Taxing Cryptocurrency: New Rules Affecting New Currencies

Earlier this month, the IRS released Revenue Ruling 2019-24, which creates new rules regarding the treatment of hard forks for digital currency. In this post, we will discuss what these new rules might mean for you.

Additionally, the IRS has recently announced that the 2019 Form 1040 will include a question about whether a taxpayer has engaged in any digital currency transaction for the year. This signals an increased interest in the IRS in enforcing taxation of digital currency transactions that some taxpayers may have never previously realized were taxable. For this reason, we will also take a look back at Revenue Ruling 2014-21, which included a Question and Answer format laying out the implications of the IRS’ position that digital currencies are taxed as capital assets.

Digital Currencies Are Capital Assets

The bulk of Revenue Ruling 2014-21 reinforces the notion that digital currencies are taxed in the same manner as other types of capital assets. Basis must be tracked to determine taxable gain, holding period must be tracked to determine the applicable tax rate, etc. The ruling also goes into the effect of gifting or donating digital currencies, which are equivalent to the effect of gifting and donating capital assets like stocks.

The Revenue Ruling recognizes, however, that while digital currencies are taxed like other capital assets, they are often used in a very different manner. Rather than merely being bought, held, and sold as an investment, they are often used to directly purchase goods, or as payment for services. The Revenue Ruling therefore goes to great lengths to make it clear that while their use in this way may resemble cash, such transactions are still treated as capital transactions and may be taxable. For instance, if you receive a digital currency as payment for work, you’re required to report as taxable ordinary income the value of the digital currency when it was received. If you later sell it, the amount you originally reported as income will serve as your basis in the digital currency, and you will recognize a gain or loss. Additionally, if you “spend” the digital currency on a product or service, rather than “selling” it on a digital currency exchange, it is still considered the sale of a capital asset for tax purposes.

For example, let’s say a freelance web developer does some work for a client, and that client pays them with 1 Bitcoin; on the day the developer receives the Bitcoin, it is worth $8,000. This $8,000 is immediately subject to both income and self-employment tax, even though the developer hasn’t yet converted the Bitcoin to cash. Assume that 3 months later, Bitcoin’s price has increased to $10,000, and the developer spends the entire Bitcoin (without first converting into cash) on new computer equipment. In addition to the income they reported when they originally received the Bitcoin, the developer now has $2,000 of income to realize; this is the difference between their basis of $8,000 (the value of the Bitcoin when they “bought” it by receiving it as taxable income) and their amount received of $10,000 (the value of the Bitcoin when they “sold” it by exchanging it for goods). Because the holding period in this transaction is less than one year, the gain would be taxable as short term capital gain, but would not be subject to self-employment tax.

The questions and answers in the Revenue Ruling make it clear that while digital currencies seem to function as a hybrid of traditional currency and capital asset, they are treated wholly as capital assets for tax purposes. They also make it clear that while taxpayers are typically paid in traditional currency instead of capital assets, being paid in capital assets like digital currency does not exempt a taxpayer from any taxes that would otherwise apply.

Hard Fork Rule

In Revenue Ruling 2019-24, the IRS sets forth the rule that when units of a new digital currency are received during a hard fork of an existing currency, the fair market value of the units received are taxable as ordinary income. In order to understand what this means to you, there are a few terms we’ll need to understand.

Fork – When a new digital currency is created, its creators program a set of initial rules into it. These rules deal with everything from how new units are created, to how transactions are verified, to various security protocols.

From time to time, developers and users of digital currencies find it necessary to update their original rules, either to fix a problem such as a security exploit, or to improve functionality such as transaction time. Because of digital currencies’ decentralized nature, while new rules may be written by the original developer or by the wider digital currency community, they only take effect when a certain percentage of users (typically a majority) update/switch their software to a version that includes these new rules. Such updates are referred to generally as “forks,” and specifically as “soft forks” and “hard forks.”

Soft Fork – To put it simply, soft forks are generally backwards compatible upgrades. That is, users who have upgraded to a software that includes a new rule, for instance one that speeds up transaction times, will still be able to engage in transactions with users who have not. These soft forks are generally uncontroversial and are widely adopted. A large portion of users will likely never even be aware that a soft fork occurred, as their software will simply update in the background and incorporate the new rules without changing the end-user experience.

Soft forks are not taxable events, as a taxpayer holds the same digital currency before and after a soft fork, with the only difference being a re-tweak of its existing rules.

Hard Fork – Occasionally, an update will be required that (often for technical reasons) cannot be made backwards compatible. These may involve fixing a critical security vulnerability, or they may involve diverging objectives and philosophies by members of the digital currency user and developer base. Whatever the reason, these hard forks require consensus to take effect, as users who adopt the new rule and users who do not will be unable to engage in transactions with each other.

