Five years or so years ago, the Internal Revenue Service (“IRS”) provided its first, and until this week, only formal advice on the taxation of cryptocurrency transactions in Notice 2014-21. This guidance, while helpful in some respects, left many questions unanswered. Additionally, the last five years have brought significant market developments in the digital asset space giving rise to new tax questions not addressed in the previous IRS guidance.
Last June, we reported that additional guidance from the IRS was forthcoming on certain tax issues related to the treatment of crypto-currency transactions. Specifically, IRS Commissioner Charles Rettig indicated in a letter to Representative Tom Emmer, a member of the Congressional Blockchain Caucus, that the IRS would publish additional guidance on the federal tax treatment of cryptocurrency transactions, including: (1) acceptable methods for calculating cost basis; (2) acceptable methods of cost basis assignment; and (3) the tax treatment of forks (defined below).
On Wednesday October 9, in Revenue Ruling 2019-24 the IRS delivered on some of those promises, publishing a Revenue Ruling on the tax treatment of forks and related airdrops and posting an accompanying information circular on its website providing a list of frequently asked questions and answers (“IRS Q&A”) that, among other things, addresses methods for determining a taxpayer’s basis in cryptocurrency. While the IRS Q&A appears to be mostly non-controversial, the treatment of forks and airdrops is likely to be the subject of debate.
“Hard Forks” and “Airdrops”:
For those wondering, “hard forks” have nothing to do with the good silverware and “airdrops” do not involve airstrikes or otherwise dropping anything from an airplane or a drone. Rather, a hard fork occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the “legacy” or existing distributed ledger used for that cryptocurrency. In other words one blockchain becomes two chains with a shared history. The hard fork may result in the creation of a second cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency which remains operational on the legacy distributed ledger. Following a hard fork, transactions involving the new cryptocurrency are recorded on the new distributed ledger and transactions involving the legacy cryptocurrency continue to be recorded on the legacy distributed ledger.
One common reason why a hard fork occurs is that a developer(s) of a network decides that the existing legacy blockchain has either been compromised or there is another problem that threatens to impair its operation. Such was the case in the hard fork that created what is now known as Ethereum (ETH) after the hack of a program that was running on the legacy blockchain, Ethereum Classic (ETC). The vast majority of users of the Ethereum network moved to the new fork (ETH) while some continued to support and utilize the legacy ETC network. However, regardless of whether a holder supported the new chain, each holder of Ethereum was granted an equal amount of ETH and ETC.
Another reason to fork a blockchain is when a split develops between factions such as miners and developers over blockchain size or other protocol characteristics. One way to create immediate users of a new cryptocurrency and potentially increase its value is to change the protocol of (or “fork”) an existing cryptocurrency and distribute units of the new cryptocurrency to the holders of the existing cryptocurrency. This is what happened when Bitcoin Cash was forked out of the original bitcoin protocol.
An “airdrop” is a term used to describe means of the distribution of units of a cryptocurrency to the distributed ledger addresses of multiple tax payer parties, often for no additional consideration. As in the case of Bitcoin Cash mentioned above, a hard fork may be followed by an airdrop, which distributes units of the new cryptocurrency to addresses owning the legacy cryptocurrency. However, a hard fork is not always followed by an airdrop and an airdrop is not always preceded by a hard fork.
Revenue Ruling 2019-24 – Addressing the Tax Treatment of Hard Forks
The IRS addressed the tax treatment of cryptocurrency hard forks and aspects of related airdrops in Rev. Rul. 2019-24. Hard forks and related airdrops raise several tax issues. The core tax concern is whether a new cryptocurrency was issued and, if so, whether the recipient should recognize income equal to the value of the new cryptocurrency at the moment it was received. Given the price volatility of some cryptocurrencies, immediate recognition could result in some taxpayers recognizing significant income followed by a precipitous decline in value.
