Beyond COVID-19: Crisis response or road to recovery?
Crisis response or road to recovery?
On October 9, 2019, the Internal Revenue Service (IRS) issued much-anticipated guidance on cryptocurrency transactions when it released Revenue Ruling 2019-24. This Revenue Ruling discusses the tax implications of two previously unsettled areas of tax law: “hard forks” and “air drops.” The IRS also updated its FAQs on virtual currency transactions. On October 10, 2019, the IRS released a draft of the updated Form 1040, Schedule 1, Additional Income and Adjustments to Income, which now includes a question about cryptocurrencies.
The IRS has not released significant guidance on virtual currency transactions in over five years. In March 2014, the IRS issued Notice 2014-21 (the Notice), stating that cryptocurrency was to be treated as property, rather than currency for US federal income tax purposes. The IRS also stated that taxpayers must "in computing gross income, include the fair market value of the virtual currency, measured in US dollars, as of the date the virtual currency was received." Following the Notice, anyone spending or exchanging a cryptocurrency was treated as if he or she was selling an asset and was required to report any resulting gain or loss for US federal income tax purposes on their return.
However, the Notice left many unanswered questions. For example, many people raised concerns about the taxability of events resulting from a change to the cryptocurrency itself, without any action on the part of the taxpayer. In the new guidance released by the IRS, the IRS attempts to address two such situations – "hard forks" and "air drops."
A hard fork occurs when a cryptocurrency on a distributed ledger undergoes a protocol change that may result in a permanent diversion from the legacy distributed ledger and in some instances, may create a new cryptocurrency. You can think of a "hard fork" as something similar to receiving a new credit card if your old one was compromised. If your card was stolen by a thief, and you report it, you will receive a new card with a different number. Your bank will deactivate the old one. That's a "hard fork"—you still can use the same brand of credit card, but the old number no longer is valid; only the new one works.
Another analogous example is if you receive new shares of company stock as a result of a merger. If you were a shareholder of ABC Company and ABC merged with XYZ Company to create 123 Corporation, in a pure-share exchange deal, shareholders of both companies would receive shares of 123 in exchange for their old shares. The shares in ABC and XYZ would be worthless as of the effective date of the merger. The "hard fork" occurs when you swap your ABC or XYZ shares for 123 shares.
Credit cards and, sometimes, shares of stock can exist in "real world" form—you have a plastic credit card or you may receive a paper share certificate. Cryptocurrency, however, only exists electronically, making a "hard fork" simpler to implement and instantaneous.
The most famous cryptocurrency "hard fork" occurred in 2016 when the Ethereum blockchain included a crowd-sourced venture capital fund called The Distributed Autonomous Organization (DAO). There was an error in the blockchain code of the DAO that enabled a bad actor to steal the cryptocurrency – US$45 million of it – from the DAO. The DAO's leaders created a new currency through a "hard fork"—making the old cryptocurrency worthless and depriving the bad actor of any value in the stolen cryptocurrency.
An airdrop occurs when cryptocurrency is distributed to the wallet addresses of multiple taxpayers, usually for free. Wallet addresses are where an individual stores his or her cryptocurrency, like a normal wallet. The goal of an airdrop is typically to cause widespread awareness and broad distribution for a blockchain project. It can also be used to incentivize previous token holders or to distribute new cryptocurrency after a hard fork to the holders of the legacy cryptocurrency. This practice has raised questions about the tax implications of airdropped cryptocurrency – if you received additional tokens through an airdrop without asking for them, essentially as a gift, do the additional tokens amount to taxable income? Revenue Ruling 2019-14 says yes.
The new Revenue Ruling addresses two specific situations: Situation 1: a hard fork of a cryptocurrency where the taxpayer receives no new cryptocurrency and Situation 2: a hard fork of a cryptocurrency followed by an airdrop of a new cryptocurrency, where the taxpayer receives new cryptocurrency.
In Situation 1, the IRS held that a taxpayer does not have gross income under Section 61 of the Internal Revenue Code of 1986, as amended, if the taxpayer did not receive any units of new cryptocurrency. Conversely, when a taxpayer receives new units of cryptocurrency from an airdrop as in Situation 2, the taxpayer would recognize ordinary gross income.
To illustrate, if your digital wallet held 50 units of cryptocurrency M with a fair market value of US$100, and after a "hard fork" you held 50 units of cryptocurrency N with a fair market value of US$100, you did not have any accession of wealth and consequently there would be no gross income to recognize. You would have the ability to buy or sell all 50 units of cryptocurrency N, but your US$100 basis has not changed.
However, if after the hard fork, 10 new units of cryptocurrency S were airdropped into your digital wallet, and your digital wallet suddenly had 50 units of cryptocurrency M with a fair market value of US$100 and 10 units of cryptocurrency S with a fair market value of US$55, you would have an accession of wealth and recognize US$55 in gross income as of that date.
The IRS further explained that a taxpayer does not "receive" cryptocurrency if the taxpayer is not able to exercise dominion and control over the cryptocurrency. For example, if new cryptocurrency is airdropped onto a digital wallet managed by a cryptocurrency exchange and that exchange does not support the new cryptocurrency, the taxpayer does not have dominion and control over the cryptocurrency. If the exchange begins to support such cryptocurrency at a later time, the taxpayer will be treated as receiving the cryptocurrency at that time, when they have the ability to transfer, sell, exchange or otherwise dispose of it.
While the crypto industry has long asked for an exemption for transactions below a certain threshold (a de minimis exemption) to spare those who engage in small transactions, like purchasing a cup of coffee with Bitcoin, the IRS did not do so. In the IRS' view, because there is not a de minimis exemption for other types of property, absent instructions from Congress, there should not be one for cryptocurrencies either.
The FAQs delved further into these topics and virtual currency transactions in general. Most notably, the IRS explained:
A draft of an updated Form 1040, Schedule 1, Additional Income and Adjustments to Income, was also released by the IRS with an additional checkbox asking taxpayers about their financial interests in virtual currency. The new form asks the following: "At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?" If the answer to this question is No and taxpayers do not have to file Schedule 1 for any other purpose, then they do not need to file Schedule 1.
© Norton Rose Fulbright LLP 2020