IRS provides guidance on cryptocurrency protocol updates


The IRS has released an internal legal memorandum (ILM 202316008) that discusses the tax consequences of a cryptocurrency protocol upgrade.


The ILM addresses whether the protocol update results in a realized gain or loss under Section 1001 and whether the taxpayer has an item of gross income under Section 61(a).


In the ILM, the taxpayer purchased 10 units of a cryptocurrency and stored them in an un-hosted wallet. The blockchain later underwent a protocol upgrade, switching from a proof-of-work to a proof-of-stake consensus mechanism.


Under Section 1001, an exchange of property is a realization event if the exchange results in the receipt of property that is materially different from the property transferred.


The IRS held that the protocol update merely changes the way that transactions are validated and does not have any effect on the units of cryptocurrency held — the change did not affect, or otherwise change, the transaction history of any blocks. Hence, a protocol upgrade will not result in a realization event under Section 1001 because the units were unchanged by the protocol upgrade.


The IRS also concluded that the taxpayer does not have an item of gross income under Section 61(a) as a result of the protocol upgrade. Under Section 61(a), all gains or accessions to wealth, which have been realized and in which the taxpayer has complete dominion over, are included in gross income. As the taxpayer derived no accession to wealth, or any other separable economic benefits from the upgrade, the protocol upgrade did not result in the taxpayer having an income inclusion.


The IRS cited Cottage Savings and Glenshaw Glass in reaching its conclusions.




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