On October 9th, the Internal Revenue Service (IRS) issued the first cryptocurrency tax guidance since 2014, advising digital currency holders on how to pay taxes on investments. The new Revenue Ruling provides FAQs covering basis, gain or loss on the sale or exchange of digital currency, and ways to determine the fair market value on the tax treatment of a cryptocurrency hard fork. Importantly, the guidance clarifies when taxes are due—an ongoing point of confusion.
As the IRS penalizes taxpayers for non-compliance, accurate record keeping is increasingly critical.
What is a Hard Fork?
A hard fork occurs when cryptocurrency on a distributed ledger experiences a shift, which may create a new cryptocurrency. In this instance, two blockchains and two currencies could occur. Transactions involving the new cryptocurrency are now recorded on the new distributed ledger, while transactions involving the former cryptocurrency are recorded in the previous distributed ledger.
Things get complicated if a hard fork is followed by an airdrop, which is a method of distributing units of a cryptocurrency to the distributed ledger addresses of numerous taxpayers. If a hard fork occurs before an airdrop, units of the new cryptocurrency are distributed to addresses comprising the legacy cryptocurrency. However, a hard fork is not always followed by an airdrop leaving the taxpayer with no receipt of the transaction when the airdrop is recorded on the distributed ledger.
A tax issue can arise if the digital currency is not immediately credited to the taxpayer’s account during the exchange. If the taxpayer is later able to transfer, sell, exchange, or get rid of the cryptocurrency, the taxpayer is regarded as receiving the cryptocurrency at that time.
How Does the New Guidance Streamline Reporting?
In terms of the new guidance’s clarification regarding a hard fork, think about it like this: if there is a fork but no new food on or near your plate, no income tax; and if there is a fork and you get new food on your plate, or you are able to eat the new food as you wish, you pay ordinary income tax on the fair market value on the day you received the new food.
Example 1: if you own BTC and there is a hard fork, and new crypto/token BCH (example) is created, but you do not receive any of it and do not have constructive receipt through exercise, control or dominion over the newly created BCH, you pay no income tax (on the creation of the BCH).
Example 2: f you own BTC and there is a hard fork, and new crypto/token BCH is created, and you either receive some BCH through an airdrop or have constructive receipt of the BCH through exercise, control or dominion over the newly created BCH, then you pay ordinary income tax based on the fair market value on the day of receipt or control over the BCH.
Owners of “existing”crypto may disagree with the IRS’s position that receipt of a newcrypto, or asset, from a hard fork of an existingcrypto should be immediately taxable to the owner of the existing crypto. Instead, the owners of the existing crypto may argue that the new forked crypto has no value upon receipt, and separately, the new forked crypto should be non-taxable upon receipt and with a zero basis, or perhaps apportioned basis, somehow. Please note that taxpayers’ opposing views and arguments (above) are not supported by, and in direct contrast with the promulgated Revenue Ruling. This IRS Revenue Ruling is considered to be “sub-regulatory” guidance. It does not have the force and effect of legislation. As the IRS conveyed in its recent Policy Statement on the Tax Regulatory Process:
Sub-regulatory guidance is not intended to affect taxpayer rights or obligations independent from underlying statutes or regulations. Unlike statutes and regulations, sub-regulatory guidance does not have the force and effect of law. Taxpayers can have confidence, however, that the IRS will not take positions inconsistent with its sub-regulatory guidance when such guidance is in effect. In applying sub-regulatory guidance, the effect of subsequent legislation, court decisions, rulings, and procedures must be considered.
Main Highlights From the FAQs.
The FAQ portion of the guidance is a valuable resource for taxpayers as it expands upon several points, including the following:
- A transfer is a non-taxable event if you transfer digital currency from a wallet, address, or your account to another wallet, address, or account that also belongs to you..
- The receipt of digital currency in exchange for performing services does not result in income.
- Compensation for services paid in digital currency that is measured in U.S. dollars at the date of receipt is subject to federal income tax withholding and employment taxes. If the cryptocurrency received is neither traded on any cryptocurrency exchange nor does it have a published value, then the value received equals the fair market value of the property or services exchanged at the time of the transaction.
- If you pay for goods or services using digital currency, the above holds true. When you make the payment, you will have a capital gain or loss. In this instance, your gain or loss is the difference between the fair market value of the services you received, and your adjusted basis in the exchanged digital currency.
- If you receive digital currency as a gift, you will only recognize income when you sell, exchange, or if it is no longer used.
- If you make a gift of digital currency to a charitable organization, you will not recognize income, gain, or loss from the donation. You will be entitled to a charitable contribution deduction equal to the fair market value of the currency when the donation is made if you have held it for a year or more.
To avoid significant penalties, taxpayers must maintain adequate tax return records. Contact Adnan Islam or your Friedman advisor to learn more about this recent guidance and ensure that your reporting process will keep you on the right side of the law.