In March 2014, the IRS issued Notice 2014-21 (the “2014 Notice”) providing that virtual currency1 is treated as property for U.S. federal income tax (“U.S. tax”) purposes. Prior to the issuance of the 2014 Notice, it was not entirely clear that virtual currency would be treated as property rather than as foreign currency. As a result of the classification of virtual currency as property, gain or loss from the sale or exchange of virtual currency held as a capital asset generally is treated as capital gain or loss. The remaining portions of the 2014 Notice provide rules that follow logically from the treatment of virtual currency as property, such as requiring a taxpayer who receives virtual currency as payment for goods or services to treat the fair market value of the virtual currency (determined by converting the virtual currency into U.S. dollars at the exchange rate at the relevant time, in a reasonable manner that is consistently applied) as payment for goods or services as of the date that the virtual currency is received. Furthermore, the 2014 Notice provides that a payment made using virtual currency is subject to information reporting and backup withholding to the same extent as any other payment made in property.
On the date the 2014 Notice was issued, the price of one bitcoin was approximately $573 and the total market value of all cryptocurrencies was roughly $8.28 billion. Since that time, the virtual currency market has experienced a massive increase in the number of virtual currencies that are traded and the value of many of such virtual currencies. After falling from all-time highs in December 2017, the price of one bitcoin was approximately $8,329 as of October 15, 2019 and the total market value of all cryptocurrencies as of such date was approximately $225.87 billion. The 2014 Notice states that “the Treasury Department and the IRS recognize that there may be other questions regarding the tax consequences of virtual currency not addressed in this notice that warrant consideration” and requested comments from the public on other aspects that should be addressed in future guidance. A number of trade organizations and practitioners have provided comments and requested further guidance since the 2014 Notice was issued; however, prior to the Guidance, the IRS had not issued additional guidance regarding virtual currencies other than a “reminder” in March 2018 for taxpayers to report their virtual currency transactions on their income tax returns.2
Despite the lack of official IRS guidance on a number of important virtual currency-related issues, the IRS has taken steps to increase its civil and criminal tax enforcement efforts with respect to virtual currency transactions. In November 2017, the IRS obtained a federal court order compelling Coinbase, a virtual currency exchange, to identify an estimated 14,000 customers who traded $20,000 or more in virtual currencies and to provide details about those transactions. In 2018, the IRS announced a Virtual Currency Compliance campaign to address non-compliance related to virtual currency.3 More recently, the IRS Criminal Investigation Division has indicated that a number of criminal virtual currency cases will become public soon.
As part of the IRS’s increased enforcement, certain taxpayers who currently hold or previously held virtual currencies have received letters regarding virtual currency-related reporting requirements.4 Although the IRS has referred to these letters as “educational” letters, taxpayers will want to exercise due care in providing appropriate responses. Taxpayers who have not properly reported the income tax consequences of virtual currency transactions may be liable for taxes, penalties and interest and, in some cases, may be criminally prosecuted.
In the draft of the 2019 IRS Form 1040, Schedule 1, the IRS added the following question for taxpayers about their virtual currency transactions: “At any time during 2019, did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?” Schedule 1 applies to taxpayers who are required to report types of income that are not included on the main Form 1040.
Revenue Ruling Addresses Hard Forks and Airdrops
In recent years, many virtual currencies have experienced forks. Generally, a fork is a change in the protocol software of a virtual currency. A fork may be classified as a hard fork or a soft fork. As described in the Revenue Ruling, a “hard fork” occurs when a virtual currency on a distributed ledger (i.e., the blockchain) undergoes a protocol change that causes a permanent split from the existing distributed ledger. The new software published and adopted as part of the hard fork is no longer compatible with prior versions. Consequently, hard forks may result in the creation of a new virtual currency on a new distributed ledger (i.e., a “chain split”) if participants continue to mine blocks under both the “old” version of the software and the post-fork version of the software.5 In the case of a chain split, the existing virtual currency would continue to be recorded on the existing distributed ledger and a new distributed ledger would be created that typically would mirror the account state of the existing distributed ledger up to a certain point in time. However, hard forks routinely occur as part of technical upgrades to blockchain protocols where there is neither a chain split nor distribution of a new virtual currency (e.g., a non-contentious hard fork).
The IRS refers to the method in which holders of the existing virtual currency receive distributed units of the new virtual currency as an “airdrop”. An airdrop is a mechanism to distribute a new virtual currency to holders of an existing virtual currency. While airdrops often occur in connection with a hard fork, airdrops also occur independently from hard forks and chain splits. A “soft” fork results in the issuance of new software that maintains compatibility with existing software.
The Revenue Ruling draws a clear distinction between a hard fork that results in the creation of a new virtual currency as compared to a hard fork that does not result in the creation of a new virtual currency.
In the Revenue Ruling, the IRS concludes that in a hard fork where the taxpayer did not receive units of the new virtual currency (i.e., no chain split occurred), the taxpayer does not have gross income as a result of the hard fork. While the Revenue Ruling is silent regarding soft forks, the Q&A confirms that a taxpayer is not required to take into account income as a result of a soft fork.
