Tag: cryptocurrency

IRS

Taxation of cryptocurrency forks and airdrops

In Revenue Ruling 2019-24 the IRS considered what are the tax consequences of crptocurrency forks and airdrops.  Those of us who hold, or held, cryptocurrency during widely-followed forks, such as Bitcoin’s 2018 fork into Bitcoin and Bitcoin Cash, know the drill.  The development community can’t agree on fundamental issues about the particular cryptocurrency, such as the amount of data each “block” should carry and how often such blocks should be validated on the blockchain.  Rather than compromising, one faction or the other generates a new code base using the existing coin and adds (or subtracts) their modifications, later releasing the new code into the world as a new coin or token.  Voila, the “fork” (as in a fork in the road) has birthed a new cryptocurrency on its very own blockchain, to thrive or survive alongside its “parent” coin.  Sometimes (as has been the case with Bitcoin Cash), that new coin thrives quite handsomely, resulting in increased wealth in the hands of the HODLer.  Money for nothing?  According to the IRS, actually, no.

The Revenue Ruling’s definitions of cryptocurrency and the mechanics of forking and airdrops is, to the credit of the IRS, spot on.  Someone has been doing their homework into what exactly they are looking at, which is important, since bad inputs make for bad outputs.  In summary, the Ruling notes that the end result of the fork is one of two scenarios:  (i) the taxpayer receives the new cryptocurrency, which is credited to his account or otherwise received by him (via “airdrop”, in the terms of the opinion); or (ii) the taxpayer does not receive the new crypto for any number of reasons, the one cited being where the exchange on which the taxpayer had her pre-fork crypto does not support the new coin, and that crypto-holder’s rights vanish into thin air.

The first conclusion the IRS comes to, which is that there is gross income to the taxpayer where he or she receives the forked coin is, in my view, correct.  Under classic income tax laws there is a clear “accession to wealth”, that is, you have more money in your pocket (perhaps a lot more) post-fork than pre-fork.

Not all income, however, is created equal in the eyes of the tax law.  Once you determine you have income you must then consider the character of that income, that is, capital, ordinary, or something else.  There are books written about these distinctions.  For our purposes, “ordinary” income includes things like a salary or proceeds from the sale of your business’ inventory.  Capital gain (or loss for that matter), in contrast, relates to purchases and sales of “capital assets”.  Capital assets are, for most people, their investments, perhaps including real estate, stocks and bonds, and cryptocurrency.  This distinction is critical, since different types of income are subject to different income tax rates.

The timing matters too – ordinary income is recognized the minute you either receive it (for cash basis taxpayers) or when “all events” have occurred (for accrual basis taxpayers) that result in the taxpayer having dominion and control over the assets.  For capital assets there is a taxable event where the property is “sold or exchanged”, that is, in some cases, mere receipt of a capital asset will not always trigger tax consequences.  Rather, the law keeps a kind of “tally” of the amount of tax you will have to pay (at some point) in what’s called the “basis” of the asset.  The “basis”, in plain language, is the amount of your investment in an asset.  If the price at sale is above your basis, voila, capital gain.  If the price is below it, capital loss.

Let’s take stock splits as an example.  Let’s say you bought 1 share of Apple (AAPL) at $300.00 (everyone seems to like using Apple as an example). Assume for purposes of this example that you are not a dealer in securities or a professional trader.  What do we know about AAPL in your hands?  (1) That is is (in all likelihood) a “capital asset” (an investment outside of your ordinary trade or business); and (2) Your “cost basis” is $300.00.  As of this evening AAPL is trading at around $317.00.  What do we know now?  We know that, given your basis of $300.00, you now have $17.00 of profit.  If you sold AAPL at $317.00, you would have $17.00 of capital gain.

Fine.  Now assume that AAPL splits two for one, that is, all shareholders of AAPL will receive double the number of their shares, so now you have two shares of AAPL.  Here’s the trick:  your basis in each of the shares is also cut in half.  Therefore, you now have two shares of AAPL.  What’s the price of each?  $158.50.  What’s your basis in each?  $150.00.  What if you sold your two post-split shares of AAPL?  What would your gain be?  Still…$17.00.  See?  Your basis “account” adjusted to reflect the economic reality of the transaction, and spread your initial $300.00 investment across the two shares.

Now imagine that instead of splitting, AAPL pays you a cash dividend of $1.00 per share every quarter (it’s actually around $0.77, but let’s use round numbers).  Dividends are, unlike shares received in a stock split, ordinary income (unless “qualified”, which we won’t get into here).  OK, so why don’t we just treat the dividend like a capital asset, and adjust the basis without having a taxable event?  Well, because the law says so, and perhaps in part because dividends are paid in cash.

The question then is, did the IRS get the second part right, that is, the character of the income that you receive when you receive airdropped tokens from a hard fork.  In my opinion, no.

Forked tokens can feel like “manna from heaven” as the saying goes, but in my opinion they much more closely resemble stock splits than dividends.  My opinion is based on what the IRS has told us for many years – that cryptocurrency is property, not money.  Property held as a capital asset that produces more property (like a stock split) should be treated in the same manner as a stock split, and not as if the forked coins are the same as cash, which they most certainly are not.

For starters, the recipient of the forked coin has extreme price risk from the get-go.  It is not uncommon for a forked coin to spike wildly upon receipt (which, according to the opinion, is then its taxable value) only to collapse violently thereafter.  The token holder may not stand a chance – if you’re not in front of your computer ready, willing and able to sell at the precise moment the coin is received – you may end up with a big tax bill AND an asset that has declined significantly in value.  This is neither consistent nor fair.  A true dividend does not have this inherent risk.  True, currencies are always fluctuating in value against other currencies (and gold), but in the short term, your $1.00 AAPL cash dividend is going to buy the same amount of coffee (perhaps half a cup) whether you’re at your computer when its paid or not.

Second, the IRS has further confounded and complicated cryptocurrency accounting for everyone.  It is bad enough that technically, you have to report either gain or loss for the use (that is, “sale or exchange”, remember?) of crypto for anything, including our proverbial cup of coffee.  Now, you must track the basis of assets with different characters.  This will be a huge challenge for developers of crypto accounting and recordkeeping software, thereby making the neat and clean records the IRS wants taxpayers to keep all the more elusive, and often inaccurate.

In essence, the IRS is looking to have it all ways – cryptocurrency is property subject to the reporting and accounting for capital gain and loss, except when it’s not.  And by the way, if you DO decide to hang on to your airdropped coins, only to sell them later if the price goes way up, you may also have capital gain to pay later, on the very same asset that gave rise to ordinary income upon receipt, even though that asset was really capital in nature all along.

So, brush off your spreadsheets.  Between cold storage wallets, intra-exchange transfers, and now, airdropped, forked coins, it will continue to be a challenge to stay in compliance in the crypto world.

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