In this Revenue Ruling, the IRS addressed whether a taxpayer recognized gross income as a result of a hard fork in two situations:
1) When the taxpayer did not receive units of a new cryptocurrency as a result of a hard fork; and
2) When a taxpayer did receive units of new cryptocurrency as a result of a hard fork.
The IRS did not address situations in which a taxpayer receives an airdrop that was unrelated to a fork. This could occur, for example, as a means of distributing a new cryptocurrency for marketing purposes (e.g., as publicity for the new currency or to promote unrelated goods or services).
In the first situation, the IRS addressed the tax consequences of a hard fork to a taxpayer where no units of the new cryptocurrency were airdropped or otherwise transferred to an account held by the taxpayer. In that situation, the IRS ruled that the taxpayer does not recognize gross income as there was no accession to wealth. This ruling makes sense, of course, since there has been no transaction in which the taxpayer realized income. It received nothing which it did not already have and, in fact, the legacy cryptocurrency may lose value if the new blockchain becomes dominant.
In the second situation, IRS addressed the tax consequences of a hard fork where the taxpayer received units of the new cryptocurrency resulting from the hard fork via an airdrop and the taxpayer had the ability to dispose of the new cryptocurrency immediately following the airdrop. In this situation, the IRS reasoned that the taxpayer received a new asset – the newly issued cryptocurrency resulting from the hard fork. Therefore, it held that the taxpayer had an accession to wealth and recognized ordinary income in the taxable year in which the new cryptocurrency was received since it had the ability to dispose of the new cryptocurrency immediately after the airdrop.
There are at least three important points to be gleaned from the second situation of the ruling:
1) The receipt by a taxpayer of units of a new cryptocurrency resulting from a hard fork is a realization event. This ruling may come as a surprise to some who argued that a hard fork was akin to a stock split or stock dividend, which in many cases does not result in the recognition of income since the issuer has essentially merely subdivided its shares. However, it may be argued that this analogy is inapposite in that the hard fork in essence creates a new issuer. To carry on the metaphor, the hard fork would be akin to a corporation distributing shares of the stock of another corporation to its shareholders, which is clearly a taxable event.
2) Although the receipt by a taxpayer of units of a new cryptocurrency resulting from a hard fork is a realization event, a taxpayer will only recognize income when it has dominion or control over new units received. For example, the IRS stated that a taxpayer does not have dominion and control over the new cryptocurrency transferred to it if the “address” to which the cryptocurrency is airdropped is contained in a wallet managed through a cryptocurrency exchange that does not support the newly-created cryptocurrency such that the airdropped cryptocurrency is not immediately credited to the taxpayer’s account at the cryptocurrency exchange. In the case of an accrual basis taxpayer, this is arguably a favorable conclusion in that an accrual basis taxpayer must generally include an amount in gross income in the taxable year in which all events have occurred which fix the right to receive such amount. In the case of a cash method taxpayer, this conclusion should follow from the general standard that requires inclusion in gross income in the taxable year it income is actually or constructively received.
3)The character of the income received upon an issuance of units of a new cryptocurrency resulting from a hard fork is ordinary. In this regard, the IRS noted that in general, income is ordinary unless it constitutes gain from the sale or exchange of a capital asset or a special rule applies. In this regard, the ruling is notably lacking in reasoning, citing only §§ 1222, 1231 and 1234A, which seem mostly irrelevant to the question. Section 1221(a), on the other hand, provides that the term “capital asset” means property held by the taxpayer other than certain specifically enumerated items, none of which appear to be relevant. In fact, Treasury Regulations state that “the term ‘capital assets’ includes all classes of property not specifically excluded by section 1221. In determining whether property is a ‘capital asset’, the period for which held is immaterial.” Since IRS has stated in previous guidance that cryptocurrency is treated as property for federal income tax purposes, this would suggest that, as a threshold matter, the receipt of units of newly issued cryptocurrency occurring as the result of a hard fork should result in a capital gain.
