On October 9, 2019, nearly five years after it last issued guidance, the Internal Revenue Service issued Revenue Ruling 2019-24 to provide new guidance for taxpayers who engage in transactions involving virtual currency, including cryptocurrency. The new guidance addressed the tax treatment of a cryptocurrency under two situations:
1. Does a taxpayer have gross income under section 61 of the Internal Revenue Code (Code) as a result of a hard fork of a cryptocurrency the taxpayer owns if the taxpayer does not receive units of a new cryptocurrency?
2.Does a taxpayer have gross income under section 61 as a result of an airdrop of a new cryptocurrency following a hard fork if the taxpayer receives units of new cryptocurrency?
According to IRS Commissioner Chuck Rettig, “[t]he new guidance will help taxpayers and tax professionals better understand how longstanding tax principles apply in this rapidly changing environment. We want to help taxpayers understand the reporting requirements as well as take steps to ensure fair enforcement of the tax laws for those who don’t follow the rules.”23
In 2014 the IRS issued Notice 2014-21 (2014-16 I.R.B. 938) which describes how the IRS applies U.S. tax principles to transactions involving virtual currency. According to the IRS, virtual currencies that can be converted into traditional currency are considered “property” for tax purposes, and a taxpayer can have a gain or loss on the sale or exchange of a virtual currency, depending on the taxpayer’s cost to purchase the virtual currency (i.e., tax basis). Thus, under general tax principles applicable to property transactions, the sale of other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences that could result in tax liability. According to the IRS, taxpayers who have engaged in any of these virtual currency transactions and have not properly reported the virtual currency transaction have failed to comply with internal revenue laws, and, when appropriate, can be liable for penalties and interest. In addition, the IRS announced last year that those dealing in large amounts of cryptocurrency may also be subject to criminal prosecution, should they fail to correctly report the income tax consequences of digital currency transactions. Criminal charges could include tax evasion and filing a false tax return. Taxpayers convicted of tax evasion may be subject to a prison term of up to five years and a fine of up to $250,000. Anyone convicted of filing a false return is subject to a prison term of up to three years and a fine of up to $250,000. The following virtual currency transactions must be reported to the IRS:
• Wage, salary, or other income paid to an employee with virtual currency is reportable by the employee as ordinary income, subject to employment taxes.
• Virtual currency received by a self-employed individual in exchange for services is ordinary income subject to self-employment tax.
• Virtual currency received in exchange for goods or services by a business is reportable as ordinary income.
• Gain on the sale of property held as a capital asset in exchange for virtual currency is reportable as a capital gain.
• Gain on the exchange of virtual currency for other property is generally reported as a capital gain if held as a capital asset and as ordinary income if it is property held for sale to customers in a trade or business.
• Payments made in virtual currency are subject to information reporting requirements to the same extent as payments made in real currency or instruments denominated in real currency.
Hard Forks and Airdrops
The new guidance focuses on hard forks and airdrops. A hard fork occurs when an existing cryptocurrency undergoes a shift – the IRS defines it as a “permanent diversion from the legacy or existing distributed ledger.” A hard fork may result in the creation of a new cryptocurrency – a second currency with a separate blockchain. Following a hard fork, transactions involving the new cryptocurrency are recorded on a new distributed ledger.
An airdrop is a way of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers. A hard fork followed by an airdrop results in the distribution of units of the new cryptocurrency to addresses containing the legacy (former) cryptocurrency. However, a hard fork is not always followed by an airdrop.
According to the IRS, a taxpayer receives an airdrop of cryptocurrency on the date and at the time the airdrop is recorded on the distributed ledger. However, a taxpayer is not deemed to receive the cryptocurrency when the airdrop is recorded on the distributed ledger if the taxpayer does not exercise dominion and control over the cryptocurrency before the airdrop is recorded on the distributed ledger. If the taxpayer later acquires the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency, the taxpayer is treated as receiving the cryptocurrency at that time. Accordingly, Revenue Ruling 2019-24 concludes (i) that a taxpayer does not have gross income as a result of a hard fork if the taxpayer does not receive the new cryptocurrency (no accession of wealth), and (ii) the taxpayer does have gross income if, as the result of an airdrop following a hard fork, the taxpayer receives units of new cryptocurrency (taxpayer has dominion and control).
If the taxpayer receives a new asset in the airdrop following the hard fork, the taxpayer has an accession to wealth and the Revenue Ruling states that this wealth is ordinary income in the taxable year in which the new cryptocurrency is received. The amount of the ordinary income is the fair market value of the new cryptocurrency. The taxpayer’s basis in the new cryptocurrency is the amount of income recognized. Accordingly, for tax purposes, airdrops can no longer be ignored when received.
New FAQs The IRS also published Frequently Asked Questions on virtual currency transactions for individuals who hold cryptocurrency as a capital asset and are not engaged in the trade or business of selling cryptocurrency.
In FAQ 29, the IRS stated that a soft fork of cryptocurrency does not result in the recognition of income. 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. Because soft forks do not result in you receiving new cryptocurrency, you will be in the same position you were in prior to the soft fork, meaning that the soft fork will not result in any income to you.
In FAQ 30, the IRS stated that the receipt of cryptocurrency in the form of a gift does not result in the recognition of income at the time of receipt of the gift. If a taxpayer receives virtual currency as a bona fide gift, the taxpayer will not recognize income until he sells, exchanges, or otherwise disposes of that virtual currency. But what about basis in the gifted cryptocurrency?
In FAQ 31, the IRS stated that the taxpayer’s basis in virtual currency received as a bona fide gift differs depending on whether you will have a gain or a loss when you sell or dispose of it. For purposes of determining whether a taxpayer has a gain, your basis is equal to the donor’s basis, plus any gift tax the donor paid on the gift. For purposes of determining whether you have a loss, your basis is equal to the lesser of the donor’s basis or the fair market value of the virtual currency at the time you received the gift. If you do not have any documentation to substantiate the donor’s basis, then your basis is zero.
In FAQ 43 the IRS stated that the Internal Revenue Code and regulations require taxpayers to maintain records that are sufficient to establish the positions taken on tax returns. Accordingly, taxpayers engaged in cryptocurrency transactions should maintain, for example, records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the virtual currency.
IRS issued letters to cryptocurrency taxpayers
In July, the IRS began sending letters to more than 10,000 taxpayers who may have failed to report or misreported transactions involving virtual currency, in violation of federal tax law. The letters – designated as Letter 6173, Letter 6174 and Letter 6174-A, stated that those who have profited from the trade or use of cryptocurrency may be liable for tax, penalties, and interest. Letters 6174 and 6174-A are informational and do not state that a response is required. However, Letter 6173 does require by a date specified in the letter that either the submission of any unfiled tax returns, filing of amended returns or for the taxpayer to certify under penalties of perjury that all tax reporting retirements relating to virtual currency were followed. The IRS is sending the letters to those taxpayers believed to have been involved in cryptocurrency transactions between 2013 and 2017. Although the IRS has not disclosed the source of its information, one likely source for the IRS is Coinbase, which was ordered by a federal court to provide the IRS data on approximately 13,000 accounts. In some cases, taxpayers could be subject to criminal prosecution. Commissioner Rettig has publicly stated that “[t]axpayers should take these letters very seriously. The IRS is expanding efforts involving virtual currency.”24