2021-04-13 17:42:15

Front Page Story And Back Page Correction: IRS Clarifies Its Public Cryptocurrency Position In Internal Guidance – Technology


United States:

Front Page Story And Back Page Correction: IRS Clarifies Its Public Cryptocurrency Position In Internal Guidance


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In Revenue Ruling 2019-24, the US Internal Revenue Service
(“IRS”) ruled that a holder of cryptocurrency who
experienced a hard fork followed by an airdrop (in which the new
currency emerging from the hard fork was distributed) had taxable
income equal to the value of the currency received. My
bitcoin-savvy friends thought the rule was gibberish because hard
forks and airdrops have nothing to do with one another. In
you-know-what-I-meant IRS Chief Counsel
Memorandum, dated March 22, 2021, the IRS corrected the
nomenclature that it used in Revenue Ruling 2019-24. ILM 202114020
also provides further guidance on airdrops.

I.  Once Again, a Tax Lawyer Attempts to Explain Aspects
of the Cryptocurrency Market

An airdrop occurs when a person delivers free cryptocurrency to
a custodial account. Frequently, these giveaways are conditioned on
the performance of an act, such as promoting the use of the
distributed currency or some other social media highlighting. On
August 1, 2017, Bitcoin Cash was distributed on a 1:1 basis for all
Bitcoins held in an eligible account. The giveaway was prompted by
the fact that all digital mining for Bitcoin itself had been
completed and Bitcoin Cash mining could replace this activity. On
April 1, 2021, each Bitcoin Cash coin was worth approximately
$558.20.

ILM 202114020 concludes that recipients of the August 1, 2017
airdrop recognize taxable ordinary income as a result of receiving
the airdrop regardless of “the specific means by which the new
cryptocurrency is distributed or otherwise made available to a
taxpayer.” This conclusion is consistent with the position
taken in Revenue Ruling 2019-24 (without consideration of whether
the airdrop is accompanied by a hard fork).

Given the volatility of cryptocurrencies, the question as to
when the income is recognized and how the cryptocurrency is valued
are important. The answer to the timing question is that the
receipt of the airdrop is taxable as soon as the recipient can
exercise dominion and control over the cryptocurrency. As a result,
if the airdrop is made to a wallet that the recipient cannot
“open,” no income is recognized until the cryptocurrency
is released to the recipient. If the cryptocurrency has
appreciated, the recipient would expect to recognize a greater
amount of income at this later date. The situation would be
exacerbated in a rising rate environment. As for valuation, ILM
202114020 states that the fair market value of the Bitcoin Cash can
be determined “using any reasonable method.”

II.  And as Though He Didn’t Already Learn His
Lesson

In contrast to airdrops, hard forks occur when an existing unit
of cryptocurrency (often, a “Coin”) is split in two. This
occurs when the predecessor unit of cryptocurrency becomes
obsolete, invalidating prior history. A fork is simply a change in
the blockchain’s protocol that the software uses to decide
whether a transaction is valid or not. If enough people continue to
desire to trade the predecessor units, there will be two separate
currencies. On the other hand, if use of the predecessor currency
becomes obsolete, each holder will be required to update the
protocols for storage and transfer to the successor units. This is
exactly what happened with Bitcoin Cash. So while it is easy to see
how airdrops are taxable, it is less clear that hard forks in and
of themselves should be considered to result in ordinary income.
But the IRS confused the two events.

Specifically, airdrops are akin to income paid on property or
compensation for services. Hard forks, on the other hand, are more
akin to recapitalizations or the splitting up of property that is
already owned. Hard forks could be treated as sales or exchanges,
but it’s unlikely that the new blockchain would differ
materially in kind and extent so as to be treated as a taxable sale
or exchange. In each of Revenue Ruling 2019-24 and ILM 202114020,
the IRS has held, however, that hard forks should be taxed in the
same manner as airdrops. Hopefully, this same treatment of
extremely different transactions will be fixed over time, even if
it is by means of another back page correction.

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