IRS Maintains Position on Taxation of Cryptocurrency Collateral：Interpreting the Jarrett v. United States Case

In 2022, the Jarrett couple filed a lawsuit against the U.S. government, seeking a refund of federal income taxes they claimed were owed to them. The case primarily revolves around the dispute over whether the Jarrett couple realized income when obtaining new cryptocurrency through staking. In the same year, the Middle District of Tennessee court dismissed the Jarrett couple's lawsuit, citing the issuance of a full refund check with statutory interest by the Internal Revenue Service (IRS) to the Jarretts as rendering the refund lawsuit moot. Subsequently, the Jarrett couple appealed to the Federal Sixth Circuit Court, which upheld the original decision. The case was finally decided on August 18th of this year.

The Jarrett v. United States case reflects differing positions between the IRS and cryptocurrency asset investors regarding the timing of income realization from staking cryptocurrency. The timing of income realization directly affects the recognition of taxable income for individuals, thereby impacting their tax liability. This article aims to analyze this case and attempt to clarify the U.S. government's approach to taxing income from staked cryptocurrency assets, providing insights for cryptocurrency tax compliance practices.

1. Case Facts and Dispute Focus

1.1 Facts Established in Two Trials

Joshua Jarrett claimed that he had overpaid his taxes for the year 2019 and sued the IRS for a refund. Jarrett produced Tezos tokens (a type of cryptocurrency) through a process called "staking."

Jarrett believed that staking essentially involved using existing Tezos tokens and computing power to generate new tokens, and thus, he should only recognize income when selling or transferring the tokens, thereby requiring taxation. However, the IRS had a different view of this process. The IRS argued that, similar to payments, wages, compensation, and other sources of income, staking involved the exchange of goods and services. When taxpayers received "rewards" generated by staking, it increased their total income (IRS Revenue Ruling 2023-14). Additionally, the IRS's "Digital Asset Issues Update" on its website classified new digital assets generated through mining, staking, and similar activities as taxable transactions. Based on this, Jarrett recognized income each time he received a token and included it in his annual taxable income.

The timing of income recognition is crucial for calculating taxable income, and, typically, delaying realization benefits taxpayers. Jarrett's tax bill depended on the value of Tezos when he realized income. Since 2018, the value of Tezos had fluctuated from 70 cents to over 8 dollars.

Jarrett claimed that in 2019, his staking activity yielded 8,876 Tezos, which he did not dispose of. The IRS considered the Tezos he obtained as realized income when he produced the tokens. Although Jarrett disagreed, federal law prohibited him from challenging his tax liability in advance—he had to pay the taxes first and then request a refund from the IRS. Consequently, the Jarrett couple reported the tokens they obtained in 2019 as income on their joint tax return and paid taxes on it. They subsequently requested a refund of $3,793, claiming that the income had not been realized. As the IRS did not respond within six months as required by law, Jarrett promptly filed a tax refund lawsuit in federal district court, seeking: (1) a judgment that Jarrett was entitled to a refund for 2019, (2) costs and attorney's fees, and (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 for $4,001.83, including $3,793.00 in federal income tax refunds and $208.83 in interest, to the plaintiff. Subsequently, the U.S. government moved to dismiss Jarrett's lawsuit on the grounds of lack of subject-matter jurisdiction under Federal Rule of Civil Procedure 12(b)(1), arguing that the refund claim had become moot—the government had already refunded the overpaid taxes and interest.

Jarrett did not cash the check and continued with the lawsuit. Simultaneously, he still asserted his right to a permanent injunction against the IRS for future income recognition of tokens obtained through staking, advocating for recognition only upon token realization, which he argued was necessary for stable tax expectations for those in the mining industry.

1.2 Dispute Focus of the Case

The main point of contention in this case is whether the court retains subject-matter jurisdiction after the U.S. government issued the tax refund check, in other words, whether the check resolves the dispute between Jarrett and the U.S. government.

According to Jarrett's argument, on one hand, while he received the check, he refused to accept (and did not cash) it, so he still had the right to litigate the tax refund. On the other hand, even if his monetary claims had become moot, his reasons for other forms of relief remained valid. The requested permanent injunction itself is a dispute that needs independent resolution, and therefore, the court should proceed with it.

However, the U.S. government contends that, based on relevant provisions of the U.S. Constitution and the Anti-Injunction Act, Jarrett's claims are moot, and the court should not rule on them.

2. Analysis of Tax Legal Relationships in the Case

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

2.1.1 District Court's Decision

Subject-matter jurisdiction refers to the court's power to adjudicate specific types of matters and provide the requested remedies. The court must have jurisdiction to make effective judgments on claims. The U.S. government argued that, according to Article III of the United States Constitution, judicial power is limited to "Cases" and "Controversies," and there is no longer any controversy in this case regarding the tax refund, so the court lacks subject-matter jurisdiction. The district court accepted this view and reasoned that when the court cannot provide any effective relief to the prevailing party, the case becomes moot. Since the U.S. government had already completed the tax refund, the court could no longer provide relief by satisfying Jarrett's tax refund request.

