Front Page Story and Back Page Correction: IRS Clarifies Its Public Cryptocurrency Position in Internal Guidance
In Revenue Ruling 2019-24, the US Internal Revenue Service (“IRS”) ruled that a holder of cryptocurrency who experienced a hard fork followed by an airdrop (in which the new currency emerging from the hard fork was distributed) had taxable income equal to the value of the currency received. My bitcoin-savvy friends thought the rule was gibberish because hard forks and airdrops have nothing to do with one another. In a you-know-what-I-meant IRS Chief Counsel Memorandum, dated March 22, 2021, the IRS corrected the nomenclature that it used in Revenue Ruling 2019-24. ILM 202114020 also provides further guidance on airdrops.
I. Once Again, a Tax Lawyer Attempts to Explain Aspects of the Cryptocurrency Market
An airdrop occurs when a person delivers free cryptocurrency to a custodial account. Frequently, these giveaways are conditioned on the performance of an act, such as promoting the use of the distributed currency or some other social media highlighting. On August 1, 2017, Bitcoin Cash was distributed on a 1:1 basis for all Bitcoins held in an eligible account. The giveaway was prompted by the fact that all digital mining for Bitcoin itself had been completed and Bitcoin Cash mining could replace this activity. On April 1, 2021, each Bitcoin Cash coin was worth approximately $558.20.
ILM 202114020 concludes that recipients of the August 1, 2017 airdrop recognize taxable ordinary income as a result of receiving the airdrop regardless of “the specific means by which the new cryptocurrency is distributed or otherwise made available to a taxpayer.” This conclusion is consistent with the position taken in Revenue Ruling 2019-24 (without consideration of whether the airdrop is accompanied by a hard fork).
Given the volatility of cryptocurrencies, the question as to when the income is recognized and how the cryptocurrency is valued are important. The answer to the timing question is that the receipt of the airdrop is taxable as soon as the recipient can exercise dominion and control over the cryptocurrency. As a result, if the airdrop is made to a wallet that the recipient cannot “open,” no income is recognized until the cryptocurrency is released to the recipient. If the cryptocurrency has appreciated, the recipient would expect to recognize a greater amount of income at this later date. The situation would be exacerbated in a rising rate environment. As for valuation, ILM 202114020 states that the fair market value of the Bitcoin Cash can be determined “using any reasonable method.”
II. And as Though He Didn’t Already Learn His Lesson
In contrast to airdrops, hard forks occur when an existing unit of cryptocurrency (often, a “Coin”) is split in two. This occurs when the predecessor unit of cryptocurrency becomes obsolete, invalidating prior history. A fork is simply a change in the blockchain’s protocol that the software uses to decide whether a transaction is valid or not. If enough people continue to desire to trade the predecessor units, there will be two separate currencies. On the other hand, if use of the predecessor currency becomes obsolete, each holder will be required to update the protocols for storage and transfer to the successor units. This is exactly what happened with Bitcoin Cash. So while it is easy to see how airdrops are taxable, it is less clear that hard forks in and of themselves should be considered to result in ordinary income. But the IRS confused the two events.
Specifically, airdrops are akin to income paid on property or compensation for services. Hard forks, on the other hand, are more akin to recapitalizations or the splitting up of property that is already owned. Hard forks could be treated as sales or exchanges, but it’s unlikely that the new blockchain would differ materially in kind and extent so as to be treated as a taxable sale or exchange. In each of Revenue Ruling 2019-24 and ILM 202114020, the IRS has held, however, that hard forks should be taxed in the same manner as airdrops. Hopefully, this same treatment of extremely different transactions will be fixed over time, even if it is by means of another back page correction.
