Through the analysis of the Jarrett v. United States case, an attempt is made to clarify the U.S. government's approach to taxing income from pledging encrypted assets, providing a reference for the compliance practice of encrypted asset taxation.
Author: TaxDAO
This article attempts to clarify the U.S. government's approach to taxing income from pledging encrypted assets through the analysis of the Jarrett v. United States case, providing a reference for the compliance practice of encrypted asset taxation. This case reflects the conservative attitude of the federal courts towards the taxation of encrypted assets, as it did not legally confirm the timing of recognizing income from pledging, but rather refused to make corresponding judgments on the grounds of jurisdiction. At the same time, the IRS's new tax ruling indicates the uncertainty and complexity of encrypted asset taxation, as well as the future development and trends of encrypted asset taxation, which is worth the close attention of investors.
In 2022, the Jarrett couple filed a lawsuit against the U.S. government, demanding the return of federal income tax that the government claimed should be refunded. The case mainly involves the dispute over whether the Jarrett couple realized income when obtaining new cryptocurrency through pledging. In the same year, the Middle District of Tennessee District Court dismissed the Jarrett couple's lawsuit on the grounds that the refund lawsuit had lost practical significance, citing the issuance of a full refund check plus statutory interest by the Internal Revenue Service (IRS) to the Jarrett couple. Subsequently, the Jarrett couple appealed to the Sixth Circuit Court of Appeals, and the court decided to uphold the original judgment. The case was ruled on August 18th of this year.
The Jarrett v. United States case reflects the different positions of the IRS and encrypted asset investors on the timing of realizing income from pledging encrypted currency, which directly affects the recognition of taxable income for individual income tax, thereby affecting the amount of tax payable. This article attempts to clarify the U.S. government's approach to taxing income from pledging encrypted assets through the analysis of this case, providing a reference for the compliance practice of encrypted asset taxation.
1. Case Facts and Controversy Focus
1.1 Facts ascertained in the two trials
Joshua Jarrett claimed that he overpaid his 2019 taxes and sued the IRS for a refund. Jarrett produced Tezos tokens (a type of cryptocurrency) through a process called "staking."
Jarrett believes that the essence of staking is to use existing Tezos tokens and computing power to produce new tokens, so he should only recognize income when the tokens are sold or transferred, thus requiring taxation. However, the IRS has a different view of this process. The IRS states that, similar to payments, wages, compensation, and other sources of income, staking involves the exchange of goods and services; when a taxpayer receives rewards generated by staking, it increases the total income (Revenue Ruling 2023-14). At the same time, the IRS's "Digital Asset Issue Update" published on its website classifies "new digital assets generated by mining, staking, and similar activities" as taxable transactions. Based on this, Jarrett realizes income each time he receives a token and includes it in the taxable income for the year.
The timing of income recognition is crucial for calculating taxable income, and in general, delaying realization is advantageous for taxpayers. Jarrett's tax bill depends on the value of Tezos when he realizes income. Since 2018, the value of Tezos has ranged from 70 cents to over 8 dollars.
In 2019, Jarrett reported that his staking activities produced 8,876 Tezos, but he did not dispose of them. The IRS considers the Tezos he obtained as income realized when he produced the tokens. Although Jarrett disagrees, federal law prohibits him from challenging his tax obligations in advance—Jarrett must pay taxes first and then request a refund from the IRS. Therefore, the Jarrett couple reported the tokens obtained in 2019 as income on their joint tax return and paid taxes on it. They later requested a refund of $3,793 from the IRS, claiming that the income was not realized. Since the IRS did not respond within six months as required by law, Jarrett promptly filed a tax refund lawsuit in federal district court, requesting: (1) a judgment that Jarrett is entitled to a refund for 2019; (2) costs and attorney's fees; (3) a permanent injunction to prevent 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 to the plaintiff, including $3,793.00 in federal income tax refunds and $208.83 in interest. Subsequently, the U.S. government filed a motion under Federal Civil Procedure Rule 12(b)(1), seeking to dismiss Jarrett's lawsuit on the grounds of lack of subject matter jurisdiction, arguing that the refund request had no practical significance—the government had already refunded the overpaid taxes and interest.
Jarrett did not cash the check and continued the lawsuit; at the same time, he still claimed that he had the right to obtain a permanent injunction against the IRS from recognizing the tokens he would obtain through staking as income, and instead recognizing them when the tokens are realized. He argued that it is necessary for miners in the industry to have stable tax revenue expectations through this permanent injunction.
1.2 Controversy focus of this case
The controversy focus of this case is whether the court still has subject matter jurisdiction over the case after the U.S. government issued the refund check. In other words, whether the check received by Jarrett resolved the dispute between him and the U.S. government.
