IRS Takes on “Hard Fork” and “Airdrop” as Part of New Guidance on Virtual Currency

Summary

The FAQ generally expands on the guidance and examples provided in Notice 2014-21 and applies the same general tax principles to additional situations such as (i) payments for services using virtual currency, (ii) exchanges of virtual currency for property (including other virtual currency), (iii) gifts and charitable donations of virtual currency and (iv) sales of multiple units of one kind of virtual currency acquired at different times. Additionally, the FAQ gives examples on how to determine the fair market value of a cryptocurrency received on an exchange or otherwise (e.g., as part of a transaction that is either recorded or not recorded on a distributed ledger, a peer-to-peer transaction or the receipt of cryptocurrency with unpublished value). Both the FAQ and the Revenue Ruling address the tax treatment of two specific types of transactions, the occurrence of a “hard fork” (i.e., when a cryptocurrency undergoes a change that may result in the creation of a new cryptocurrency in addition to the legacy cryptocurrency) and an “airdrop” (i.e., when a taxpayer receives new units of cryptocurrency following a hard fork). The Revenue Ruling and the FAQ make clear that a taxpayer is taxed only if the taxpayer receives a new virtual currency, which requires that the taxpayer be able to exercise complete dominion and control over the new virtual currency. Thus, the tax treatment of virtual currencies is consistent with the tax treatment of other properties. 

Frequently Asked Questions on Virtual Currency Transactions

Similar to Notice 2014-21, the FAQ applies only to virtual currency that has an equivalent value in real currency or acts as a substitute for real currency (convertible virtual currency).¹ The FAQ covers all types of convertible virtual currency, regardless of the label applied, under the tax definition of a virtual currency, such as digital currency and cryptocurrency (i.e., a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain).

The FAQ reaffirms Notice 2014-21 in providing that virtual currency is treated as property for U.S. federal income tax purposes and general tax principles applicable to property transactions apply to virtual currency transactions. For example, when a taxpayer receives a virtual currency in exchange for services, whether or not through an exchange platform, the taxpayer is required to include the fair market value of the virtual currency in gross income as measured in U.S. dollars at the time of receipt. If a taxpayer acquires virtual currency on an exchange, the taxpayer’s basis in the virtual currency will be equal to the amount spent to acquire the virtual currency (including fees, commissions and other acquisition costs) as measured in U.S. dollars at the time of acquisition. The taxpayer’s holding period starts on the day after the virtual currency is received or acquired. If a taxpayer holds virtual currency as a capital asset, upon the sale of the virtual currency, the taxpayer will recognize capital gain or loss that will be either long-term or short-term depending on the taxpayer’s holding period.

Fair Market Value of Cryptocurrency

For cryptocurrency received in a transaction facilitated by an exchange, the fair market value of the cryptocurrency is the amount recorded by the exchange for that transaction in U.S. dollars; if the transaction is not recorded, the fair market value is the amount the cryptocurrency was trading for on the exchange in U.S. dollars at the time the transaction would have been recorded. For cryptocurrency received in a transaction not facilitated by an exchange (e.g., a peer-to-peer transaction), a taxpayer may rely on cryptocurrency or blockchain explorers or other published evidence that establishes the cryptocurrency’s fair market value. For cryptocurrency that does not have a published value, its fair market value is the fair market value of the property or services exchanged for it.

Payments for Services Using Virtual Currency

The FAQ confirms that payments for services with virtual currency, whether to an employee or to an independent contractor, will be taxed as ordinary income to the service provider in the amount of the fair market value of the virtual currency as measured in U.S. dollars at the time it is received. Based on the FAQ and Revenue Ruling, the time of receipt will be the time when the taxpayer is able to exercise complete dominion and control over the virtual currency. For example, in a transaction recorded on a distributed ledger, a taxpayer is considered to have dominion and control over the virtual currency on the date and at the time the taxpayer has the ability to transfer, sell, exchange or otherwise dispose of such virtual currency. If an independent contractor receives virtual currency for performing services, such virtual currency will be treated as self-employment income. Similarly, if an employer uses virtual currency as remuneration for services, it will constitute wages for employment tax purposes. If the service recipient held the virtual currency as a capital asset, the service recipient will also recognize a capital gain or loss on the exchange in the amount equal to the fair market value of the services received over the service recipient’s adjusted basis in the virtual currency (i.e., the adjusted basis equals the service recipient’s cost basis as increased by certain expenditures and decreased by certain deductions or credits in U.S. dollars).

Taxpayers who expect to use virtual currency in compensating their employees and independent service providers should carefully assess (a) their own potential tax liabilities on any gains associated with the use of virtual currency, (b) their employment tax obligations and (c) related withholding and information reporting obligations.

Exchanges of Virtual Currency for Property (Including Other Virtual Currency)

The FAQ includes multiple scenarios involving the exchange of virtual currency for property or vice versa. A taxpayer will recognize gain or loss upon the exchange of virtual currency for other property (which includes other virtual currency) in the amount equal to the fair market value of the property received over the taxpayer’s adjusted basis in the virtual currency exchanged. The nature of the recognized gain or loss will depend on whether the taxpayer held the virtual currency as a capital asset. The taxpayer’s basis in the property received will equal the fair market value of such property at the time of exchange.

