On Oct. 9, 2019, the Internal Revenue Service (the “Service”) issued Revenue Ruling 2019-24 concerning the tax consequences of virtual currency hard forks, as well as FAQs on the taxation of virtual currency generally. This was the first guidance released by the Service on the subject since issuing Notice 2014-21 in 2014. A discussion of the 2014 guidance and related issues is available here.
Revenue Ruling 2019-24
Revenue Ruling 2019-24 addresses the income tax consequences to taxpayers that hold a virtual currency that experiences a hard fork. In general, a virtual currency is a digital system of value (other than the U.S. dollar or a foreign currency). Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are recorded on a distributed ledger, such as a blockchain. The blockchain holds the ownership records of the virtual currency, and all transfers of the currency are recorded on the distributed ledger. A hard fork occurs when the currency undergoes a protocol change that results in a diversion of the distributed ledger (i.e., a split of a single strand of code into two separate strands that are not compatible with each other). A hard fork may result in one virtual currency becoming two separate virtual currencies, such as the widely publicized 2017 hard fork of bitcoin that resulted in the creation of a new virtual currency — bitcoin cash. In that transaction, every holder of bitcoin retained their bitcoin and also received bitcoin cash.
Revenue Ruling 2019-24 holds that when, as a result of a hard fork, a taxpayer receives new virtual currency over which it has dominion and control (including from an air drop, which is where a taxpayer’s ledger account is credited with additional virtual currency), the fair market value of the new virtual currency is included in the taxpayer’s income on the date of receipt as ordinary income, and the taxpayer’s basis in such currency is equal to the amount of the income recognized. Thus, the amount of income recognized is neither affected by the taxpayer’s pre-fork tax basis in the virtual currency nor in the pre- and post-fork trading prices of such currency. For example, assume a taxpayer owns virtual currency S with a tax basis of $50 and a fair market value of $100. S undergoes a hard fork that results in the taxpayer receiving new virtual currency T that trades at a price of $25. The taxpayer in that case would recognize $25 of ordinary income, regardless of whether the taxpayer’s basis in S is $0, $50 or $100, and regardless of whether following the fork the trading price of S remains $100 or drops to $75.
The holding is fundamentally premised on (i) the Service’s conclusion in Notice 2014-21 that virtual currency is property for tax purposes and (ii) the general principle that a taxpayer recognizes income when the taxpayer's property generates cash or other property. The taxpayer retains the property it originally owned and also acquires new property. The value of the latter constitutes income, and because the taxpayer retains the property it originally owned (rather than disposes of a portion of such property), its tax basis in such property is not relevant in determining the amount of income recognized and the income is ordinary.
While this analysis is certainly reasonable and is somewhat analogous to a distribution of cash or property in respect of stock, there are other ways to view a hard fork. For example, a hard fork could be viewed as a split or division of the pre-fork virtual currency into two separate virtual currencies. It is not the receipt of something new, but rather a division of what existed into two items of property. This characterization is more akin to a stock split or a stock dividend in shares, or to a subdivision of land, none of which are taxable. Even if a hard fork is more analogous to a distribution of property in respect of stock, such distributions are only taxable to the extent of the corporation’s earnings and profits and otherwise constitute a return of capital to the extent of the holder’s basis. In other words, the tax law acknowledges that a distribution by a corporation is not taxable to the extent it represents a distribution of part of the corporation’s corpus.
Moreover, the treatment set forth in the Revenue Ruling could lead to harsh results. If the value of the pre-fork virtual currency declines following the fork (which one would expect to occur at least some of the time in an efficient market), the taxpayer could have taxable income without any accretion to wealth. Rather, the taxpayer could end up with a capital loss in the original virtual currency that cannot offset the ordinary income from the hard fork. When Ethereum underwent a hard fork in 2016, at the time almost all of the value shifted to the new virtual currency created, while the value of the pre-fork virtual currency dramatically declined.
On the same day that the Service issued Revenue Ruling 2019-24, it released “Frequently Asked Questions on Virtual Currency Transactions” (FAQs). Two overlapping factors led to the issuance of the FAQs. First, many taxpayers trading in virtual currencies are not familiar with certain basic tax concepts and principles relevant to the proper treatment of virtual currency transactions. Second, and perhaps to some extent a consequence of the first, there is a tremendous lack of compliance with tax reporting and payment obligations in connection with virtual currency transactions. The FAQs are part of an effort by the Service to put taxpayers on notice of their tax obligations.
The FAQs reiterate the Service’s conclusion in Notice 2014-21 that virtual currency is property for federal income tax purposes, and transactions involving virtual currency should be analyzed in that context. The FAQs provide general answers to questions concerning common virtual currency transactions, including sales, purchases, and exchanges for property or services. Select topics are discussed below.
Establishing the fair market value of a virtual currency is critical in determining the tax consequences of the receipt and disposition or exchange of virtual currency. Yet, due to volatility in value and, frequently, lack of centralized valuation systems, establishing the value of any specific virtual currency creates difficulties for many taxpayers. Even if there were sources available for establishing the value of a virtual currency at a given time, such sources frequently do not agree on a uniform value for the virtual currency.
The FAQs provide that if a virtual currency is received in a transaction facilitated by a virtual currency exchange, the value of the virtual currency received is the amount recorded by the exchange for that transaction in U.S. dollars. If the transaction is not recorded on a distributed ledger, then the fair market value is the amount the virtual currency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger. The Service will accept as evidence of fair market value the value as determined by a virtual currency explorer that analyzes worldwide indices of a virtual currency and calculates the value of the virtual currency at an exact date and time. If none of the above options are available, the value of the virtual currency is equal to the fair market value of the property or services exchanged for the virtual currency when the transaction occurs. While this latter approach may not lead to readily determinable values, that is an endemic problem in valuing any form of non-publicly traded property and is not unique to virtual currency. If virtual currencies gain traction as a means of exchange, then presumably valuation methodologies will develop to provide for market efficiency and functionality.
The FAQs provide that, generally, the holding period for virtual currency begins on the day after it is received. In the case of a gift of virtual currency, the holding period is tacked to that of the prior owner, provided that the taxpayer has proper documentation to establish the prior owner’s holding period.
The basis of virtual currency in the hands of a taxpayer is generally equal to the cost to acquire the currency, or if exchanged for services or property, the fair market value of the virtual currency on the date of receipt. When a taxpayer that owns multiple units of the same virtual currency with different bases sells some of its units, the taxpayer may choose (i.e., specifically identify) which units are sold, provided the taxpayer can substantiate its basis in such units. This approach is consistent with existing rules for allocating basis in property other than securities. However, in many instances it is difficult for taxpayers to maintain a record of separate tax bases of the virtual currency they own and to specifically identify which currency is sold. Perhaps in recognition of this, the FAQs provide that if a taxpayer does not specifically identify which units are sold, the units are deemed sold in the order of acquisition — i.e., on a first-in, first-out basis.