In some cases, hard forks are met with little controversy, and the new rules they contain are adopted nearly universally and instantly. For example, if an exploit exists that allows other users to access your digital currency without authorization, or to send fake transactions, most users will upgrade their version to include rules which prevent this. In this case, the new rules become part of the existing digital currency, and anyone not adopting the new rules is essentially locked out until they update. In these cases, much like with soft forks, no new digital currency is created, and per the Revenue Ruling, no taxable event has occurred.

Hard Fork with Airdrop – In other cases, hard forks are controversial, and a consensus can’t be reached. For instance, when Bitcoin Cash split from Bitcoin in 2017, it was done over a difference in objectives rather than a security concern. Specifically, some users wanted to make a technical change (increasing block size) which they thought would reduce transaction fees and encourage Bitcoin to be used as a currency rather than an investment. Other users disagreed with the change, either because they disagreed with its stated objective, or because they had concerns with whether the technical changes would achieve their desired goal.

As it was clear that proponents of the change would not be able to achieve a consensus with its opponents, they could not implement their change as a mere update. This would result in one group updating, with another group refusing to do so, both calling themselves Bitcoin and neither able to engage in transactions with the other. This would create confusion with users, make the currency less useable, and likely undermine the currency’s value.

To get around this problem, proponents of the change created an entirely new currency called “Bitcoin Cash.” Because they viewed this currency as an iteration or upgrade of Bitcoin, however, they did not start out with zero units of currency, but rather issued everyone a unit of Bitcoin Cash for every unit of Bitcoin they owned at the time of the split. This blanket issuance of Bitcoin Cash to everyone who already owned Bitcoin is what the Revenue Ruling refers to as an “airdrop.”

Nevertheless, although initial shares of Bitcoin Cash were based on shares of Bitcoin, and although they share much of the same technical backbone, they are permanently from the moment of Bitcoin Cash’s creation separate digital currencies. That is, if a vendor is set up to take traditional Bitcoin, they cannot be paid in Bitcoin Cash. Additionally, the creation of new units of Bitcoin does not create new units of Bitcoin Cash, and one currency cannot be converted into the other. An airdrop such as that of Bitcoin Cash creates a permanent divergence.

Airdrop Tax Implication – The IRS holds in Revenue Ruling 2019-24 that when a hard fork occurs in which a new currency is created, the receipt of the new currency (the “airdrop”) is a taxable event resulting in ordinary income equal to the value of the new currency. They go on to state that the taxable event occurs at the moment a taxpayer has “control” over the new digital currency, rather than when it is announced or when the taxpayer eventually sells it.

This rule will likely come to a surprise to many taxpayers who owned shares of Bitcoin on August 1, 2017, the day on which Bitcoin Cash forked off Bitcoin. While many people who owned Bitcoin as an investment in an online digital “wallet” such as Coinbase may have noticed that they suddenly had two balances (one for Bitcoin, and one for Bitcoin Cash) that started to diverge in value, they likely did not realize that when this new balance popped up on their user page, a taxable event had actually occurred in the eyes of the IRS.

The IRS does adopt one sensible rule to protect digital currency owners when a new currency is airdropped as a result of a hard fork. Most importantly, while the taxable event typically occurs when units of the new currency are received (that is, recorded on the digital currency’s blockchain ledger), there must also be constructive receipt, also known as control.

While an airdrop essentially credits a new currency to a taxpayer by assigning it to their digital currency wallet (essentially a piece of software that allows a user to access and control the currency ascribed to a particular address), the IRS recognizes that many users do not maintain an actual digital currency wallet. Rather, they have an account with one or more of a number of online services (such as Coinbase) which maintain their own wallets, and credit the user with an ownership stake of a portion of the digital currencies they hold (much like most investors own stock through a broker like Schwab, rather than holding paper certificates in a drawer). The IRS therefore holds in the Revenue Ruling that if a taxpayer owns a digital currency through such a service, they do not have “control” and thus no taxable event has occurred, if and until the service credits them with a share of the new currency and allows them to dispose of it.

Because the airdrop of a new digital currency creates an entirely new trading market, it is likely that a user gains control of the new currency during a period of extreme volatility. If they do not sell their units simultaneously with receiving them (which could be a practical impossibility), it may therefore be difficult to determine their exact fair market value, and thus the amount of ordinary income recognized by the taxpayer and their basis in the new currency. The IRS does not address this, however, and seem to feel that this will not create an undue burden on taxpayers.

If you have tax questions for your business, call our office at 816-561-5000 or send us a message in the form below. We’ll be in touch to schedule a consultation.

*This post was originally published on October 21, 2019