Pivotal court cases often set a precedent that shape the tax landscape for years to come. Among these influential cases are the Glenshaw Glass Company (Glenshaw) case and the Cottage Savings Association (Cottage) case. These cases have a significant influence on the approach to digital asset taxation. As we delve into these cases, we will explore how the Internal Revenue Service (IRS) references these cases, analyze the fact patterns, and outline the tax implications.
What happened in Glenshaw
Glenshaw was a glass bottle manufacturer involved in litigation with Hartford-Empire Company, which manufactured machinery used by Glenshaw. They settled the legal dispute with the Hartford-Empire Company, and Glenshaw received around $800,000, of which $324,529.94 were punitive damages for fraud and antitrust violations. Glenshaw didn't report the $324,529.94 as income. The IRS examined them and ruled they should have included the punitive damages in their gross income. Glenshaw fought this ruling to the Supreme Court and lost. The punitive damages were deemed taxable income.
The Court’s interpretation of §22(a) (now §61(a)) of the tax code, which defines gross income, is an important takeaway. The Court emphasized that the statute is broad and includes gains, profits, and income derived from any source except those specifically exempted. When there are instances of undeniable accession to wealth, clearly realized, and in which the taxpayers have complete dominion, it will be income unless it is specifically exempt.
Glenshaw references in IRS digital asset tax guidance
Rev. Rul. 2019-24
Rev. Rul. 2019-24 outlines the tax treatment for hard forks followed by an airdrop. The IRS's analysis highlights the point from Glenshaw that under §61, gross income includes all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion and control. Receiving an additional hard forked token as an airdrop is income because the taxpayer has accession to wealth and dominion and control over that new wealth. There is no additional wealth or gross income to report if you don’t receive a new cryptocurrency from the hard fork. Here are examples of each situation.
Bonnie owns Crypto A. Crypto A experiences a hard fork, resulting in the creation of Crypto B. Crypto B is not airdropped or otherwise transferred to an account or wallet controlled by Bonnie. Bonnie doesn’t receive a new cryptocurrency; therefore, she has no reportable income.
- Craig owns 10 tokens of Crypto C. Crypto C experiences a hard fork, creating Crypto D. 20 tokens of Crypto D were airdropped into Craig’s wallet, where he has the ability to dispose of Crypto D. The fair market value (FMV) of Crypto D was $20 ($1 per token) on the day Craig receives them. Craig now owns 10 tokens of Crypto C and 20 tokens of Crypto D. Craig has $20 ($1 * 20) of ordinary income because his wealth has increased by $20, and he has the ability to dispose of Crypto D.
Rev. Rul. 2019-24 and the examples within it make it clear that in the spirit of Glenshaw, receiving additional wealth is income subject to tax when you have dominion and control over it.
IRS CCA 202316008
IRS CCA 202316008 confirms that a protocol change does not result in income or a taxable disposition (we will discuss this portion later) when a distributed ledger undergoes a protocol change. The protocol change is not income because there isn’t an additional new cryptocurrency, and you are in the same position as before the protocol change.
Again, the IRS highlights the point from Glenshaw that under §61, all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion and control, is includable in gross income. However, in this case, there is no accession of wealth when a protocol change doesn’t result in the issuance of a new token. For example, Ethereum (ETH) underwent a protocol change, switching from a Proof of Work (PoW) to a Proof of Stake (PoS) consensus mechanism. After the update, ETH holders still held the same ETH coins (but PoS enabled) they had before the change.
- Sam holds 100 ETH before the update. Sam’s 100 ETH updates automatically to PoS-enabled ETH. He does not receive any new tokens. He still holds the same 100 ETH from before the update. In this situation, Sam will not have any income to report.
Unlike Glenshaw, Sam has no additional wealth or income to report due to this protocol change. He is in the same financial position as he was before the upgrade.
Rev. Rul. 2023-14
In Rev. Rul. 2013-14, the IRS guides us on the tax treatment of staking rewards generated by a PoS blockchain. This Rev. Rul. states that staking rewards are income when the taxpayer has dominion and control over the rewards. Again, the IRS references the Glenshaw case to point out that under §61, all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion and control, are included in gross income.
This ruling is significant because this is not the conclusion certain stakeholders in the industry were hoping for. The industry sought clarity on staking rewards since a Tennessee couple (Joshua and Jessica Jarrett) amended their 2019 tax return in 2021 to remove staking rewards they originally reported as income at the time of receipt. They argued that staking rewards should not be taxable upon receipt because they are newly created property. Newly created property is taxed only at the time of sale under the current tax code. For example, a painter doesn’t pay tax when they paint a new painting; tax is due when he sells the artwork for money. The court dismissed this case due to mootness. Basically, the court said there was no point in discussing the issue because the couple received their requested refund.