Regarding Jarrett's argument that "they had the right to refuse the refund and obtain a judicial determination," the court found that Jarrett relied on Campbell-Ewald Co. v. Gomez to support this argument. However, in that case, the situation was different as the defendant made a settlement offer (a tender), which was insufficient to end the case. In contrast, in this case, the U.S. government issued a check directly to Jarrett, and whether Jarrett deposited that check did not affect the existence of the dispute.

In conclusion, the district court found that there was no longer any dispute in the case concerning the tax refund and, therefore, denied jurisdiction.

2.1.2 Federal Circuit Court's Decision

The Federal Circuit Court stated that they adopted a "fresh perspective" to review the district court's mootness determination, which involved examining whether the government had adequately demonstrated that the case was moot. After extensive examination of prior case law and Supreme Court cases, the Circuit Court agreed that a defendant's settlement "offer" cannot provide complete relief to the plaintiff, but actual payment can. The Circuit Court further noted that there was no reason to decide the effectiveness of the check based on how Jarrett handled it, as 26 U.S.C.  6611(b)(2) provides that "the obligation to pay interest by the IRS and the termination of the refund check occur simultaneously," regardless of whether the taxpayer accepts the check. Additionally, the Circuit Court denied the similarity between the Campbell-Ewald case and the present case.

During the appeal process, the IRS issued Revenue Ruling 2023-14, which determined that token rewards obtained through staking should be recognized as income when dominion is obtained. The Circuit Court found that this ruling did not affect the 2019 tax liability.

2.2 Is Jarrett's request for a permanent injunction considered an independent dispute?

2.2.1 District Court's Judgment

Regarding the dispute over the permanent injunction, the court determined that two regulations excluded Jarrett's request for "prospective relief." First, according to Section 2201(a) of the United States Code, federal tax suits brought under the Internal Revenue Code (IRC) are excluded from declaratory relief. Second, the Anti-Injunction Act prohibits lawsuits "for the purpose of restraining the assessment or collection of any tax."

On the other hand, the plaintiff's lawsuit was based on Section 7422 of Title 26 of the United States Code, "Civil Actions for Refund Claims," which necessarily addresses the past rather than the future. Claims under this provision are "to recover any internal revenue tax alleged to have been erroneously or illegally assessed," meaning Jarrett cannot bring a lawsuit solely involving prospective tax relief.

Furthermore, Jarrett argued that their lawsuit request falls under the "no real controversy" exception. However, the court countered by stating that this exception does not apply in this case. The "no real controversy" exception has two types: (1) voluntary cessation of challenged conduct and (2) capable of repetition yet evading review. Regarding the first type, the court argued that the government's refunding of taxes was not a "voluntary cessation of conduct" because the government did not change its tax rules and regulations but merely refunded Jarrett's taxes. As for the second type, the court stated, "the capable of repetition principle applies only when the plaintiff can reasonably demonstrate that he will again be subjected to the alleged illegal conduct." Since the question of whether Jarrett's Tezos creation constitutes taxable income "will never be resolved definitively," and any subsequent refund claims would be based on different tax years, the situation "cannot be capable of repetition."

In conclusion, the district court determined that it should not exercise jurisdiction over the tax injunction.

2.2.2 Federal Circuit Court's Judgment

Regarding the permanent injunction, the Federal Circuit Court's overall stance was that the regulations confirm retroactivity. They determine the appropriateness of taxes previously assessed and paid, not for future tax years. In this regard, the Circuit Court's reasoning was similar to that of the district court, asserting that "only judgments favorable to the government tomorrow would violate the Anti-Injunction Act in tax cases."

Another important point made by the Circuit Court was that after the refund request itself was denied, relief for prospective relief alone cannot support a refund case. The court's reasoning on this issue was relatively weak, citing only the Christian Coal case to state that "the court lacks jurisdiction over lawsuits that contain only prospective claims without an actual refund request."

3 U.S. Attitude Toward Taxation of Cryptocurrency Assets

While the legal issues in this case are relatively straightforward, they reflect the attitudes of federal courts and the IRS towards the taxation of cryptocurrency assets, particularly highlighting the overall regulatory direction of the IRS. Based on the analysis of the case facts and legal arguments, this article attempts to interpret the possible viewpoints of federal courts and the IRS on cryptocurrency asset taxation.

3.1 Federal Court's Overall Attitude

On July 26, 2023, during the oral arguments in the Circuit Court, Chief Judge acknowledged that allowing the government more time to determine its position on complex or novel issues could have some benefits in this case.

