous owner which is the baker/Delegate.
Bakers have full authority to pay or not pay the delegation rewards, not the protocol itself. Public blockchain protocols are designed for a world where you cannot trust a single person or entity. Yet with tezos, Delegators are delegating their tezos tokens to bakers/Delegates and have to trust that the baker/Delegate will pay them. Delegators must select their baker/Delegate based on public reputation and good standing record of historical payments. Bakers/Delegates are tangible and identifiable parties with the ability to control/edit payments or simply run away from the obligation to pay.
In delegation, corresponding accounting entries exist with delegated rewards. One side of the entry is an outgoing payment from the baker/Delegate, and the other side is an incoming payment to the Delegator.
Tezos bakers don’t work together, they compete with each other. Yet Delegators do work together with bakers/Delegates. Through delegation, a baker/Delegate gains access to participation and voting rights of more tezos tokens which gives them a greater chance of getting to bake the block or pass a vote.
Two identifiable and unrelated parties, that are not in a partnership together, cannot both be the creator of the new tezos tokens.
The culmination of this evidence demonstrates that Jarrett, in his role as a Delegator, was not the creator of the newly created tezos tokens but instead received them from someone else (the baker/Delegate).
Taxation of tezos delegation rewards akin to crop sharing
Operating on the basis that Jarrett has not created the tezos tokens when he delegated his participation rights to another baker/Delegate, we can analogize his role as that of a landowner who has given land use rights to a tree growing and timber harvesting operation (the baker/Delegate).
The baker/Delegate grows the trees and harvests the timber, retaining all legal rights and ownership to the timber harvest. The baker/Delegate as timber harvest operator agrees to pay “rent” to the landowner (the Delegator) for the use of his “land” (tezos tokens) by way of 20% of the timber harvest produced. The landowner (the Delegator) has realized income at the moment the timber harvest is counted and segregated (e.g. credited to his tezos wallet where he has dominion and control over the assets). The landowner (the Delegator) has received a payment of realized income “from someone else”, the baker/Delegate, who is an identifiable party that first held legal title/ownership of the new tokens.
As the landowner (the Delegator) does not meet the definition of “farmer” under Treas. Reg. § 1.175-3 then they are not eligible for deferral of recognition of taxable income under Treas. Reg. § 1.61-4(a). The “rental income” is therefore taxable to the landowner in the year of receipt (e.g. credited to his tezos wallet where he has dominion and control over the assets).
Even in the case of a farmer who is eligible for deferral of taxable income recognition Treas. Reg. § 1.61-4(a), the transfer of new token rewards into the private wallet of the Delegator creates a larger balance for future baking cycles and consequently a larger token reward. The Delegator is now in the position of earning more income without having to purchase new tezos tokens. It is interesting to consider whether this qualifies as “reduced to money equivalent” similar to the transfer of livestock into breeding herds. I do not further explore this concept given that the analysis ends with the definition of a farmer.
Conclusion
We should distinguish “what does the law currently say” from “what do we want the law to say”. The Lummis Gillibrand proposal mentioned at the beginning of this blog post urges the deferral of taxable income recognition for staking rewards until the time they are sold. In the absence of new laws that specifically address crypto staking rewards, we are left with applying existing law when discussing past events.
My challenge to the tax lawyers is to pick this up and have a second look at taxation of staking rewards that are paid through delegations, including those from centralized exchanges (i.e. private, off-chain). Differentation of assets and the design of how they are paid out will be very relevant to such analysis, such as examining the differences between staking on Tezos vs Cardano.
This blog set out to explore a silent area of the Jarrett vs US case. I welcome new angles and challenges to the ways of thinking presented either in the Jarrett case or this blog. New pieces of information or relevant analogies could change the proposed outcomes and I welcome the discussion. Grab some time in my calendar link below to chat!
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References / Footnotes
Footnote 1: “Brief in Support of Taxpayer Joshua Jarrett’s 1040-X Amended Return and Claim for Refund” https://static1.squarespace.com/static/62f147feb8108a08e666aea5/t/63127d123ecc7346d75c3963/1662156052488/Brief-of-Taxpayer-Jarrett-in-Support-of-Refund-Claim-July-31-2020.pdf
Footnote 2: the 2,253.98 of tezos rewards credited on 14 April 2019 were likely apportioned between a 2018 and 2019 accrual though this has not been confirmed and is not relevant to the blog today.
Footnote 3: Law, Policy, and the Taxation of Block Rewards, by Omri Y. Marian, June 6 2022, Accessed from: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4159946
Footnote 4: https://tezos.org.ua/en/blog/how-to-choose-a-baker
Footnote 5: The protocol doesn’t distribute delegation rewards, rather the bakers do: Bakers can be dishonest https://blockdaemon.com/docs/protocol-documentation/tezos/how-tezos-staking-works/
Footnote 6: Calculator for dishonest bakers tracking https://baking-bad.org/blog/2018/12/05/baking-bad-tezos-rewards-auditor-get-started/
Footnote 7: Caution, inappropriate or offensive language. Payouts are controlled by someone else https://www.reddit.com/r/tezos/comments/9qkl19/tezos_baking_club_is_a_total_scam_3_months_baking/
Footnote 9: that Jarrett did not delegate to any exchanges in 2019 is confirmed by looking at the total 2019 tezos purchases quoted in the Brief of 98,554. In reviewing the Jarrett wallet you can see tezos deposits from Coinbase and Kraken wallet addresses totaling 98,552 in 2019. If Jarrett had staked while on Kraken or Coinbase then the amounts coming from those wallets would have exceeded the purchases number of 98,554. Kraken started supporting staking of tezos on Dec 13, 2019. Retail staking of tezos on Coinbase was launched in June 2019.
Footnote 10: Crop sharing and farming leases, ownership, and liens https://www.youngfarmers.org/wp-content/uploads/2019/01/Growing-on-Solid-Ground-A-Farmers-Guide-to-Land-Tenure.pdf
Cases / Regulations Quoted
Strong v. Commissioner, 91 T.C. https://casetext.com/case/strong-v-commissioner-of-internal-revenue
Tatum v. Commissioner, 400 F.2d https://casetext.com/case/tatum-v-cir
Dudden v. Commissioner, 91 T.C. https://casetext.com/case/dudden-v-commr-of-internal-revenue
Treas. Reg. § 1.61-4 https://www.law.cornell.edu/cfr/text/26/1.61-4
Treas. Reg. § 1.175-3 https://www.law.cornell.edu/cfr/text/26/1.175-3
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