On October 9, 2019, the Internal Revenue Service (“IRS”) released its latest buzzkill, Rev. Rul. 2019-24, answering questions involving hard forks of cryptocurrency, which, as explained more below, is where a new type of cryptocurrency is created and there is a permanent diversion from legacy currency or existing distributed ledger. In conjunction with the release of Rev. Rul. 2019-24, IRS also released new FAQs involving virtual currency transactions.1 Previously, in Notice 2014-21, the IRS explained what virtual currency is, how it has an equivalent value to currency, and that cryptocurrency is a type of virtual currency that uses cryptography to digitally record transactions on a distributed ledger. Additionally, and perhaps most importantly, the IRS explained that virtual currency is treated as property for federal income tax purposes. The consequences of such treatment are that any exchange of virtual currency is a tax recognition event triggering gain or loss on any appreciation or depreciation.
Ruling 2019-24 Summary
Rev. Ruling 2019-24 addresses “hard forks” and taxability associated with a hard fork where a new cryptocurrency is “airdropped” to the holders of the existing cryptocurrency at the time of the hard fork.
First, in the cryptocurrency world, we come across some new vocabulary.
A “hard fork” occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the existing distributed ledger. A hard fork may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency 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.
An airdrop is a means 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 cryptocurrency. However, a hard fork is not always followed by an airdrop. When a hard fork is followed by an airdrop, the cryptocurrency holders effectively acquire new interests without any action. It happens automatically.
Relevant to the issues discussed are Internal Revenue Code Sections 61(a)(3), 1273(b)(5), 1011, 1016, and 451(b)(1)(C). In summary, gross income means income from whatever source derived, including gains from the sale or exchange of property. A taxpayer using the cash method of accounting includes an itemin gross income in the year it is actually or constructively received. A taxpayer using an accrual method of accounting generally includes an amount in gross income no later than the tax year in which all the events have occurred which fix the right to receive such amount.
The Two Hypotheticals
Rev. Rul. 2019-24 presented two scenarios:
In Situation 1, a hard fork occurred, but there was not an airdrop. In this scenario, there was no tax as a result of the hard fork because the taxpayer did not have an accession to wealth as no new property was received.
In Situation 2, there was an airdrop and the holder of the cryptocurrency was deemed to have ordinary income at the time of the airdrop because the taxpayer, upon receipt of the new airdropped cryptocurrency, would be able to dispose of that new cryptocurrency.
The Fun Kill
It seems that the ruling distinguishes taxability upon the recipient’s ability to dispose of the new cryptocurrency created from the hard fork . Since no special rule applies and due to the fact the hard fork is not considered a sale or exchange of capital assets, the income, per the Revenue Ruling, is ordinary.For example, Bitcoin Cash (BCH) (aka “Not Bitcoin”) forked at block 556766, November 15, 2018. For each Bitcoin Cash an owner held at the time, that owner received one Bitcoin SV (BSV). At the beginning of November 14, 2018, the day before the hard fork, Bitcoin Cash was trading for $514.43. As of the beginning of November 15, 2018, the day following the hard fork, Bitcoin Cash was trading for $444.07. At open on November 15, 2018, Bitcoin SV’s value was $176.28.2 Thus, based on the foregoing, it seems that the event carried with it massive tax ramifications for those holding substantial amounts of Bitcoin Cash. Based on Rev. Ruling 2019-24, a taxpayer holding one BCH at the time of the hard fork would be subject to ordinary income on the $176.28. Tragically, holders of Bitcoin SV experienced a drop to around $100 following the hard fork. In this case, there would be, assuming a top marginal rate of 37%, a $65 tax bill on the BSV received from the hard fork by virtue of the ownership of the one BCH. Compound the tax bill with the $76 drop in value and a holder would net approximately $35. With a capital gains rate of 23.8%, including net investment income tax, the holder would be able to offset about $18 in tax from the losses.
At its core, the result of this hard fork and the dip in value almost resulted in an aggregate negative effective wealth increase for owners of Bitcoin Cash. With the ordinary income hit on the front end and potential capital loss on the back end, the result of this scenario yields a similar result to that of a section 83(b) election gone bad. The risk here however is that with substantial holdings, one may find themselves unable to utilize the capital loss but whipsawed with ordinary income.
For those with substantial cryptocurrency holdings, news of a hard fork is not to be taken lightly. Some planning can go a long way and as shown above and based on the IRS position described in the Revenue Ruling, there is a substantial possibility of a whipsaw effect.