As the IRS ramps up its enforcement efforts, recently issued guidance highlights the need for taxpayers to become and remain compliant with their virtual currency reporting obligations.
The IRS issued a revenue ruling (Rev. Rul. 2019-24
) and 43 frequently asked questions
(FAQs) to clarify and expand on existing guidance on the tax treatment of cryptocurrency transactions involving so-called “hard forks” and “airdrops.”
This guidance, coupled with a new question related to virtual currencies on the draft 2019 Schedule 1 of Form 1040, “U.S. Individual Income Tax Return,” and comments from senior IRS officials telegraph an increased enforcement effort by the government. Taxpayers transacting in cryptocurrency or other virtual currencies should analyze such transactions to determine their compliance with the law for income tax purposes.
Generally, a 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. Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. Cryptocurrencies are open-source and are not issued, backed or regulated by any governmental authority. A cryptocurrency platform, such as bitcoin, can be developed by anyone while the units of currency, typically coins, are “mined” by computers performing complex mathematical calculations. Each cryptocurrency, of which there are many, has its own blockchain-specific software protocols that govern its operation. Like most software, platform developers may choose to update the protocols for a number of a reasons.
Together, these features can provide cryptocurrency users with numerous benefits, including security, anonymity and the ability to avoid transaction fees, exchange rates and other costs commonly associated with payments processed by more traditional banks or financial institutions.
Recognizing the increased use of such virtual currencies, the IRS in 2014 issued Notice 2014-21
, which designated virtual currencies as property for federal tax purposes. In so doing, the IRS applied longstanding tax principles to cryptocurrency transactions. Five years later, the IRS has revisited cryptocurrencies by addressing potentially taxable events, while concurrently working through a significant compliance and enforcement effort.
Special rules for hard forks and airdrops
Rev. Rul. 2019-24 provides guidance on hard forks and airdrops, two separate but sometimes related events that can occur when holding cryptocurrency.
A change in a blockchain protocol creates a divergence, or fork, in the blockchain. One such divergence is a “hard fork.” With a hard fork, the blockchain undergoes a protocol change that results in a permanent diversion from the legacy or existing distributed ledger. A hard fork may result in the creation of a new cryptocurrency or a new distributed ledger, in addition to the legacy distributed ledger. Occasionally, hard forks are followed by “airdrops,” which are essentially promotional distributions of coins to attract new users to a cryptocurrency.
Rev. Rul. 2019-24 explores two such scenarios applying the general concepts of dominion and control found in Commissioner v. Glenshaw Glass Co.
, 348 U.S. 426 (1955). In Scenario 1, the taxpayer owns cryptocurrency (Crypto M) that experiences a hard fork, which results in the creation of a new cryptocurrency (Crypto N). Crypto N is not airdropped or otherwise transferred into an account owned or controlled by the taxpayer. The IRS states that in this case, the taxpayer did not receive any units in Crypto N from the hard fork and does not have an accession to wealth. Therefore, the taxpayer does not have gross income under Section 61 as a result of the hard fork.
In Scenario 2, a taxpayer holds 50 units of a cryptocurrency (Crypto R) that experiences a hard fork that results in the creation of a new cryptocurrency (Crypto S). On the day of the hard fork, 25 units of Crypto S are airdropped to the taxpayer’s distributed ledger address and the taxpayer has the ability to dispose of the 25 units of Crypto S immediately following the airdrop. Accordingly, the taxpayer has 50 units of Crypto R and 25 units of Crypto S. Scenario 2 also posits that the fair market value of the 25 units of Crypto S, at the date and time of the air drop, is $50, and that the taxpayer receives Crypto S solely because of her ownership of Crypto R at the time of the hard fork. The IRS holds that the taxpayer’s receipt of Crypto S is an accession to wealth and that the taxpayer has ordinary income in the year in which the Crypto S was received. The taxpayer includes into her income $50, which is the fair market value of the 25 Crypto S units when the airdrop was recorded on the distributed ledger. Her basis in Crypto S is $50—the amount of income recognized.
Airdrops are generally received when recorded on the distributed ledger/blockchain, but may sometimes be constructively received prior. An airdrop is considered received when the taxpayer has dominion and control over the cryptocurrency. Thus, if an airdrop has been recorded on the blockchain, but the taxpayer is unable to immediately transfer, sell, exchange, or otherwise dispose of the cryptocurrency, it is not considered received until taxpayer gains that ability.
The newly issued FAQs restate much of the guidance provided in Notice 2014-21, but offer new and expanded guidance in certain areas. For example, they state that a taxpayer can identify a specific unit of a virtual currency that is sold, exchanged or otherwise disposed. This requires documenting the unit’s unique digital identifier or specified transaction information. The FAQ also provides new information regarding information reporting, clarifies that soft forks and receiving bona fide gifts of cryptocurrency do not generate income, and addresses other assorted issues that may arise.
Next steps for taxpayers and the IRS
Rev. Rul. 2019-24 should be construed as the IRS’s litigating position with respect to the general tax treatment of cryptocurrencies and realization and recognition events for chain splits like hard forks and air drops. Accordingly, taxpayers should determine whether relevant hard fork and airdrop transactions in prior, open tax years were consistently reported, and whether they should file a qualified amended return to avoid the assessment of accuracy-related penalties.
The government is unmistakably pursuing compliance with respect to cryptocurrency transactions through various means. In 2017, a U.S. district court enforced a so-called “John Doe” summons by the IRS against Coinbase, Inc., a virtual currency exchange, in which the IRS sought significant information of certain Coinbase customers, including user profiles, know-your-customer due diligence, documents regarding third-party access, transaction logs, records of payments processed, correspondence between Coinbase and its users, account or invoice statements, records of payments, and exception records produced by Coinbase’s anti-money laundering system.
Just months later, the IRS announced a virtual currency compliance campaign
through the Large Business & International division, whereby compliance would be encouraged through examinations as well as outreach. In July 2019, the IRS announced
that it planned to send letters to nearly 10,000 taxpayers, educating them on tax compliance with respect to virtual currencies.
Most recently, the IRS has discussed efforts it is undertaking to require information reporting under Section 6045, and presumably through Form 1099, for reporting of gross proceeds from cryptocurrency transactions. A regulatory project for such reporting is listed on the IRS and Treasury Department’s Priority Guidance Plan
Finally, the 2019 draft Form 1040 contains a yes or no question on Schedule 1 asking whether the taxpayer received, sold, sent, exchanged, or otherwise acquired any financial interest in a virtual currency. This question would require taxpayers to answer affirmatively on a tax return, and gives rise to the potential for criminal exposure should a taxpayer answer the question incorrectly. The IRS and Department of Justice have pursued both civil and criminal actions against taxpayers that did not correctly answer a similar question on Schedule B regarding a taxpayer’s financial interest in, or signature authority over, a foreign financial account. Taxpayers should take note of the government’s methods in exacting compliance in the context of foreign financial accounts and the similarity to which such methods will also be used in virtual currency compliance.
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