On October 9, 2019, the Internal Revenue Service (IRS) issued guidance addressing select issues involving the tax treatment of virtual currency transactions and reminding taxpayers of their reporting obligations. The guidance, provided in the form of a revenue ruling (the Revenue Ruling) and a set of frequently asked questions (FAQ), specifically addresses the tax treatment of cryptocurrency received for services, the calculation of gains and losses and tax basis in cryptocurrencies, and the method of reporting transactions for virtual currency holders. See Rev. Rul. 2019-24.
The Revenue Ruling and the FAQ are intended to supplement an IRS notice issued five years prior in March 2014, which provides that for purposes of federal income tax, virtual currencies should be treated as property, and general tax principles applicable to property transactions apply to virtual currency transactions. See Notice 2014-21.
The IRS has stated that the purpose of the new guidance is to help taxpayers better understand their reporting obligations for specific transactions involving virtual currency.
Background and Definitions
The Revenue Ruling and the FAQ define virtual currency as a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than representation of the US dollar or a foreign currency (“real currency”). Cryptocurrency is defined as a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger.
Within this context, the IRS explains that a “hard fork” occurs when cryptocurrency on a distributed ledger undergoes a protocol change or shift, resulting in a permanent divergence from the existing distributed ledger and potentially resulting in the creation of new cryptocurrency. Following a hard fork in which a new cryptocurrency is issued, the new cryptocurrency is recorded on the new distributed ledger and transactions involving the prior existing cryptocurrency continue to be recorded in the prior distributed ledger.
In some instances, a hard fork will be followed by an “airdrop.” An airdrop is a method of distributing units of a cryptocurrency to the addresses of taxpayers included on the distributed ledger. In the case where an airdrop follows the occurrence of a hard fork, units of the new cryptocurrency are distributed to addresses included on the prior distributed ledger.
Though hard forks are not always followed by an airdrop, the possibility of receiving units of new cryptocurrency have raised several questions for taxpayers regarding the tax implications of such distributions.
The New Guidance
Intended to provide taxpayers with a better understanding of how to apply well established tax principles to a quickly developing and changing technological environment, the Revenue Ruling addresses two specific questions:
- Whether a taxpayer has gross income under § 61 of the Internal Revenue Code (Code) as a result of a hard fork of a cryptocurrency the taxpayer owns if the taxpayer does not receive units of a new cryptocurrency; and
- Whether a taxpayer has gross income under § 61 of the Code as a result of an airdrop of a new cryptocurrency following a hard fork if the taxpayer receives units of new cryptocurrency.
The Revenue Ruling holds that in the first instance, where a taxpayer does not receive units of a new cryptocurrency as a result of a hard fork, the taxpayer also does not have gross income under § 61.
Where a taxpayer does receive units of new cryptocurrency as the result of an airdrop following a hard fork, the Revenue Ruling holds that the taxpayer has an accession to wealth and therefore has ordinary income under § 61. The amount included in gross income is equal to the fair market value of the cryptocurrency when the airdrop is recorded on the distributed ledger. This analysis relies on the ability of the taxpayer to exercise dominion and control over the units of new cryptocurrency at the time of the airdrop.
The FAQ, additionally, provides further insight into the application of long-standing tax principles to virtual currency transactions. The FAQ reiterates that when taxpayers sell virtual currency, they must recognize any capital gain or loss on the sale, subject to applicable capital loss deductibility limitations. Gain or loss on the sale of virtual currency is measured by the difference between the taxpayer’s adjusted basis in the virtual currency and the amount the taxpayer actually received in exchange for the virtual currency. The FAQ allows the taxpayer to use specific identification for determining basis, with FIFO being the deemed method if currency is not specifically identified. LIFO is not a recognized method to account for basis.
The FAQ also touches on a number of other issues, such as the tax treatment of virtual currency received in exchange for services, the tax treatment of virtual currency received as a bona fide gift, and the method of determining the fair market value of cryptocurrency received through a cryptocurrency exchange.
Eversheds Sutherland Observation: The IRS’s new virtual currency guidance marks the latest step in a series of recent efforts by the agency to increase compliance and enforcement in this space. In July 2019, the IRS announced through a news release that it had begun sending letters to taxpayers with virtual currency transactions that have either potentially failed to report income or did not accurately report their transactions. The IRS anticipated that by the end of August, over 10,000 taxpayers would receive these letters. The letters followed the IRS’s issuance of a “John Doe” summons to Coinbase, one of the largest platforms for exchanging bitcoin and other forms of virtual currency, and Coinbase’s production of approximately 13,000 customer records to the IRS. With the new guidance, the IRS continues to demonstrate that it is focused on addressing reporting issues related to virtual currency.
The new guidance, however, has already received criticism in the industry for creating rules that may result in unfair or unexpected consequences. In the case of hard forks, for instance, some observers have suggested that, under the guidance, third parties can now create tax reporting obligations on taxpayers by foisting cryptocurrency on them through an unwanted airdrop. Others have noted that the new guidance does not create any “de minimis” tax exemptions for small cryptocurrency transactions, such as using bitcoin to purchase a cup of coffee. Future guidance may be forthcoming from the IRS in these and other areas. In the meantime, taxpayers should take heed of the IRS’s reminder, in the FAQ, to maintain records sufficient to establish the positions taken on their tax returns regarding virtual currency, such as records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the virtual currency in question.
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