However, shortly after the oral arguments, the IRS issued Revenue Ruling 2023-14, explicitly stating their disagreement with Jarrett's position. Jarrett quickly pointed this out to the appellate court and insisted that they have the right to a hearing on their case and seek injunctive relief because they might face similar tax assessments in the future.

The federal courts generally take a conservative approach to cryptocurrency asset taxation. They did not provide legal confirmation on the timing of income recognition for collateralized assets but instead refused to adjudicate on jurisdictional grounds. The district court stated in its judgment, "The plaintiff requests the court's advice on whether he is entitled to a refund under current tax law, but the court does not provide advice." Regarding Revenue Ruling 2023-14, the court believed that "this may mean that similar refunds to Jarrett may not be approved in the future," but it did not evaluate the revenue ruling. Given the earlier statement by the Chief Judge of the Circuit Court, the courts consider cryptocurrency asset taxation to still be an emerging area, and it is evidently premature to make a legal determination on the timing of income recognition.

3.2 IRS's View on Relevant Issues

3.2.1 Timing of Collateralized Income Recognition

The IRS explicitly opposed Jarrett's position, arguing that income from collateral should be determined when control of the tokens is acquired. This involves a question of timing. The IRS assessed taxes for the 2019 tax year, and Jarrett filed their lawsuit in 2022, with Revenue Ruling 2023-14 being issued on July 31, 2023. In other words, the IRS clarified the timing of collateralized income recognition in 2023. However, regardless of the timing, the IRS has consistently held that collateralized income should be recognized when control of the tokens is acquired, at least since 2019.

As the IRS's revenue ruling does not have the force of law, to avoid the risk of the revenue ruling being rejected by the courts, the IRS adopted a strategy of denying jurisdiction in this lawsuit. This allowed them to avoid substantive consideration of the timing of income recognition for collateralized income. The IRS's litigation strategy was successful, as Jarrett's lawsuit did not challenge Revenue Ruling 2023-14 or the IRS's prior tax practices as a legal challenge. This means that it is foreseeable that the IRS will continue to judge the timing of income recognition for collateralized income based on the standard of "acquiring control of the tokens" in the foreseeable future.

3.2.2 Possible Directions for Taxing Collateralized Income

As mentioned earlier, while the IRS's revenue ruling does not have legal force, it serves as guidance on taxation, allowing the IRS to assess taxes using the same standard in similar cases. Moreover, the IRS believes that each tax year may have different circumstances and, therefore, different tax consequences. Hence, even investors who have received refunds in the past few years or whose collateralized tokens have not been cashed out and recognized as income must be cautious: in future tax years, collateralized income is likely to be recognized when control of the tokens is acquired. However, because Revenue Ruling 2023-14 is based on only two cases, there are relatively few precedents accumulated in practice at present. We recommend that investors consult with professionals to determine their future tax strategies.

3.3 Discussion of Other Legal Issues in the Case

3.3.1 Jurisdiction Issue

Jarrett v. United States provides an important precedent for jurisdiction in tax refund cases. On one hand, it confirms that once the government issues a refund check, the tax refund dispute is extinguished. This means that taxpayers have difficulty using litigation to challenge the tax terms of the IRS. Jarrett argued in the appellate brief that the government can strategically mail refund checks, suspending the refund litigation for various reasons. Undoubtedly, the government can use this strategy to avoid substantive review of disputed tax policies. However, the court holds a different view, believing that while satisfying all the requirements of a citizen in individual litigation may be a government's strategy, this strategy generally does not raise concerns about government abuse of power. The government must pay the full refund and interest to achieve an undisputed result, and this is done in the context of public opinion and other forms of supervision. These limitations prevent the government from abusing its power and require it to operate within its limits.

3.3.2 Nature of Tax Refund Litigation

On the other hand, the case further confirms the "backward-looking" nature of tax refund litigation, and it seems difficult to obtain court recognition for litigation strategies that seek permanent injunctions for future tax years through tax refund lawsuits. In fact, one of Jarrett's purposes in filing the lawsuit was to challenge the IRS's income recognition timing (reflected in Revenue Ruling 2023-14) and to argue that income from collateral should be recognized at the time of "cash-out." 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 thinking on the taxation of income from collateralized cryptocurrency assets, providing reference for cryptocurrency tax compliance practices. The case reflects the conservative stance of federal courts on cryptocurrency asset taxation. They did not confirm the timing of income recognition for collateralized assets legally but instead refused to adjudicate on jurisdictional grounds. Meanwhile, the IRS's new revenue ruling highlights the uncertainty and complexity of cryptocurrency asset taxation and showcases the future development and trends of cryptocurrency asset taxation, which investors should closely monitor.