As the use of virtual currency evolves, so does the explanation of how it’s taxed. Last month, the Internal Revenue Service (IRS) released new guidance for taxpayers who engage in transactions involving virtual currency – including cryptocurrency. The new guidance was released to answer questions many taxpayers and professionals have about the treatment of the hard fork of a cryptocurrency. A hard fork occurs when cryptocurrency on a distributed ledger undergoes a shift. The best-known hard fork of cryptocurrency was the fork created by Bitcoin Cash in 2017.
Previously, in Notice 2014-21, the IRS defined cryptocurrencies as assets rather than currencies, defining tax treatments for sales and exchanges of such assets (normally generating capital gains and losses), as well as for mining the coin (generally giving rise to ordinary income).
In effect, some advisors and taxpayers believed that taxpayers receiving Bitcoin Cash had income as they had an accession to wealth by receiving new currency; however, this treatment proposed a new issue. When Bitcoin Cash emerged in 2017, major exchanges, such as Coinbase and Itbit, boycotted the currency, which prevented some individuals with Bitcoin on deposit with certain exchanges to access the related Bitcoin Cash. The IRS has attempted to give some guidance as to whether the taxpayer has a true accession to wealth when a fork takes place by issuing Revenue Ruling 2019-14.
A hard fork occurs when a cryptocurrency on a distributed ledger undergoes a shift resulting in a permanent diversion from the legacy or existing distributed ledger. A hard fork may result in the creation of a new cryptocurrency – meaning that two block and two currencies could occur. Following a hard fork, transactions involving the new cryptocurrency are recorded on the new distributed ledger, and transactions involving the former cryptocurrency continue to be recorded in the prior distributed ledger.
An airdrop is a method of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers. If a hard fork is followed by an airdrop, units of the new cryptocurrency are distributed to addresses containing the legacy cryptocurrency and are generally received on the date and at the time it is recorded on the ledger. A taxpayer only has receipt of the cryptocurrency when he or she is able to exercise dominion and control over the cryptocurrency.
Moreover, because a hard fork is not always followed by an airdrop, a taxpayer may constructively receive cryptocurrency before the airdrop is recorded on the distributed ledger. Thus, if the taxpayer later acquires the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency, the taxpayer is treated as receiving the cryptocurrency at that time.
As such, the ruling provides the following guidance:
- A taxpayer does not have gross income under IRS §61 as a result of a hard fork of a cryptocurrency the taxpayer owns, if the taxpayer does not receive new units of cryptocurrency; and
- A taxpayer has gross income, ordinary in character, under §61 as a result of an airdrop of a new cryptocurrency following a hard fork if the taxpayer receives units of new cryptocurrency.
The ruling provides two different examples to illustrate the holdings:
Example 1
A holds 50 units of Crypto M, a cryptocurrency. On Date 1, the distributed ledger for Crypto M experiences a hard fork, resulting in the creation of Crypto N. Crypto N is not airdropped or otherwise transferred to an account owned or controlled by A.
A did not receive units of the new cryptocurrency, Crypto N, from the hard fork; therefore, A does not have an accession to wealth and does not have gross income under § 61 as a result of the hard fork
Example 2
B holds 50 units of Crypto R, a cryptocurrency. On Date 2, the distributed ledger for Crypto R experiences a hard fork, resulting in the creation of Crypto S. On that date, 25 units of Crypto S are airdropped to B’s distributed ledger address and B has the ability to dispose of Crypto S immediately following the airdrop. B now holds 50 units of Crypto R and 25 units of Crypto S. The airdrop of Crypto S is recorded on the distributed ledger on Date 2 at Time 1 and, at that date and time, the fair market value of B’s 25 units of Crypto S is $50. B receives the Crypto S solely because B owns Crypto R at the time of the hard fork. After the airdrop, transactions involving Crypto S are recorded on the new distributed ledger and transactions involving Crypto R continue to be recorded on the legacy distributed ledger.
B received a new asset, Crypto S, in the airdrop following the hard fork; therefore, B has an accession to wealth and has ordinary income in the taxable year in which the Crypto S is received. See §§ 61 and 451. B has dominion and control of Crypto S at the time of the airdrop, when it is recorded on the distributed ledger, because B immediately has the ability to dispose of Crypto S. The amount included in gross income is $50, the fair market value of B’s 25 units of Crypto S when the airdrop is recorded on the distributed ledger. B’s basis in Crypto S is $50, the amount of income recognized. See §§ 61, 1011, and 1.61-2(d)(2)(i).
In contrast, the ruling holds that when a soft fork occurs, the soft fork will not trigger taxable income. A soft fork occurs when a distributed ledger undergoes a shift that does not result in the creation of new currency.
Additionally, the IRS has already stated that virtual currency is to be treated as a capital asset if it can be converted into cash. This means that capital gains rules apply to any gains or losses on the sale or transfer of virtual currency. As such, it is imperative for taxpayers to maintain excellent records to establish positions taken on tax returns. Moreover, the IRS is targeting non-compliance through a variety of efforts. In July of this year, the IRS began mailing letters to taxpayers who may have failed to report or misreported transactions involving cryptocurrency. Those taxpayers may be liable for tax, penalties, and interest.
The new guidance can be found at Revenue Ruling 2019-24 (downloads as a PDF) and the frequently asked questions (FAQs) on the IRS website.
If you are unsure whether your Cryptocurrency transaction are taxable, contact Onyx Tax today for a consultation and stay ahead of the game.