The IRS has released new guidance on the U.S. tax treatment of cryptocurrency for the first time since 2014. The guidance includes Revenue Ruling 2019-24, which provides guidance on the tax treatment of hard forks. The IRS also released a series of FAQs covering a variety of topics that expand on Notice 2014-21.
Revenue Ruling 2019-24
Revenue Ruling 2019-24 generally concludes on two scenarios involving hard forks. A hard fork occurs when a blockchain undergoes a protocol change resulting in a permanent diversion from the legacy or existing blockchain, which may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. In the first scenario, the cryptocurrency blockchain experiences a hard fork but the taxpayer does not receive units of a new cryptocurrency, and in the second scenario, the taxpayer receives units of new cryptocurrency “as a result of an airdrop of a new cryptocurrency following the hard fork.” The Revenue Ruling concludes that the taxpayer does not have income in the first scenario. However, in the second scenario, the taxpayer has ordinary income because he has experienced an accession to wealth. The income arises at the time of the airdrop because the taxpayer is, at that time, able to exercise dominion and control over the forked cryptocurrency.
The Revenue Ruling’s analysis on this point appears to be based on some misconceptions about how units of a new cryptocurrency are accessed by holders of a pre-fork cryptocurrency, and confusion about the relationship between forks and airdrops. An airdrop is distinct from a hard fork – it is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers. Because of this apparent confusion, the Revenue Ruling does raise some practical issues:
- What is meant by the receipt of an airdrop of new currency following the fork? For example, does it apply when a custodial wallet provider permits access to the forked cryptocurrency? If the wallet provider does not permit access to the forked cryptocurrency right away (or at all), does the wallet provider have income?
- What if the taxpayer directly holds a private key associated with a wallet address on a blockchain that undergoes a hard fork?
- The value of the forked cryptocurrency may be initially high but quickly plummet in value if it does not gain wide acceptance. The effect of the Revenue Ruling appears to be that the taxpayer will recognize ordinary income with no cash to pay the tax, and then recognize a capital loss on the original cryptocurrency (to the extent the value has shifted to the forked cryptocurrency).
- In addition, it is not clear whether the guidance applies to airdrops of alt-coins to wallets to attract attention and a wider distribution for such alt-coins. Often such coins are airdropped to wallets whose owners have done nothing to receive them and, in fact, may not even be aware of the airdrop or want the airdropped coin.
Nevertheless, the guidance might be read as saying that a taxpayer will recognize income whenever the taxpayer gains dominion and control over the new cryptocurrency following a hard fork (i.e., the ability to dispose of the new cryptocurrency). Although the guidance does not technically apply to an airdrop without a fork (as neither of the fact scenarios involves such an airdrop), the reasoning would likely make that taxable as well.
FAQs for Investors
The IRS also released a series of FAQs that expand on Notice 2014-21. The FAQs apply only to investors holding cryptocurrency as a capital asset. Some of the significant points include:
- Cryptocurrencies are generally valued as of the date and time the transaction is recorded on the distributed ledger (for on-chain transactions) or would have been recorded on the distributed ledger (for off-chain transactions). For transactions occurring on a cryptocurrency exchange, the value is the amount recorded by the exchange. For peer-to-peer transactions, the IRS will accept the value as determined by a blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates the value of the cryptocurrency at an exact date and time. This valuation method seems to require the combination of two different services – that of a blockchain explorer that tracks transactions, and that of an index that calculates value.
- Taxpayers may specifically identify which units of cryptocurrency are deemed to be sold by documenting the unique digital identifier, such as the private key, public key, and wallet address, or by showing the transaction information for all units of a specific virtual currency held in a specific wallet. If the taxpayer does not specifically identify the unit sold, the units are deemed to be sold on a first-in-first-out (FIFO) basis. The provision of a cost basis assumption is welcome guidance, but the FAQ does not permit other assumptions, such as last-in-first-out (LIFO) or average cost basis. In addition, because specific identification is tied to a wallet and not a transaction identifier, if taxpayers want to use specific identification, they should hold cryptocurrency acquired at different times in different wallets.
- If a taxpayer donates cryptocurrency to a charity, he or she will not recognize income from the donation and generally will be able to deduct the fair market value of the cryptocurrency if it is held for more than one year.
- Taxpayers must retain records regarding their cryptocurrency transactions that document receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the cryptocurrency.
In the press release that accompanied the guidance, the IRS warned that “[t]axpayers who did not report transactions involving virtual currency or who reported them incorrectly may, when appropriate, be liable for tax, penalties and interest. In some cases, taxpayers could be subject to criminal prosecution.” Because revenue rulings reflect the IRS’s position on how current law applies to a particular set of facts, they apply retroactively. Taxpayers who did not report income from prior hard forks should consider whether to file amended returns if the tax year is still open. This is true, even though many practitioners believed that there were reasonable analogies that would result in hard forks not giving rise to current income (e.g., stock splits, purchasing pregnant livestock, sale of extracted minerals or timber cut from land, division of trust, or sale of portion of larger property).