However, where the taxpayer received a new virtual currency in an airdrop following a hard fork, the ruling states that the taxpayer has an accession to wealth, and consequently has ordinary income in the taxable year in which the new virtual currency is “recorded on the distributed ledger.”6 In the case of such an airdrop, the taxpayer has an initial tax basis in the new virtual currency equal to the amount of income realized in connection with the airdrop. In support of its conclusion that the airdrop results in gross income, the ruling’s statement of law cites only section 61(a)(3), which includes gains derived from dealings in property in gross income, and Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955), which held that “accessions to wealth, clearly realized, over which a taxpayer has complete dominion are included in gross income.” The analysis does not explain why the airdrop results in the realization of either gain derived from property dealings or an accession to wealth. While Glenshaw Glass involved a taxpayer’s receipt of cash (such that no further realization event could have been required), the facts of the Revenue Ruling involve only changes to the blockchains in which the taxpayer has property rights. The Revenue Ruling does not analyze whether such changes involve a “sale or other disposition of property” under section 1001 that results in the realization of gain from dealings in property. The Revenue Ruling also fails to address airdrops outside the context of a hard fork (for example, through so-called “promotional airdrops”), but presumably the IRS will adopt the same position as in the hard fork context.
The Revenue Ruling introduces a number of complex and difficult reporting questions for airdrops of new virtual currencies that have de minimis value (which may include promotional airdrops). The Revenue Ruling does not include any exceptions from income realization treatment for hard forks that results in an airdrop of a new virtual currency other than where the taxpayer has no dominion and control over such virtual currency. In particular, the Revenue Ruling does not address logistical and security challenges for taxpayers who hold their virtual currency wallets in “cold storage” (i.e., neither the existing virtual currency nor the new virtual currency may be readily accessible).
In addition, the Revenue Ruling does not address airdrops of volatile new virtual currencies that significantly drop in value following the airdrop, or new virtual currencies that are difficult to value or that have limited marketability. The Revenue Ruling also fails to address airdrops where the existing virtual currency becomes effectively worthless immediately following the hard fork and where the new virtual currency has significant value. This type of scenario is common following a chain split because typically at least one of the two chains will have a thin market and, therefore, may be subject to volatile price fluctuations.
Prior to the issuance of the Revenue Ruling, the IRS had issued no guidance regarding forks or airdrops. Accordingly, the Revenue Ruling announces the IRS position on these issues for the first time. As the Revenue Ruling does not include an effective date, the IRS may seek to apply the positions described in the Revenue Ruling retroactively to transactions that occurred prior to October 9, 2019. In March 2019, the Department of Treasury and the IRS had stated in a Policy Statement on the Tax Regulatory Process that it would not use subregulatory guidance (like revenue rulings) if the intended interpretation would have the effect of creating new legislative rules on matters not addressed in existing regulations.7 Given that there are no existing regulations that warranted application by the Revenue Ruling, and given the absence of analysis in the Revenue Ruling of whether a hard fork results in a realization event, the issuance of the Revenue Ruling rather than notice-and-comment rulemaking to address this issue appears inconsistent with the Policy Statement. It is also more likely to invite taxpayers to take positions contrary to the IRS’s position than if the IRS had issued regulations.
Q&A Supplements Existing Guidance
The Q&A provides a summary of the IRS’s position on various virtual currency-related issues and supplements the 2014 Notice and the Revenue Ruling; however, the Q&A principally restates existing law (including the rules articulated in the 2014 Notice and the Revenue Ruling) and does not provide significant additional guidance.
The Q&A provides that a taxpayer is entitled to specifically identify which unit or units of virtual currency are involved in a sale or exchange. A taxpayer may document this through a private key, public key, and address or by records showing the transaction information, including the (i) date and time each unit was acquired, (ii) taxpayer’s basis and fair market value at the time of acquisition, (iii) date and time each unit was sold or exchanged, and (iv) fair market value of each unit when sold or exchanged. If a taxpayer does not specifically identify which unit or units of virtual currency are involved in a sale or exchange, the IRS will deem the unit or units as sold on a first in, first out (FIFO) basis. The Q&A also confirms that taxpayers are not required to recognize income as a result of transfers between wallets, addresses or accounts owned by the same person.
Significant Issues Remain
The Guidance does not address a number of open U.S. tax issues that market participants have raised over the last several years. In particular, the Guidance does not provide any de minimis exception with respect to recognition of gain on virtual currency transactions (e.g., permitting taxpayers to not report transactions under a certain dollar threshold), which likely would require action by Congress. The Guidance does not provide any description of international tax reporting or compliance issues, such as “subpart F” treatment of non-U.S. token issuers, or U.S. trade or business issues for non-U.S. traders or dealers in virtual currency under section 864(b).
We will continue to monitor developments in this area. Please contact any member of the Shearman & Sterling LLP tax team for further information.
1 The IRS has defined the term “virtual currency” as “a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the United States dollar or a foreign currency” and has described cryptocurrency as a type of virtual currency.
5 The two most well-known examples of hard forks that resulted in chain splits are the October 2016 fork which created Ethereum Classic, and the August 2017 fork which created Bitcoin Cash. In both forks, sufficient mining resources continued to mine the existing software (in the case of Ethereum (“ETH”), what is now referred to as Ethereum Classic (“ETC”), and in the case of the Bitcoin Cash (“BCH”) fork, what is known as Bitcoin (“BTC”). In each case, holders of ETH on the date of the ETC fork received an equivalent amount of “new” ETC in their accounts, and holders of BTC received an equivalent amount of “new” BCH in their accounts.
6 The Revenue Ruling states that a taxpayer is not treated as receiving the new cryptocurrency until it can exercise dominion and control over such cryptocurrency (e.g., the applicable wallet must support the new cryptocurrency).
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