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Hard Forks and Airdrops: Tax Concerns with Cryptocurrency 2.0


See the end of this article for updates made 1/13/2020.

Hard forks and airdrops.

No idea what I’m talking about?

Then you’re probably not immersed in cryptocurrency.

Maybe you’ve heard the terms, but you’re foggy on what they mean and how it all works—and what it may have to do with your taxes. In that case, you and the IRS are in the same boat!

Whereas the IRS has made some progress in clarifying how cryptocurrency is taxed, there are still areas of opaqueness. The tax result of “hard forks” and “airdrops” resides in those areas.

Actually, aside from some guidance issued by the IRS in 2014 and some accompanying FAQs on the IRS website, there is no guidance in this area.

The IRS issued Revenue Ruling 2019-24 back in October 2019, addressing the tax ramifications of hard forks and airdrops. However, it seems they might have fumbled it, ultimately creating more confusion rather than bringing clarity.

In fact, it seems the IRS is unclear on exactly what occurs when there is a hard fork.

If you want a fully-detailed definition of a hard fork, you might check out this Investopedia article; for the definition of airdrops, read this one.

Interestingly, the Revenue Ruling is, by its own claim, based on “long-standing bedrock principles and definitions” to arrive at the IRS position on this. It’s basically a question of the definition of gross income and constructive receipt.

First, is there gross income involved, and secondly, can you exercise “dominion and control” over the income?

Those seem like pretty straightforward questions with clear answers until you read the IRS examples in the Revenue Ruling, which are basically as follows:

Example 1: You own cryptocurrency X. On a certain date, the distributed ledger/blockchain experiences a hard fork resulting in the creation of cryptocurrency Y. However, cryptocurrency Y is NOT airdropped to an account you own or control, so you DO NOT have income.

At that point, if you’re knowledgeable in cryptocurrency transactions, you might be scratching your head and thinking, “Say what?”

Example 2: You own cryptocurrency X. On a certain date, the distributed ledger/blockchain experiences a hard fork resulting in the creation of cryptocurrency Y. On that same date, units of cryptocurrency Y are airdropped into your legacy account (where you hold cryptocurrency X). You have ORDINARY INCOME of whatever the fair market value of cryptocurrency Y is on that date.

Now, you’re likely really confused… or the IRS is.

In simple terms, when there is a hard fork and another cryptocurrency is created, you own both the old/legacy cryptocurrency and the new “forked” cryptocurrency. No airdrop needs to take place and, in the real world of cryptocurrency, none does. So why is the IRS conflating these two things?

It’s a question the IRS really needs to clarify ASAP.

Airdrops are often (maybe most often) marketing ploys. They are used to draw attention to a new cryptocurrency or a new product. They make it appear that you just get something for nothing. WRONG! The IRS position is unequivocally that you have received income. This is simple.

What is NOT simple and NOT clear is what happens from a tax standpoint when a hard fork occurs. There are legislators and academics and professionals who are making the case, based on existing tax law, that there is no “recognition event” (i.e. – no income to be recognized) when a hard fork occurs.

The IRS seems to be saying the opposite, yet for some reason tying it to the simultaneous occurrence of an airdrop.

The new cryptocurrency that is generated when a hard fork occurs is similar in nature to a stock split or stock dividend, or even a parcel of land that is split. You have not received something for nothing.

In a stock split or stock dividend, the value of the original stock you owned is diluted. The basis in the stock originally held is shared or allocated to the total number of shares owned after the stock split or stock dividend.

Based on the recent revenue ruling, this does NOT seem to be the position the IRS is taking; their position seems to be that a recognition event has occurred. In other words, that income should be recognized. However, they shoot their position in the foot when conflating it with an airdrop.

If you like to categorize things as black and white, good and bad, then this would definitely be bad news.

The Revenue Ruling issued by the IRS in October 2019 is stating the IRS’s position on this for all time—or, so it seems. The ruling doesn’t indicate any effective dates.

Read that carefully.

You might be thinking, “OK, going forward, I’ll definitely be on the lookout for cryptocurrency units acquired via airdrops and I promise I’ll report it.” That’s great, but you need to be looking backward as well.

The scary thing about this kind of income is that there is no reporting of it to you, the taxpayer. You DON’T receive a 1099 for this, so it’s just up to you to track it and report it. And the IRS is on the hunt for this kind of unreported income.

On the 2019 Form 1040, Schedule 1, every taxpayer is required to answer a question, under penalty of perjury:

“At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

There is a three-year statute of limitations based on the date of filing of a tax return for the IRS to commence an audit; however, if they find a substantial understatement of tax (more than 10% of the tax due not paid), then the statute of limitations is increased to six years.

What is simply NOT clear at this point: Is the IRS position that cryptocurrency units acquired via a hard fork ARE income?

There is no clear answer, and the scope of tax at stake here is huge.

In 2017, the most famous cryptocurrency, Bitcoin, encountered a hard fork. It’s an interesting history, so you might want to Google it. The hard fork resulted in Bitcoin Cash, a brand new cryptocurrency.

Those who owned Bitcoin also owned Bitcoin Cash after the hard fork. The scope of the transaction was about $6 billion, and the potential unpaid tax if the IRS considers the resulting Bitcoin Cash to be taxable income is about $2.3 billion. A staggering number!

As the taxpayer facing these confusing regulation rulings, what are you supposed to do?

Recommendations:

If you’re feeling unsure and looking for a trusted financial advisor, we’re always available to talk to you – give us a call at 214-761-8304 or contact us via our website.

Updated 1/13/2020:

When Revenue Ruling 2019-24 was released, there was confusion in the use of the term “air drop” as it relates to a “hard fork.”

The IRS lawyer who wrote the ruling, Suzanne Sinno in the Office of Associate Chief Counsel (Income Tax & Accounting), has clarified that the term is used in a broad sense of simply having received new coins by some means. In this case, via a hard fork.

The related FAQs on the IRS website related to virtual currency, in response to the question:

One of my cryptocurrencies went through a hard fork but I did not receive any new cryptocurrency. Do I have income?

The answer is:

If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency, whether through an airdrop (a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses) or some other kind of transfer, you don’t have taxable income.

This, in effect, broadens the definition of air drop to include “some other kind of transfer.”

The question above is about that not having occurred, but the IRS intent is that if “some other kind of transfer” did occur, then YOU HAVE INCOME.

It is now critical that you review your cryptocurrency transactions in order to determine if any of them experienced a hard fork, and, if so, did you then have access to the new cryptocurrency.

You may need to file amended returns if you determine that income was omitted from a prior year tax return.