On the other hand, it is clear that certain items not specifically excluded from the definition of a capital asset are nevertheless treated as producing ordinary income. Thus, the Supreme Court has stated that “it is evident that not everything which can be called property in the ordinary sense and which is outside the statutory exclusions qualifies as a capital asset. This Court has long held that the term ‘capital asset’ is to be construed narrowly in accordance with the purpose of Congress to afford capital-gains treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time…” In the case of a cryptocurrency airdrop received by a taxpayer as a result of a hard fork, the new units clearly have not been held over a substantial period of time and the value of the units does not arise from appreciation in the asset received. On balance, the scale appears to tip in favor of ordinary income character, but it would be helpful if the IRS provided some rationale for its holding.
IRS Answers to Cryptocurrency Q&A’s
In addition to Revenue Ruling 2019-24, the IRS issued a document entitled “Frequently Asked Questions on Virtual Currency,” posing (and answering) 43 questions on cryptocurrency transactions. Most of these questions and answers were addressed in previous guidance or amounted to logical extensions of such guidance. However, there was some new guidance of note – in particular with regard to the determination of tax basis – which we address below.
Question 25 and 26 of the IRS Q&A address how a taxpayer determines a cryptocurrency’s fair market value at the time of receipt. In this regard, the IRS stated that cryptocurrency received in a transaction facilitated by a cryptocurrency exchange, is valued as the amount that is recorded by the cryptocurrency exchange for that transaction in U.S. dollars. However, if the cryptocurrency was received in a peer-to-peer transaction or some other type of transaction that did not involve a cryptocurrency exchange, the fair market value of the cryptocurrency is determined as of the date and time the transaction is recorded on the applicable distributed ledger, or would have been recorded on the ledger if it had been an on-chain transaction. As evidence of fair market value the IRS will accept the value as determined by a cryptocurrency or blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates the value of the cryptocurrency at an exact date and time.
In Q29, the IRS addressed whether a taxpayer has income when a soft fork of cryptocurrency occurs (A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger, and thus does not result in the creation of a new cryptocurrency. The IRS indicated that because soft forks do not result in the receipt of new cryptocurrency, the taxpayer will be in the same position as it was prior to the soft fork, meaning that the soft fork will not result in any income. This answer – while perhaps obvious – is useful guidance.
In the same vein, the IRS provided guidance that is helpful in Q35, addressing whether a taxpayer is required to recognize income, gain, or loss if it transfers cryptocurrency from one wallet account to another. The IRS held that the transfer is a non-taxable event, even if the taxpayer received an information return, such as a Form 1099-K or 1099-B, from an exchange or platform as a result of the transfer.
Notably, in A36-38, the IRS provided long-awaited guidance on acceptable methods for determining a taxpayer’s basis in cryptocurrency, including whether specific identification is allowed. Practitioners had taken differing positions on this matter. In A36, the IRS stated that a taxpayer may choose which units of virtual currency are deemed to be sold, exchanged, or otherwise disposed of if it can specifically identify which units of virtual currency are involved in the transaction and substantiate its basis in those units. This is good news for investors who have kept records sufficient to allow them to identify units in which they have gains and losses, thereby allowing them to sell offsetting lots and reduce net gain for federal income tax purposes.
Importantly, A37 addresses how a taxpayer may identify a specific unit of virtual currency. The IRS indicated that this may be accomplished by either documenting the specific unit’s unique digital identifier such as a private key, public key, and address, or by keeping records showing the transaction information for all units of a specific virtual currency, held in a single account, wallet, or address. This information must show: (1) the date and time each unit was acquired, (2) the taxpayer’s basis and the fair market value for each unit at the time it was acquired, (3) the date and time each unit was sold, exchanged, or otherwise disposed of, and (4) the fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.
Finally, in A38, the IRS indicated that if a taxpayer does not specifically identify units of virtual currency, the units are deemed to have been sold, exchanged, or otherwise disposed of in chronological order beginning with the earliest unit of the virtual currency purchased or acquired; that is, on a first in, first out (FIFO) basis.