Even though the IRS issued the couple’s requested refund, the guidance and lessons learned from Glenshaw are that staking rewards are income when you have dominion and control over them.
How does Glenshaw impact my taxes?
Glenshaw and the IRS guidance that refers to the case share a common theme ᠆᠆ any new cryptocurrency that a taxpayer has dominion and control over is income based on the FMV at the time of receipt. A specific exemption is required to exclude a particular type of transaction from gross income.
As a result, staking rewards from a PoS blockchain network need an exemption under §61 to be excludable from income.
Unless Congress changes the Internal Revenue Code (IRC), the conservative approach is to treat any cryptocurrency receipt that increases your wealth as ordinary income once you have dominion and control over it.
What happened in Cottage
Cottage was a savings and loan association that engaged in a complex transaction that involved the simultaneous sale of participation interests in 252 mortgages and the purchase of participation interests in 305 other mortgages, all secured by single-family homes. The FMV of the received interests was approximately $4.5 million, while the face value of Cottage's interests was $6.9 million, which resulted in a $2.4 million loss. Cottage Savings sought a tax deduction on its 1980 federal income tax return for the difference between the face value of the interests it traded and the fair market value of the interests it received, which was initially allowed by the Tax Court but later disallowed by the Court of Appeals. The Supreme Court eventually deemed that the underlying interests in the loans were materially different enough because they consisted of different debtors and were secured by other homes. Cottage was allowed to report the loss on their tax return.
The court relied on §1001(a) and Reg §1.1001-1(a) to make their judgment. These sections define the computation of the gain or loss from the sale or other disposition of property. For a disposition event to occur, the following criteria must be met (Reg §1.1001-1)
- There must be an exchange (Exchange requirement) and
- The property received must differ materially from the property given up (Material difference requirement)
Cottage references in IRS digital asset tax guidance
IRS CCA 202316008
We already discussed CCA 202316008 above and determined that a protocol change isn’t gross income, but do you realize a capital gain or loss under §1001 due to the protocol upgrade?
The IRS states in CCA 202316008 that an exchange of property is a realization event under §1001 only if the exchange results in the receipt of property materially different from the property transferred. They go on to say that to be “different” in the sense of being “material” for purposes of §1001, they must embody legally distinct entitlements and see Cottage Savings Assn vs. Commissioner. Unfortunately, the IRS stops short of saying what is a material different crypto. In the example, the taxpayer does not exchange any crypto assets. The protocol is updated, and the token holders have the same assets as before the update. The taxpayer owns the same units before and after the upgrade, and there is no exchange. This example differs from the Cottage case. In the Cottage case, there was an exchange, and the underlying assets were materially different.
This broad example in the CCA could indicate that the IRS interprets liquidity and wrapped tokens as materially different assets, resulting in a taxable disposition subject to capital gains tax.
How does Cottage impact my taxes?
The Cottage case will be important in determining the taxability of advanced DeFi transactions like staking, working with liquidity pools, wrapping, and lending. Cottage was allowed to take a tax loss when exchanging participation interests in different mortgage loans. The court deemed that the underlying interests in the loans were materially different enough because they consisted of different debtors and were secured by other homes. This fact pattern was enough for a taxable disposition to have occurred. The IRS can argue that exchanging one digital asset for another is taxable because the new digital asset has legally distinct entitlements that differ from the original digital asset.
For example, Chris stakes 1 ETH on Lido and receives 1 stETH. Chris purchased this ETH for $1,000 several years ago. When he trades 1 ETH for 1 stETH, stETH is worth $1,500.
If converting ETH to stETH is a taxable disposition event, Chris must report $500 ($1,500 - $1,000) of capital gains. The cost basis of the stETH will be $1,500.
When he returns the stETH and withdraws his ETH, Chris has another taxable disposition.
For example, Chris returns 1 stETH to Lido and redeems the original 1 ETH he staked. ETH is worth $1,700 when he sends his stETH back to Lido. Chris will have a $200 ($1,700 - $1,500 (cost basis from staking example)) capital gain from unstaking the assets.
Unless Congress changes the IRC, the conservative approach is to treat any sale or exchange of one digital asset for another as a taxable disposition subject to capital gains taxes.
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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.