IRS issues guidance on hard forks and airdrops

This month, the Internal Revenue Service issued its first guidance on the taxation of cryptocurrency in five years. Revenue Ruling 2019-24 addresses the taxation of “hard forks.” The IRS also issued a set of FAQs that address virtual currency transactions for those who hold virtual currency as a capital asset.

If you held bitcoin through a wallet (like Coinbase) in 2017, you would have logged into your account one day to find a new coin named bitcoin cash sitting in your account. Eventually, you would have been able to spend or convert the bitcoin cash to U.S. dollars. You would have been the beneficiary of a hard fork, and you may have wondered if you had taxable income as a result of the fork and, if so, when.

Technically, hard forks are software changes that split a network into two — the network running the original software and the network running the new software. The coin that trades on the network with the new software is considered a hard fork of the coin from the original network. Thus, when bitcoin forked, owners of bitcoin could double spend their coins, once on the old chain as bitcoin and again on the new chain as bitcoin cash. Similarly, ethereum is the result of a 2016 hard fork of ethereum classic following a hacked funding mechanism.

An airdrop is a distribution of a token or coin to numerous holders’ wallets and results in a holder receiving new coins with no action on the holder’s part. Airdrops are used to increase the size of a network, resulting in a larger user-base and a wider distribution of tokens or coins.

The tax treatment of a fork prior to the new ruling was not clear under general principles of tax law. In the oft-cited case of Commissioner v. Glenshaw Glass (1955), the U.S. Supreme Court construed the term “gross income” as “instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” A forked coin sounds a lot like income under that definition; however, other cases have drawn distinctions. For example, the Supreme Court earlier held that stock dividends are not gross income as they do not represent an accession to wealth. Similarly, a stock split does not increase a shareholder’s wealth. A fork may seem like a stock split, but the economic oddity is that the value of the coin does not halve when it forks, like the price of stock would (theoretically) in a 2-for-1 split.

Other nontaxable analogies in the tax law include accessions to wealth such as calves from cows and fruit from fruit trees. Taxable analogies include prizes and awards. None of the authorities perfectly fit the description of a hard fork, creating uncertainty but also arguably giving taxpayers a basis for treating hard forks as nontaxable events.

Due to that uncertainty, the American Bar Association Tax Section commented and asked the IRS to issue guidance in 2018. In the ”be careful what you ask for” category, the ABA suggested that the IRS adopt a rule that a hard fork would generate a tax event but that the tax on that event would be zero. Correspondingly, the taxpayer’s basis in the forked coin would also be zero. Thus, the tax event would effectively be delayed until the taxpayer sold or converted the new coins.

The IRS accepted the ABA’s suggestion that hard forks generate a tax event but came to a different conclusion on the timing and amount. Under the new ruling, a hard fork will be a taxable event if a taxpayer receives units of a new cryptocurrency, but the amount of tax will not be zero. Instead, the taxpayer will have income equal to the fair market value of the coins created in the hard fork, which is recognized when the taxpayer has “dominion and control over the cryptocurrency so that [he/she] can transfer, sell, exchange, or otherwise dispose of the cryptocurrency.” Thus, a fork in a blockchain may result in tax obligations for every holder of coins on the chain. Similarly, an airdrop of new tokens or coins will result in income to the recipients when received.

The IRS also issued a set of FAQs on the same day addressing other issues relating to cryptocurrencies. The FAQs provide that a taxpayer’s basis in crypto will be the amount spent to acquire the cryptocurrency, the quoted price on the exchange, or the fair market value as reported on an index, depending on how the crypto was acquired. Taxpayers are expressly permitted to use specific identification or first-in-first-out (FIFO) accounting to calculate gains or losses. These rules are generally viewed as taxpayer favorable as prior to the FAQ it was not clear that taxpayers could use FIFO. 