While taxpayers may disagree with some of the IRS’ interpretations with respect to the tax treatment of hard forks, it is nevertheless helpful to obtain some guidance on the tax treatment of these transactions. In addition, the IRS Q&A’s provide some additional guidance on outstanding cryptocurrency tax issues. In particular, the IRS’ approval of the use of the specific identification method for determining a taxpayer’s basis in cryptocurrency and the method for documenting this determination is welcome news.
As we have noted in previous posts there are many other areas where guidance is needed on the application of federal income tax rules to cryptocurrency transactions. Such areas include whether an exchange of one cryptocurrency for another can be treated as a like-kind exchange prior to the 2018 tax year, the characterization of cryptocurrency as a commodity or a security for purposes of the mark-to-market and wash sales rules, under what circumstances Section 1032 applies to the issuance of tokenized securities and the proper application of international tax reporting requirements to holders of cryptocurrency and institutions which provide cryptocurrency accounts (e.g., wallet providers and exchanges). Notwithstanding, we applaud the IRS’ efforts to issue this guidance especially considering the burden they are shouldering in providing guidance on issues arising from recently-enacted tax reform measures.
Citing § 61(a)(3) (except as otherwise provided by law, gross income means all income from whatever source derived, including gains from dealings in property.); Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955) (Under § 61, all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion, are included in gross income.)
 Question 23 of the IRS Q&A address how to calculate income from cryptocurrency received following a hard fork. The answer states that when the taxpayer receives cryptocurrency from an airdrop following a hard fork, it will have ordinary income equal to the fair market value of the new cryptocurrency when it is received, which is when the transaction is recorded on the distributed ledger, provided it has dominion and control over the cryptocurrency so that it can transfer, sell, exchange, or otherwise dispose of the cryptocurrency.
 See § 305(a) (except as otherwise provided, gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders); Eisner v. Macomber, 252 U.S. 189 (1920) (“We are clear that not only does a stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder, but that the antecedent accumulation of profits evidenced thereby, while indicating that the shareholder is the richer because of an increase of his capital, at the same time shows he has not realized or received any income in the transaction.”)
 See e.g., Peabody v. Eisner, 247 US 347 (1918).
 § 451(b) (but not later than that date that such income is taken into account as revenue on an applicable financial statement).
 § 451(a). The facts in Situation 2 of the ruling also indicate that the income is not constructively received. Treas. Reg. § 1.451-2 provides that income although not actually reduced to a taxpayer’s possession is constructively received by it in the taxable year during which it is credited to its account, set apart for it, or otherwise made available so that it may draw upon it at any time, or so that it could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. In the example set forth above, the airdropped units were contained in a wallet managed through a cryptocurrency exchange that does not support the newly-created cryptocurrency such that the airdropped cryptocurrency is not immediately credited to the taxpayer’s account at the cryptocurrency exchange. In that case, it would difficult to say that the taxpayer could have drawn upon it when it was received since the exchange did not support the newly-created cryptocurrency.
 Excluded categories include inventory, depreciable property, certain patents, inventions and the like, accounts or notes receivable acquired in the ordinary course of trade or business, certain publications of the United States Government, certain commodities derivative financial instruments held by a commodities derivatives dealer, and supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer.
 Notice 2014-21, 2014-16 I.R.B. 938.
 Commissoner v. Gillette Motor Transport, Inc., 364 US 130 (1960).
 If the transaction is facilitated by a centralized or decentralized cryptocurrency exchange but is not recorded on a distributed ledger or is otherwise an off-chain transaction, then the fair market value is the amount the cryptocurrency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it had been an on-chain transaction.
 This has also been described as a change in protocol that is backwards compatible.
 H.R. 1, commonly referred to as The Tax Cuts and Jobs Act of 2017, limited the application of the like-kind exchange rules to real estate transactions effective for exchanges completed after December 31, 2017.
 Section 1032 of the Internal Revenue Code of 1986, as amended, states that “[n]o gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation.”