According to Jarrett's view: on the one hand, although he received the check, he refused to accept (and did not cash) the check, so he can still file a lawsuit for the refund. On the other hand, even if his monetary lawsuit request has no practical significance, his reasons for other forms of relief are still valid. The requested permanent injunction itself is a dispute that needs to be independently resolved, so the court should hear it.
However, the U.S. government believes that, according to relevant provisions of the U.S. Constitution and the Anti-Injunction Act, Jarrett's claim has no practical significance, so the court should not make a judgment on it.
2. Analysis of Tax Legal Relationship in the Case
2.1 Whether the court has subject matter jurisdiction over Jarrett's tax refund
2.1.1 Judgment of the district court
Subject matter jurisdiction refers to the power of the court to adjudicate specific types of matters and provide the requested remedies. The court must have jurisdiction to make a valid judgment on a claim. The U.S. government argued that, according to Article III of the U.S. Constitution, the judicial power is limited to "cases" and "controversies," and there is no longer a controversy in this case regarding the tax refund, so the court does not have the corresponding subject matter jurisdiction. The district court acknowledged this view and argued that when the court cannot provide any effective relief to the prevailing party, the case loses practical significance. Since the U.S. government has completed the tax refund, the court cannot provide relief to Jarrett by satisfying his tax refund request.
Regarding Jarrett's argument that "they have the right to refuse the tax refund and obtain a judicial ruling," the court believed that Jarrett mistakenly relied on the Campbell-Ewald v. Gomez case to support this argument. Because the situation in that case was that the defendant made a settlement proposal, and the settlement proposal was not enough to end the case. In this case, the U.S. government directly issued a check to Jarrett, rather than a proposal; whether Jarrett deposits this check does not affect the existence of the dispute.
In summary, the district court believed that because there was no longer a dispute in the tax refund case, they denied their jurisdiction.
2.1.2 Judgment of the federal circuit court
The federal circuit court stated that they adopted a "fresh perspective" to review the district court's ruling of no practical significance, that is, to examine whether the government had sufficiently proven that the case had no practical significance. After extensive examination of previous precedents and Supreme Court cases, the circuit court agreed that the defendant's relief "proposal" does not allow the plaintiff to obtain complete relief, but actual payments can. The circuit court further argued that there is no reason to determine the validity of the check based on how Jarrett handles it. Title 26 of the U.S. Code, Section 6611(b)(2) provides 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 Revenue Ruling 2023-14, which stated that the token rewards obtained through staking should be recognized as income when they are acquired. The circuit court believed that this ruling did not affect the taxation for 2019.
2.2 Whether Jarrett's application for a permanent injunction constitutes an independent dispute
2.2.1 Judgment of the district court
Regarding the dispute over the permanent injunction, the court believed that two statutes exclude the "prospective relief" sought by Jarrett. The first is based on Title 28 of the U.S. Code, Section 2201(a), which excludes federal tax lawsuits brought under the Internal Revenue Code (IRC) from declaratory relief. The second is that 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 is based on Title 26 of the U.S. Code, Section 7422, "civil actions for refund," and such a lawsuit is necessarily directed at the past rather than the future. Claims under this provision "are for the recovery of any alleged overpayment of any internal revenue tax," which means that Jarrett cannot file a lawsuit involving only anticipated tax relief.
Furthermore, Jarrett argued that their lawsuit request falls under the exception of "no practical significance," but the court countered that this exception does not apply in this case. There are two types of exceptions to "no practical significance": (1) voluntary cessation of the challenged conduct; (2) capable of repetition yet evading review. Regarding the first situation, the court believed that the U.S. government's tax refund action was not "voluntary cessation of conduct" because the U.S. government did not change its tax rules and regulations, but only refunded Jarrett's taxes. As for the second situation, the court stated, "The capable of repetition principle only applies when the plaintiff can reasonably demonstrate that he will be affected by the alleged illegal conduct again." Since the issue of whether the Tezos created by Jarrett constitutes taxable income "will never be definitively resolved," any subsequent tax refund requests are based on different tax years, so the situation "cannot be repeated."
In summary, the district court believed that it should not have jurisdiction over the tax injunction.
2.2.2 Judgment of the federal circuit court
The federal circuit court's overall attitude towards the permanent injunction is that the regulations confirm it to be retrospective. They determine the appropriateness of previously assessed and previously paid taxes, rather than for future tax years. On this point, the reasoning of the circuit court is similar to that of the district court, stating that "a ruling that is only favorable for tomorrow would violate the prohibition on declaratory judgments in tax cases."
Another important point made by the circuit court is that after the refund request itself is rejected, anticipated relief alone cannot support a refund case. The court's reasoning on this point is relatively weak, only citing the Christian Coal case to explain that "the court does not have jurisdiction over lawsuits that only contain prospective claims in the absence of an actual refund request."
