New U.S. Tax Court Decision Elevates Need for Cryptocurrency Tax Bill

The Paschall Decision
In 2021, the taxpayers held Cardano tokens, a form of cryptocurrency, in a digital wallet at eToro. eToro served as a validator on the Cardano blockchain and earned Cardano tokens for recording transactions in the tokens. eToro, in connection with its validator activities, allowed its customers to provide tokens that eToro, as a validator, was required to pledge to the blockchain. If a customer did not opt out of the service, it received either 75% or 90% of the tokens awarded to eToro for the pledge. The Cardano tokens could be converted into cash at will but could not be transferred to another digital wallet. The taxpayers did not opt out and received Cardano tokens with a value of $33,354 in 2021. The court should have stopped here. The taxpayers leased their tokens to their wallet provider and received rent for the use of the tokens. Rent is taxable, full stop.^[3]

Instead of finding the rent was taxable, the Tax Court treated the taxpayers as though they acted as validators. And given the fact that the compensation for the use of the tokens was so obviously taxable, contorted the law to find that proof-of-stake rewards should be immediately taxable. The Tax Court employed a three-part analysis to hold that the taxpayers received taxable income when “validator rewards” were transferred to their digital wallet by eToro. First, citing Glenshaw Glass,^[4] the court held the fact that the taxpayers could reduce the Cardano tokens to cash at any time was evidence that they possessed dominion and control over the tokens. Under this test, a cash basis taxpayer is subject to tax on income that they can exercise dominion and control over regardless of whether they choose to do so. (This was clearly true—the rent was taxable income to the taxpayers.)

Second, the court rejected the taxpayer’s position that the staking rewards were akin to a non-taxable stock dividend because the taxpayer’s interest in Cardano was increased. (If, for example, a sole owner of a corporation receives a stock dividend, they won’t have any income because they owned 100% of the corporation before and after the dividend.) This clearly misses the point. In eToro’s hands, the staking rewards should have been deferred income because no one paid the staking rewards for eToro. We’ll have to wait for the decision in Jarrett^[5] to hopefully see this analysis properly applied.

Third, the court rejected the taxpayer’s position that the receipt of the Cardano tokens was akin to a property owner removing minerals or growing crops (the income from which is not taxed until the minerals or crops are sold). This last holding appears to have prompted by the fact that the taxpayers themselves “lacked the power to decide whether (and when) the property was created.” The total inapplicability of this rule to the receipt of compensation for allowing another person to use your property should have provided a clue to the court that it…