Gifts and Charitable Donations of Virtual Currency

Bona fide gifts of virtual currency are generally not income to the recipient until the recipient sells or otherwise disposes of the virtual currency. Upon a sale, the recipient’s basis in the gift depends on whether the recipient has gain or loss. If the recipient has gain, the recipient’s basis is equal to the donor’s basis plus any gift tax the donor paid. If the recipient has loss, the recipient’s basis is the lower of either the donor’s basis or the fair market value of the virtual currency at the time of the initial gift. Gift recipients must substantiate the donor’s basis; without evidence, a recipient’s basis is zero. Recipients’ holding period of virtual currency includes the holding period of the donor, unless the recipient cannot substantiate the donor’s holding period, in which case the holding period begins the day after receipt of the gift.

Charitable contributions of virtual currencies generally do not result in the recognition of gain or loss on the virtual currency for the donor (as opposed to a service recipient who pays an employee or independent contractor in virtual currency as discussed above). For charitable contributions of virtual currency where the donor held the virtual currency for more than a year at the time of donation, the donor’s deduction is the fair market value of the virtual currency; for donations where the donor held the virtual currency for a year or less, the donor’s deduction is the lesser of the donor’s basis and the fair market value of the virtual currency at the time of donation. Prospective donors now have clarity on the favorable nonrecognition rule for charitable donations.

Sales of Multiple Units of One Kind of Virtual Currency Acquired at Different Times

In virtual currency transactions, taxpayers who own multiple units of one kind of virtual currency purchased at different times and with different basis amounts may specifically identify which units are a part of the transaction as long as they can substantiate for each unit (1) the date and time of acquisition, (2) the basis and fair market value of the virtual currency at acquisition, (3) the date and time of sale and (4) the fair market value of each unit when sold and the value of money or property received in exchange. Without substantiation, units are deemed to have been sold in chronological order beginning with the earliest unit acquired (i.e., on a FIFO or first in, first out basis). Taxpayers should maintain streamlined records in respect of their virtual currencies to avoid being forced into the default FIFO rules.

Hard Fork, Airdrop and Revenue Ruling 2019-24

Revenue Ruling 2019-24 addresses whether a taxpayer has gross income under Section 61 of the Internal Revenue Code of 1986 (the Code)² as a result of two types of transactions: the occurrence of a hard fork (i.e., when a cryptocurrency undergoes a change that may result in the creation of a new cryptocurrency in addition to the legacy cryptocurrency) and an airdrop (i.e., when a taxpayer receives new units of cryptocurrency following a hard fork). The Revenue Ruling addresses only transactions involving a cryptocurrency, a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger. The IRS ruled on two separate fact patterns and both conclusions hinged on whether the taxpayer in the particular case “received” the newly created cryptocurrency for U.S. federal income tax purposes. The IRS explained that although the receipt of cryptocurrency from an airdrop generally occurs when it is recorded on the new distributed ledger, “receipt” for U.S. federal income tax purposes does not occur unless the taxpayer is able to exercise complete dominion and control over the new cryptocurrency. For example, the IRS stated that a taxpayer does not have dominion and control if the address to which the new cryptocurrency is airdropped is in a wallet managed through a cryptocurrency exchange that does not support the newly created cryptocurrency. In that example, the IRS stated that the taxpayer is treated as receiving the new cryptocurrency for U.S. federal income tax purposes only when the taxpayer acquires the ability to transfer, sell, exchange or otherwise dispose of the new cryptocurrency.

In the first fact pattern, a taxpayer owned a cryptocurrency that experienced a hard fork, resulting in the creation of a new cryptocurrency that was not airdropped or otherwise transferred to the taxpayer’s account. In this case, the IRS ruled that because the taxpayer did not receive the new cryptocurrency and did not have accession to wealth, the taxpayer did not have gross income as a result of the hard fork.

In the second fact pattern, a taxpayer owned a cryptocurrency that experienced a hard fork, resulting in the creation of a new cryptocurrency, but this time the new cryptocurrency was airdropped to the taxpayer’s distributed ledger address and the taxpayer had the immediate ability to dispose of the new cryptocurrency. In this case, the IRS ruled that the taxpayer had an undeniable accession to wealth, clearly realized, and the taxpayer had complete dominion and control over the new cryptocurrency at the time of the airdrop. Therefore, the IRS ruled that the taxpayer had ordinary income in the amount of the fair market value of the new cryptocurrency measured at the time the airdrop was recorded on the taxpayer’s distributed ledger.

The FAQ provides additional guidance on the treatment of hard forks. The fair market value of the new cryptocurrency realized as a result of a hard fork is measured at the time of receipt, which is typically when the transaction is recorded on the distributed ledger, provided the taxpayer has complete dominion and control over the new cryptocurrency. The taxpayer’s basis in the new cryptocurrency will equal the amount included in income for tax purposes, which is the fair market value of the new cryptocurrency at the time of receipt. These circumstances surrounding a hard fork should be distinguished from the occurrence of a “soft fork” when a legacy cryptocurrency undergoes a change, but the change does not result in the creation of a new cryptocurrency. In those situations, the taxpayer will not have a taxable recognition event because the taxpayer will not receive any new cryptocurrency as a result of the soft fork.

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¹ See Sections 2 and 3, Notice 2014-21. Virtual currency is 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 merely a subset of virtual currency.  

²  All Section references are to the Code.