The Internal Revenue Service issued a revenue ruling and a set of FAQs that are intended to supplement earlier guidance issued by the IRS in a 2014 notice regarding how to treat transactions in virtual currencies under federal tax laws and regulations. The additional guidance had been widely anticipated because of recent calls by lawmakers for more clarity on the taxation of virtual currencies and because of changes in the virtual currency market place, specifically the rapid growth (and periodic crashes) of some of the most popular virtual currencies, since the IRS last addressed the topic five years ago in Notice 2014-21 (Revenue Ruling 2019-24, October 9, 2019).
IRS Commissioner Charles Rettig said in a press release that the IRS is “committed” to educating the public on tax obligations related to virtual currencies. “The new guidance will help taxpayers and tax professionals better understand how longstanding tax principles apply in this rapidly changing environment,” said Rettig. “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.”
Hard forks and Revenue Ruling 2019-24. On a virtual currency blockchain, a hard fork occurs when a protocol change in the blockchain produces a new virtual currency in addition to the original virtual currency. Examples would be the hard forks that resulted in Bitcoin and Bitcoin Cash and Ethereum and Ethereum Classic. The reasons for a hard fork can vary, but they include the more innocuous such as a group of users who want to create a rival virtual currency with different characteristics as well as the potentially less innocuous such as a 51-percent attack waged by those with a controlling share of the original virtual currency. In any event, a hard fork of a virtual currency can implicate tax laws and the application of those laws can become ever more complicated depending on how the hard fork was executed.
Revenue Ruling 2019-24 seeks to address some of the tax issues that can result from a hard fork. The Revenue Ruling defines “hard fork” to mean “a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger.” Transactions in the new virtual currency would be recorded on that virtual currency’s distributed ledger and transactions in the legacy virtual currency would be recorded on the legacy distributed ledger.
The Revenue Ruling posits two examples of hard forks, both of which contemplate the creation of new virtual currencies, but only one of which results in an “airdrop” of the new virtual currency. The Revenue Ruling defines “airdrop” as the distribution of a virtual currency to multiple taxpayers’ distributed ledger addresses (note that not all forks result in air drops). The tax treatment of the two hypothetical hard forks varies significantly based on the presence or absence of an airdrop and the taxpayer’s ability to dispose of the new virtual currency. The two examples also address only ordinary income under Internal Revenue Code Section 61, which contemplates income from whatever source derived, unless such income is adjusted under another Code provision. The following examples have been abstracted from the Revenue Ruling:
- Example 1—Taxpayer holds units of the virtual currency Crypto M. A hard fork results in the creation of new virtual currency Crypto N. The new virtual currency is neither airdropped to the taxpayer nor is it transferred to an account owned or controlled by the taxpayer. The taxpayer never received the new virtual currency and, thus, had no accession to wealth. The taxpayer has no gross income from the hard fork.
- Example 2—Taxpayer holds units of the virtual currency Crypto R. A hard fork results in the creation of new virtual currency Crypto S. The hard fork results in an airdrop of 25 units of Crypto S to the taxpayer’s distributed ledger address and the taxpayer is able to immediately dispose of Crypto S. The Crypto S airdrop is recorded on the applicable distributed ledger and, as of that time, the taxpayer’s Crypto S has a fair market value of $50. The taxpayer received an accession to wealth in the form of units of Crypto S, which constitutes $50 in gross (ordinary) income in the taxable year in which the Crypto S was received. The taxpayer’s basis in Crypto S is also $50.
- A taxpayer does not have gross income under Section 61 as a result of a hard fork of a cryptocurrency the taxpayer owns if the taxpayer does not receive units of a new cryptocurrency.
- A taxpayer has gross income, ordinary in character, under Section 61 as a result of an airdrop of a new cryptocurrency following a hard fork if the taxpayer receives units of new cryptocurrency.
Revised FAQs. The IRS also published an expanded set of FAQs that more than doubles the number of FAQs published with the 2014 Notice from 16 to 43. The new FAQs re-affirm that, for purposes of federal tax law, virtual currencies are treated as property and virtual currency transactions are subject to general principles of taxation. However, the IRS noted that the new FAQs generally are limited to the treatment of virtual currencies as capital assets.
