Recent IRS guidance on cryptocurrency concludes that owners realize income when a hard fork is followed by an airdrop. Although many other cryptocurrency issues remain unsettled, the IRS may also be signaling stepped-up compliance efforts.
The new IRS cryptocurrency guidance clarifies that:
- a hard fork alone does not produce income, but
- a hard fork followed by an airdrop produces gross income equal to the value of the airdropped currency.
Cryptocurrency Forks and Air Drops
A cryptocurrency exists on a distributed ledger, such as a blockchain. A fork in a cryptocurrency is a change in the ledger protocol that causes a diversion from the existing (or legacy) ledger.
Currency forks may be hard or soft. A soft fork is often just an update to the ledger protocol that leaves both the legacy ledger and the new ledger functional and compatible with each other. In practice, however, the new ledger may slowly replace the legacy ledger as users update their software.
A hard fork is different, because the legacy ledger and the new ledger are completely independent. A hard fork may create a brand new currency, leaving the legacy currency as a separate, but still functional currency. Transaction involving the legacy currency continue to be recorded on the legacy ledger, while transaction involving the new currency are recorded on the new ledger.
An airdrop is a distribution of cryptocurrency units, commonly known as tokens or coins, to multiple ledger addresses. Airdrops can have many purposes. For instance, an airdrop may distribute previously purchased or earned coins, it may be intended to reward users of the currency, or it may distribute coins a new currency after a hard fork.
Hard Fork + Air Drop = Income
The new IRS cryptocurrency guidance reaches six conclusions:
- A soft fork does not cause the cryptocurrency owner to receive income.
- A hard fork by itself also does not cause the cryptocurrency owner to receive income.
- If there is a hard fork followed by an airdrop of new currency, however, the cryptocurrency owner realizes ordinary income when the new currency is received.
- The new currency is received when the owner can transfer, sell, exchange or otherwise dispose of it. This generally occurs when the airdrop is recorded on the distributed ledger.
- The amount of income the owner realizes is equal to the fair market value of the new currency at the time the owner receives it.
- The amount of income the owner reports is also the owner’s basis in the new currency.
Broader Application of Cryptocurrency Guidance
The IRS based its conclusions on general tax law principles under IRC §§61, 451 and 1011. Thus, even though these conclusions are phrased pretty narrowly, they probably apply more broadly.
For instance, although the guidance expressly recognizes income only when an airdrop follows a hard fork, the same rules probably apply to any gratuitous airdrop. Thus, a cryptocurrency owner probably realizes income on any distribution of coins that are not compensation for goods or services, or gifts made with a donative intent.
Cryptocurrency Tax Compliance
Although the new guidance leaves many cryptocurrency issues unsettled, the IRS may be preparing a new tool in its compliance efforts. In the draft Form 1040 issued in October, the first question on Schedule 1 asks:
At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?
This is similar to an existing question on Schedule B that asks if the taxpayer had a financial interest or signature authority over a financial account in a foreign country. Taxpayers who overlook the Schedule B question or answer it incorrectly may, accidentally or intentionally, violate FATCA reporting requirements.
The new cryptocurrency question may be a sign that IRS compliance efforts for virtual currency may follow the FATCA playbook. Apparently, the IRS expects taxpayers to answer the cryptocurrency question even if they are not otherwise required to file Schedule 1 to report additional income and adjustments to income.
By Kelley Wolf, JD, LLM