The U.S. Internal Revenue Service (IRS) has taken a significant step to provide much-needed clarity for crypto users. On October 9, 2019, the tax authority published an announcement of Revenue Ruling 2019-24, which addresses an array of questions concerning tax compliance related to cryptocurrency airdrops and blockchain hard forks.
The issue of how to tax forked digital currencies has caused quite a stir, even in Capitol Hill. In July 2019, U.S. Congressman Tom Emmer introduced the "Safe Harbor for Taxpayers with Forked Assets" bill, which sought to bring tax clarity to the cryptocurrencies that are generated as the result of hard forks and shield holders from tax penalties pending a guidance review from the IRS. That guidance is now here, but cryptocurrency users might be left with more questions than answers.
"The new guidance will help taxpayers and tax professionals better understand how longstanding tax principles apply in this rapidly changing environment,” IRS Commissioner Chuck Rettig explained in the announcement. “We want to help taxpayers understand the reporting requirements as well as take steps to ensure fair enforcement of the tax laws for those who don't follow the rules.”
Clarity on Forks and Taxable Activities
On the issue of forks, the guidance states that assets created from existing blockchains are to be treated as “an ordinary income equal to the fair market value of the new cryptocurrency when it is received.”
“If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency, whether through an airdrop (a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses) or some other kind of transfer, you don’t have taxable income,” the document reads.
However, a trader would be liable to pay taxes on forked assets if they have control over the assets and can use them. This raises questions over what constitutes “control” or claiming an asset; for example, are forked coins that are credited to a user’s exchange account “claimed” if they don’t have access to the private keys?
For airdrops, the tax liability occurs when the new owner receives the coins and can “transfer, sell, exchange, or otherwise dispose of it.” As cryptocurrency users who operate ERC-20 wallets know, during the ICO boom and beyond, multiple tokens may be airdropped into wallets without users necessarily knowing about it or approving of it, and often without any effort on their part to claim these assets. Under this guidance, it appears as though these assets would be subject to taxation as well.
This directive naturally raises concerns. Rob Odell, vice president of product at cryptocurrency lending service SALT, noted that the new rule puts it under the tax burden of holding these newly created assets as a result of holding the original assets on behalf of clients.
“Hard forks already create numerous challenges for us as a lending company; additional stress on infrastructure, keeping nodes running, administrative work and more,” Odell said in a statement sent to Bitcoin Magazine. “Supporting a new asset with little knowledge into its long term viability and liquidity is problematic.”
For instance, this rule would add confusion around one of the space’s best-known hard forks, which saw the Bitcoin blockchain forked into the Bitcoin Cash blockchain.
“When BCH forked from BTC, we took over a year before deciding to add BCH as collateral,” Odell said. “This ruling muddies the water on how we hold and recognize assets on behalf of borrowers. We hope for further clarity and a deeper understanding from the IRS on how this translates to our business and more importantly, our customers assets.”
The guidance also orders that cost bases should be calculated by taking into account how much money was spent in acquiring the cryptocurrencies, “including fees, commissions and other acquisition costs in U.S. dollars.”
The IRS touches on the cost basis of each cryptocurrency unit spent in a taxable transaction as well, noting that the value of cryptocurrency purchased on an exchange should be calculated based on its selling price (in dollars) on the exchange.
If the purchase is made on a decentralized exchange or a peer-to-peer platform, the guidance recommends the use of a cryptocurrency price index. Per the document, this could be “a cryptocurrency or blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates the value of the cryptocurrency at an exact date and time.”
A Valiant, Incomplete Effort
The new cryptocurrency tax guidance serves as a follow-up to Notice 2014-21, which sets "general principles of tax law to determine that virtual currency is property for federal tax purposes." While the previous notice did leave plenty of questions unanswered, many had high hopes that this latest one was going to help clear things up. However, this document also left some loose ends untied.
The IRS finds it hard to differentiate between airdrops and hard forks, which is a bit awkward considering its desire to regulate the industry. The guidance seems to suggest that there are hard forks which include airdrops, while in truth both are independent and mutually exclusive.
Bitcoin engineer and professional cypherpunk Jameson Lopp is among those who believe the new guidance created more questions than it answered. Questioning the IRS's new rule to tax holders who receive forked coins and airdrops even if they didn't request them, Lopp asked the IRS about possible scenarios where holders "have keys but no software from which to spend the asset," keep an asset and then see it drop 90 percent in value or have an asset that wasn't trading pre-fork.
The idea that a taxable event can be created once a hard fork occurs for every holder of the coins on the old blockchain is disturbing. Once the asset is in your possession — with or without your knowledge — you'll owe income tax.