The IRS and Cryptocurrency

There is a misconception that cryptocurrencies are not being regulated in the United States.  In actuality, the Internal Revenue Service (IRS) first issued guidance on virtual currencies way back in 2014.  The IRS is currently working on updating their tax forms to include cryptocurrencies, and just last week they released new tax guidance on cryptocurrencies.  As the end of the 2019 tax season nears, accountants, tax professionals and others directly dealing with cryptocurrencies, need to be aware of the developments in the cryptocurrency tax regulations.

The initial IRS guidance in 2014 never used the term “cryptocurrency” but, it did acknowledge that Bitcoin and other cryptocurrencies fell within their definition of “virtual currencies”.  That guidance made two very important statements regarding the tax classification of virtual currencies, and the tax treatment of the sale and exchange of virtual currencies:

Tax Treatment of Virtual Currency:

For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency

Sale and Exchange of Virtual Currency:

In general, the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.

The simple summary is that the IRS looks at cryptocurrencies like stock.  If you own a cryptocurrency, and it increases in value, then you may have to report capital gains.  If it loses value, then you may be able to report capital losses. Any receipt of cryptocurrency whether it be from mining, or as payment for some type of goods or services, will likely need to be reported as taxable gross income. 

The new guidance given last week explained the IRS’ approach to taxing cryptocurrencies received from hard forks and airdrops.  Before we look at the guidance, let’s first explore what hard forks and airdrops are.

What is a Hard Fork?

In a nutshell, a hard fork is when a single cryptocurrency splits into two.  A hard fork starts with an update or upgrade to the software or protocol on a blockchain platform.  The upgrade to the platform’s code will create a new version of the software. If that new version is incompatible with the older version, then the cryptocurrency being used on the older version would not function on the newer version.  Therefore, a cryptocurrency compatible with the newer version of the software needs to be created. The creation of a new cryptocurrency results in two separate blockchains, with two separate and incompatible versions of software, and two separate tokens.

In comparison, a soft fork occurs when the older and newer versions of the software remain compatible and no new token is needed.

What is a Cryptocurrency Airdrop?

A cryptocurrency airdrop is when coins or tokens are distributed into various cryptocurrency wallets for free.  This method is often used by blockchain platforms during a new coin issuance to bring attention and drive user adoption to their token.  In the cases of a hard fork, an airdrop is performed to distribute tokens of the new software version’s cryptocurrency to wallet addresses of those who held the older version of tokens.  This allows the participants on the older blockchain to now participate on the newer blockchain.

IRS Guidance on Airdrops and Hard Forks

The newly released IRS guidance addresses whether or not a taxpayer has gross income under the Internal Revenue Code as a result of an airdrop of a new cryptocurrency after a hard fork.  

The IRS has advised that if there is no issuance of new cryptocurrency after a hard fork, then the individual does not have gross income.  However, if there was an airdrop or receipt of a new cryptocurrency after a hard fork occurred via airdrop or other form, then the recipient of a new cryptocurrency does have gross income attributable to themselves at the time they receive the units.

 The IRS defines the term “received” as being the time a person has dominion or control of the units to the extent that they can transfer, sell or otherwise dispose of the cryptocurrency.