On October 9, 2019, the IRS released Revenue Ruling 2019-24, which provides guidance with respect to hard forks and airdrops of cryptocurrency, and new frequently asked questions (FAQs), which provide guidance on other cryptocurrency issues. Rev. Rul. 2019-24 and the new FAQs represent the most significant cryptocurrency guidance the IRS has published since the limited guidance provided five years ago in Notice 2014-21, which sets forth the IRS position that virtual currency should be treated as property rather than currency for U.S. federal income tax purposes.
Taxpayers involved in investing in, trading, or creating cryptocurrency assets should find the new guidance a worthwhile read. While this guidance is helpful, the FAQs are focused on reiterating the application of basic income tax principles to cryptocurrency transactions. More complicated technical questions are largely left unaddressed. As a result, taxpayers will have to continue to seek advice from their own counsel.
The revenue ruling addresses: (1) whether a hard fork of a cryptocurrency creates taxable income under § 61 if the taxpayer does not receive the new cryptocurrency, and (2) whether a hard fork with an airdrop creates taxable income when the taxpayer receives the new cryptocurrency. In short, the IRS’s answer is “no” to (1) and “yes” to (2).
The IRS defines a hard fork as occurring “when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger.” A hard fork may result in the creation of a new cryptocurrency in addition to the old cryptocurrency. In addition, the IRS defines an airdrop as “a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.” A hard fork is not always followed by an air drop.
In its analysis, the IRS focuses on whether the taxpayer has “dominion and control” over the new cryptocurrency after a hard fork. As a result, the revenue ruling holds that:
The determination of what is considered “dominion and control” and receipt is critical. The revenue ruling provides in the background section that “[a] taxpayer does not have receipt of cryptocurrency when the airdrop is recorded on the distributed ledger if the taxpayer is not able to exercise dominion and control over the cryptocurrency.” The IRS provides that inability to exercise dominion and control over the cryptocurrency can occur when the cryptocurrency is in a wallet managed through an exchange that does not support the newly-created cryptocurrency so it is not credited to the taxpayer’s account. The revenue ruling also provides in the background section that a taxpayer may constructively receive cryptocurrency prior to the airdrop being recorded on the distributed ledger, with receipt occurring when the taxpayer is able to transfer, sell, exchange or otherwise dispose of the cryptocurrency. The revenue ruling does not elaborate or provide any additional examples of dominion and control and constructive receipt.
The new FAQs provide answers that are consistent with Notice 2014-21 and Rev. Rul. 2019-24 and address some technical issues, such as how to determine the value of cryptocurrency, how to calculate gain or loss in cryptocurrency transactions and whether a soft fork is a taxable event. Overall, the new FAQs seem designed to reiterate and reinforce the application of basic income tax principles to cryptocurrency to ensure compliance.
The IRS defines virtual currency as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. Convertible virtual currency is virtual currency that is convertible into “real” currency or is used as a substitute for real currency. The FAQs that the IRS published on October 9 apply to various types of convertible virtual currency that are used as a medium of exchange. The FAQs do not address the treatment of contracts for the future receipt of virtual currency.
If a taxpayer acquires the same kind of cryptocurrency at different prices and then sells or exchanges some of that cryptocurrency, the taxpayer should be careful to identify which units were sold or exchanged. The FAQ says that absent specific identification, the taxpayer will be deemed to sell the first units acquired (i.e. a first in, first out, or FIFO method).
However, the FAQ also provides guidance on how to specifically identify the cryptocurrency sold that will be respected by the IRS. A taxpayer can identify a specific unit of virtual currency by documenting its unique digital identifier, such as a private key, public key and address, or by records showing the transaction information for all units of the virtual currency held in a single account, wallet or address. That information must show the date and time each unit was acquired, the taxpayer’s basis and the fair market value of that unit at the time each unit was acquired, the date and time each unit was sold, the fair market value of each unit when sold and the amount of money or the value of property received for each unit.
The fair market value of cryptocurrency is an important issue, particularly given the volatility of certain cryptocurrency assets. The FAQ states that cryptocurrency received in a transaction facilitated by a cryptocurrency exchange is the amount that is recorded by the cryptocurrency exchange for that transaction in U.S. dollars. If a transaction facilitated by a cryptocurrency exchange is not recorded on a distributed ledger, then the fair market value is the amount the cryptocurrency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it had been an on-chain transaction, i.e., a transaction recorded on a distributed ledger.
If a taxpayer receives cryptocurrency in a transaction not facilitated by a cryptocurrency exchange, such as via a peer-to-peer transaction, then the FAQ states that the IRS will accept as evidence the value as determined by 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. The FAQ is not prescriptive as to which index or data source should be used. In addition, in lieu of an “explorer value,” the FAQ permits the taxpayer to establish the value of the asset under general valuation principles. In the case of cryptocurrency that is not traded on any exchange and does not have a published value, the fair market value of the cryptocurrency is the fair market value of the property or services exchanged for the cryptocurrency.
Pursuant to Notice 2014-21, convertible virtual currency is treated as property for U.S. federal income tax purposes, rather than as currency, so the rules that apply to transactions involving property also apply to transactions involving cryptocurrency. At numerous points, the FAQ cites IRS publications setting out the general principles for property transactions as providing the relevant authority on point. As under Notice 2014-21, the FAQs reiterate that the taxpayer will recognize gain or loss when the taxpayer sells convertible virtual currency for real currency, uses convertible virtual currency to pay someone for performing services; or exchanges convertible virtual currency for other property.
If a taxpayer receives convertible virtual currency as payment for the performance of services, either as an independent contractor or as an employee, then the taxpayer will recognize income equal to the fair market value of the convertible virtual currency in U.S. dollars at the time it is received. The FAQ notes that receipt of virtual currency is taxable income that must be reported by the employee or contractor, regardless of whether the transferor issues a W-2 or Form 1099 to report the payment.
The rules that apply to gifts of property and donations of property to charity apply to gifts of convertible virtual currency and donations of convertible virtual currency. Thus, for example, if a taxpayer makes a tax-deductible donation of appreciated cryptocurrency to a charity, the taxpayer does not recognize the built-in gain in that cryptocurrency.
According to the FAQ, a so-called “soft fork” occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger. Holders of cryptocurrency that undergoes a soft fork are treated as holding the same cryptocurrency after the soft fork as before. Therefore, the soft fork does not result in the realization of income.
Similarly, if a taxpayer moves cryptocurrency from one wallet, address or account belonging to the taxpayer to another wallet, address or account belonging to the taxpayer, the taxpayer will continue to hold the same cryptocurrency that was held before, so there is no taxable event, even if the taxpayer receives an information return from an exchange or platform as a result of the transfer.