3. U.S. Attitude towards Taxation of Encrypted Assets
Although the legal relationship in this case is relatively simple, it reflects the attitudes of the federal courts and the IRS towards the taxation of encrypted assets, especially reflecting the overall regulatory direction of the IRS. Based on the analysis of the case facts and legal analysis, this article attempts to interpret the possible viewpoints of the federal courts and the IRS on the taxation of encrypted assets.
3.1 Overall Attitude of the Federal Courts
On July 26, 2023, during the oral arguments in the circuit court, the Chief Justice acknowledged that allowing the government more time to determine its position on difficult or novel issues could have certain benefits.
However, less than a week after the oral arguments, the IRS issued Revenue Ruling 2023-14, explicitly stating their disagreement with Jarrett's views. Jarrett quickly pointed this out to the appellate court and insisted that they have the right to have their case heard and seek injunctive relief because they may be subject to similar taxes in the future.
The federal courts overall maintain a conservative attitude towards the taxation of encrypted assets. They did not legally confirm the timing of income from pledging, but rather refused to make corresponding judgments on the grounds of jurisdiction. The district court stated in its ruling: "The plaintiff requests the court to provide advice on whether they have the right to a tax refund under current tax law, but the court does not provide advice." Regarding IRS Revenue Ruling 2023-14, the court believes that "this may mean that future tax refunds similar to those obtained by Jarrett may not be approved," but it did not evaluate the tax ruling. Considering the previous statement by the Chief Justice of the circuit court, the court believes that the taxation of encrypted assets is still an emerging field, and it is clearly premature to confirm the timing of income from a legal perspective.
3.2 IRS's Viewpoints on Relevant Issues
3.2.1 Timing of Pledging Income Recognition
The IRS explicitly opposes Jarrett's view, believing that income from pledging should be determined when control of the tokens is obtained. This involves a question of timing. The IRS was collecting taxes for the 2019 tax year, while Jarrett filed the lawsuit in 2022, and IRS Revenue Ruling 2023-14 was issued on July 31, 2023; in other words, the IRS only explicitly stated the timing of income recognition from pledging in 2023. However, regardless, the IRS has believed (at least since 2019) that income from pledging should be determined when control of the tokens is obtained.
Because the IRS's tax ruling does not have legal force, to avoid the 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 substantive scrutiny by the court on the issue of the timing of income recognition from pledging. The IRS's litigation strategy was successful, and Jarrett's lawsuit did not constitute a legal challenge to IRS Revenue Ruling 2023-14 and the IRS's previous tax practices. This means that in the foreseeable future, it can be expected that the IRS will continue to judge the timing of income from pledging based on the standard of "obtaining control of the tokens."
3.2.2 Possible Direction of Taxation of Pledging Income
As mentioned earlier, although IRS Revenue Ruling 2023-14 does not have corresponding legal force, it has the effect of guidance in taxation, allowing the IRS to collect taxes in similar situations based on the same standard. In addition, the IRS believes that each tax year will generate different tax liabilities due to different circumstances. Therefore, even investors who have received refunds in the past few years or have not recognized income from pledging tokens due to non-withdrawal must be cautious: in future tax years, income from pledging is likely to be recognized when control of the tokens is obtained. However, because Revenue Ruling 2023-14 is based on only two cases, and there are few precedents accumulated in practice, 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
The Jarrett v. United States case provides an important precedent for the jurisdiction of tax refund cases. On the one hand, it confirms that after the IRS issues a tax refund check, the tax refund dispute is extinguished; meaning that taxpayers have difficulty obtaining substantive scrutiny of the IRS's tax provisions through litigation requests. Jarrett stated in the appeal that the government can strategically mail refund checks and suspend refund lawsuits at any time for various reasons. Undoubtedly, the IRS can use this strategy to avoid substantive scrutiny of controversial tax policies and effectively implement them.
However, the court has a different view, believing that while satisfying all of a citizen's requirements in individual litigation may be a government strategy, this strategy usually does not raise concerns about the government's abuse of power. The government must pay full refunds and interest to achieve the purpose of no dispute, and it is in the case of public opinion on the government's concessions resulting from the litigation. In other words, the IRS's strategy still comes at a cost and is subject to public opinion and other forms of oversight. These limitations prevent the IRS 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 "retrospective" nature of tax refund litigation, and the litigation strategy of seeking a permanent injunction for future taxes through tax refund litigation seems difficult to be recognized by the court in this context. In fact, one of the purposes of Jarrett's lawsuit was to challenge the IRS's timing of income recognition (reflected in Revenue Ruling 2023-14) and to attempt to confirm that the timing of income from pledging should be at the time of "withdrawal." It is unfortunate that the court did not support Jarrett's request.
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