Still, some of the new FAQs address previously un-addressed issues. For example, Question 29 addresses soft forks (as opposed to the hard forks discussed in Revenue Ruling 2019-24), something that occurs normally in the building of a blockchain or distributed ledger and which the IRS states does not result in a diversion of the ledger or the creation of a new virtual currency. As a result, a taxpayer would not have any income from a soft fork.
Question 35 states that a transfer from one digital wallet or other account belonging to a taxpayer to another digital wallet or account that also belongs to that same taxpayer would not be a taxable event. Questions 36-38 state that a taxpayer may identify specific units of a virtual currency to be disposed of but the taxpayer must document her basis in those units (e.g., detailed information about the virtual currency associated with a unique digital identifier such a private or public key); absent proper documentation, units of a virtual currency to be disposed of are accounted for on a first in, first out (FIFO) basis.
Question 5 states that, for purposes of determining whether a taxpayer has a long- or short-term capital gain, the holding period begins the day after acquisition of the virtual currency and ends when the virtual currency is disposed of. If the virtual currency was held for more than one year, the gain/loss is a long-term capital gain/loss, while there would be a short-term capital gain/loss if it was held for one year or less.
Questions 30-32 state that income from a bona fide gift of virtual currency would not be recognized until the virtual currency is disposed of. This group of questions also addresses how to calculate basis in gifted virtual currency and confirms that the holding period for gifted virtual currency includes the donor’s holding period, at least to the extent the recipient can document the donor’s holding period. Questions 33 and 34 address charitable contributions of virtual currency, which generally would not result in recognized income, gain, or loss if donated to a charity described in Code Section 170(c).
Lawmakers seek clarity from IRS. Lawmakers have periodically called for additional IRS guidance during the past several years. A reply by Commissioner Rettig to a letter from Rep. Tom Emmer (D-Minn) earlier this year indicated that the issuance of further guidance on virtual currencies was a priority for the IRS. Specifically, Commissioner Rettig said the IRS intended to publish guidance addressing three topics: (1) acceptable methods for calculating cost basis; (2) acceptable methods of cost basis assignment; and (3) tax treatment of forks. (See, Letter of Rep. Tom Emmer to IRS Commissioner Rettig, April 11, 2019; Letter from Commissioner Rettig to Rep. Tom Emmer, May 16, 2019).
In the 116th Congress, the Safe Harbor for Taxpayers with Forked Assets Act of 2019 (H.R. 3650; the bill was originally introduced in the 115th Congress as H.R. 6973), sponsored by Rep. Emmer, would provide temporary relief for taxpayers who experience forks in the virtual currency they hold. First, the bill would provide that the IRS could not impose penalties or additions to tax regarding underpayments or understatements attributable to a taxpayer’s attempt to comply with tax laws applicable to the receipt or disposition of virtual currency. The provision would provide relief from Code Sections 6662 to 6664 regarding accuracy-related and fraud penalties.
Second, the bill would provide for no penalties or additions to tax regarding any failure during the applicable period to file a return or report or to make a tax payment that is attributable to the filing or payment requirements for the receipt or disposition of virtual currency. The provision would impact the following Code provisions: (1) Section 6651—failure to file a return or to pay tax; (2) Section 6654—individual’s failure to pay estimated income tax; (3) Section 6655—corporation’s failure to pay estimated income tax; (4) Section 6656—failure to make a deposit of taxes; (5) Section 6698—failure to file a partnership tax return; (6) Section 6699—failure to file an S corporation tax return.
Other proposed tax legislation, such as the Token Taxonomy Act (see, H.R. 2144 and H.R. 7356), sponsored by Rep. Warren Davidson (R-Ohio) and first introduced in the last Congress, would address IRAs, collectibles, like kind exchanges, and the taxation of gains from the sale of virtual currencies. The Token Taxonomy Act also would exempt digital tokens from the definition of “security” under federal securities laws.