First published in BanklessDAO’s Decentralized Law, “Legal Entity Solutions for DAOs,” March 3, 2022.

Over the past few years, there have been increasing calls for digital asset entities to go on the offensive to elicit guidance and clarity from U.S. regulatory bodies such as the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and Internal Revenue Service (IRS). Litigation can often be a valuable tool for obtaining clarity, or resisting perceived regulatory overreach by the government. This type of action is usually referred to as a  ‘pre-enforcement challenge’ or ‘preemptive action.’ Generally, a party seeking to pursue a pre-enforcement challenge must demonstrate a ‘credible threat’ of enforcement. In other words, someone seeking pre-enforcement relief must show that: (i) they engage or plan to engage in conduct that arguably falls within the scope of a given law; and (ii) it is likely that the government will enforce that law against them. Once these prerequisites are established, the party can seek declaratory — or other — relief clarifying the law or regulation. However, in many cases, statutes and regulations procedurally limit potential challenges in a manner that can ultimately reduce precedential efficacy. For instance, challenges to certain SEC orders and rules need to follow specific procedures, and challenges to U.S. tax laws in certain venues do not allow for the issuance of declaratory relief.

Issues relating to Coinbase’s ‘Lend’ product and Terra’s suit against the SEC in response to subpoenas are two examples of calls for, or the actual filing of, affirmative pre-enforcement actions. A current and ongoing example of preemptive litigation designed to elicit regulatory clarity is the suit brought by Josh and Jessica Jarrett against the IRS. The suit — seemingly backed by the Proof of Stake Alliance — attempts to establish precedent regarding interpretation of the Internal Revenue Code as it relates to taxation of proof-of-stake (PoS) rewards. The Jarretts’ suit highlights some of the issues presented when attempting to utilize preemptive litigation as a mechanism to clarify regulatory uncertainty.

In 2019, the Jarrets requested a refund of amounts paid to the IRS on Tezos staking rewards issued in the native token. There is currently no direct guidance from the IRS on how PoS rewards are taxed. Existing guidance has addressed instances where a taxpayer receives tokens as part of a hard fork and from proof-of-work mining. In those instances, the IRS has determined that because cryptocurrency is ‘property’ for tax purposes, the tokens received are ordinary income at the time the taxpayer can dispose of them, i.e. at the time they are created and issued as block rewards. By contrast, the Jarretts have asserted that this type of PoS staking reward is not taxable until it is sold, exchanged, or otherwise disposed of by the taxpayer. In May 2021, when the IRS did not respond to their request in a timely manner, the Jarretts filed suit in the U.S. District Court for the Middle District of Tennessee. On February 3, 2022, the U.S. Department of Justice (DOJ) Tax Division informed the Jarretts and the court that a full refund had been approved and that it had directed the IRS to issue the refund. However, the Jarretts rejected the IRS’s offer because the IRS would not provide assurance that staking rewards constitute taxable income at the time of disposition. Instead, the Jarretts continue pursuing the suit in an effort to receive a definitive ruling they believe will be binding on the IRS.

The IRS’s offer to the Jarretts prompted widespread — and presumptively premature — claims that the IRS has capitulated on its position regarding staking rewards. Unfortunately, the fact that the IRS issued a refund to the Jarretts does not provide any inference of guidance that taxpayers can or should rely upon. Notwithstanding the Jarretts’ rejection of the IRS’ offer, the tax refund was purportedly delivered on February 14, 2022. On February 28, the DOJ filed a motion to dismiss the Jarretts’ attempt to obtain an official ruling from the court.

An important procedural issue raised by the the DOJ, and overlooked by the myriad of internet posts claiming victory for the Jarretts, is whether directing a refund renders the Jarretts’ case moot as there is no longer a live controversy for the court to settle. The DOJ also stressed the second, arguably determinative, point that prospective or declaratory relief is unavailable in a refund lawsuit in the district court. The lack of resolution of the Jarretts’ claims regarding the treatment of staking rewards is not likely to be a strong argument against mootness. The Jarretts have filed a timely opposition to the DOJ’s motion. It is also worth noting that Coin Center filed an amicus brief echoing the Jarretts’ arguments and reiterating the importance of and need for clarification. However, it is unlikely that the court will ultimately issue a ruling on the motion that is favorable to the Jarretts.

Notwithstanding any ultimate outcome, the best-case precedential value of the Jarretts’ lawsuit is likely to be nominal. For anyone not familiar with the inner workings of the IRS’s tax administration regime, there are multiple levels of formal and informal guidance affecting taxpayers as individuals or as a whole. Beyond that guidance, lawsuits to clarify ambiguities in the law can be heard in three primary trial court forums, the U.S. Tax Court, U.S. District Courts, or the U.S. Claims Court. The taxpayer has the right to choose the forum, subject to venue considerations. However, these three courts have different jurisdictional scope, procedural guidelines, and issue rulings with varying levels of precedential value. Ultimately, even if the court issues the type of order the Jarretts are seeking, the decision is not binding beyond that district. As noted on the table below, the Jarretts’ case would have to be appealed through multiple levels of appellate courts before it would have widespread precedential value.

Currently, PoS blockchains represent over half of the 1.68 trillion USD cryptocurrency market capitalization, and five of the top ten PoS blockchains have a stake rate greater than 50%. This is not including the valuation of Ethereum’s future transition to PoS. How the United States government treats PoS rewards is incredibly relevant to U.S. citizens and domiciled digital asset entities and requires clarity. While the offer of a refund to the Jarretts was lauded as an important and exciting moment for the crypto community, most commentators incorrectly attributed the IRS’s response as setting precedent. Unfortunately, because the IRS may have rendered the lawsuit moot by issuing a refund and because the venue precludes declaratory relief, even in the best case scenario for the Jarretts it is unlikely their lawsuit will generate regulatory clarity or have an impact on future IRS policy and guidance.

Individuals and digital asset entities subject to U.S. laws are subject to regulatory uncertainty that often limits involvement and innovation in the cryptocurrency space. Preemptive actions are an important and often necessary mechanism to resolve that uncertainty. However, parties considering litigation as a mechanism to elicit clarity should understand that litigating effectively against the U.S. government involves a variety of legal issues and procedural hurdles that are not generally present in litigation between private parties, and should plan accordingly if they intend to establish meaningful precedent.

lawpanda is a U.S. attorney with an active litigation and counseling practice. He is a member of BanklessDAO’s Legal Guild, LexDAO, the LexPunkArmy, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Connect on Twitter, LinkedIn, or at lawpanda.eth@gmail.com.