The IRS finally released its promised guidance on tax issues related to cryptocurrencies in the form of Revenue Procedure 2019-24[1] and a set of frequently asked questions on the IRS website.[2]

The Revenue Procedure looks to answer a question many have had about how to treat the hard fork of a cryptocurrency. The best-known hard fork of a cryptocurrency was the fork that created Bitcoin Cash in August 2017.[3] Investopedia’s article on Bitcoin Cash describes the fork and related issues as follows:

Amidst a war of words and staking out of positions by miners and other stakeholders within the cryptocurrency community, Bitcoin Cash was launched in July 2017. Each Bitcoin holder received an equivalent amount of Bitcoin Cash, thereby multiplying the number of coins in existence. Bitcoin Cash debuted on cryptocurrency exchanges at an impressive price of $900. Major cryptocurrency exchanges, such as Coinbase and Itbit, boycotted Bitcoin Cash and did not list it on their exchanges.[4]

In Notice 2014-21 the IRS had defined cryptocurrencies as assets rather than currencies, defining tax treatments for sales and exchanges of such assets (normally generating capital gains and losses), as well as for mining the coin (generally giving rise to ordinary income). But the concept of a “hard fork” wasn’t covered in the guidance and isn’t much like any other transaction that tax advisers often encounter.

Some advisers had speculated it should be treated as a form of like-kind exchange (where original Bitcoin is “exchanged” for Bitcoin and Bitcoin Cash), but many had issues with that treatment and Congress effectively mooted the discussion for future forks when the Tax Cuts and Jobs Act modified IRC §1031 to limit like-kind exchanges to those exchanges involving real property. Some felt that the taxpayers receiving Bitcoin Cash had income as they had an accession to wealth by receiving the new currency (note the $900 debut price)—but, as the Investopedia article noted, major exchanges were boycotting the currency—so some individuals with Bitcoin on deposit with certain exchanges might not get access to the related Bitcoin Cash.

The IRS has attempted to give some guidance looking at whether the taxpayer has a true accession to wealth when a fork takes place.

The ruling describes the issues of a hard fork of cryptocurrency as follows:

A hard fork is unique to distributed ledger technology and occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or 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.

Cryptocurrency from an airdrop generally is received on the date and at the time it is recorded on the distributed ledger. However, a taxpayer may constructively receive cryptocurrency prior to the airdrop being recorded on the distributed ledger. A taxpayer does not have receipt of cryptocurrency when the airdrop is recorded on the distributed ledger if the taxpayer is not able to exercise dominion and control over the cryptocurrency. For example, a taxpayer does not have dominion and control if the address to which the cryptocurrency is airdropped is contained in a wallet managed through a cryptocurrency exchange and the cryptocurrency exchange does not support the newly-created cryptocurrency such that the airdropped cryptocurrency is not immediately credited to the taxpayer’s account at the cryptocurrency exchange. If the taxpayer later acquires the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency, the taxpayer is treated as receiving the cryptocurrency at that time.[5]

Based on these concepts, the ruling comes to two holdings:

(1) A taxpayer does not have gross income under § 61 as a result of a hard fork of a cryptocurrency the taxpayer owns if the taxpayer does not receive units of a new cryptocurrency.

(2) A taxpayer has gross income, ordinary in character, under § 61 as a result of an airdrop of a new cryptocurrency following a hard fork if the taxpayer receives units of new cryptocurrency.[6]

The ruling offers two different examples to illustrate these holdings.

Example 1 (Based Revenue Procedure 2019-24)

A holds 50 units of Crypto M, a cryptocurrency. On Date 1, the distributed ledger for Crypto M experiences a hard fork, resulting in the creation of Crypto N. Crypto N is not airdropped or otherwise transferred to an account owned or controlled by A.

A did not receive units of the new cryptocurrency, Crypto N, from the hard fork; therefore, A does not have an accession to wealth and does not have gross income under § 61 as a result of the hard fork.[7]

Example 2 (Based on Revenue Procedure 2019-24)

B holds 50 units of Crypto R, a cryptocurrency. On Date 2, the distributed ledger for Crypto R experiences a hard fork, resulting in the creation of Crypto S. On that date, 25 units of Crypto S are airdropped to B’s distributed ledger address and B has the ability to dispose of Crypto S immediately following the airdrop. B now holds 50 units of Crypto R and 25 units of Crypto S. The airdrop of Crypto S is recorded on the distributed ledger on Date 2 at Time 1 and, at that date and time, the fair market value of B’s 25 units of Crypto S is $50. B receives the Crypto S solely because B owns Crypto R at the time of the hard fork. After the airdrop, transactions involving Crypto S are recorded on the new distributed ledger and transactions involving Crypto R continue to be recorded on the legacy distributed ledger.

B received a new asset, Crypto S, in the airdrop following the hard fork; therefore, B has an accession to wealth and has ordinary income in the taxable year in which the Crypto S is received. See §§ 61 and 451. B has dominion and control of Crypto S at the time of the airdrop, when it is recorded on the distributed ledger, because B immediately has the ability to dispose of Crypto S. The amount included in gross income is $50, the fair market value of B’s 25 units of Crypto S when the airdrop is recorded on the distributed ledger. B’s basis in Crypto S is $50, the amount of income recognized. See §§ 61, 1011, and 1.61-2(d)(2)(i). [8]

The frequently asked questions indicate that they are issued primarily to expand upon the concepts found in the five year old Notice 2014-21. The FAQ also cautions that it only applies to cryptocurrency treated as a capital asset. [9]

The FAQ consisted of 43 questions and answers when originally published. The IRS is known to revise such FAQs from time to time, and it is possible more information will eventually be published here so advisers should keep an eye on the web page for changes.

The final question provides taxpayers and their advisers with guidance on the type of records the IRS believes should be maintained by those who have cryptocurrency transactions.

Q43. What records do I need to maintain regarding my transactions in virtual currency?

A43. The Internal Revenue Code and regulations require taxpayers to maintain records that are sufficient to establish the positions taken on tax returns. You should therefore maintain, for example, records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the virtual currency. [10]

The IRS also deals with the methods a taxpayer may use to determine which specific cryptocurrency blocks have been sold to properly determine the basis, defaulting to FIFO but allowing specific identification:

Q36. I own multiple units of one kind of virtual currency, some of which were acquired at different times and have different basis amounts. If I sell, exchange, or otherwise dispose of some units of that virtual currency, can I choose which units are deemed sold, exchanged, or otherwise disposed of?

A36. Yes. You may choose which units of virtual currency are deemed to be sold, exchanged, or otherwise disposed of if you can specifically identify which unit or units of virtual currency are involved in the transaction and substantiate your basis in those units.

Q37. How do I identify a specific unit of virtual currency?

A37. You may identify a specific unit of virtual currency either by documenting the specific unit’s unique digital identifier such as a private key, public key, and address, or by records showing the transaction information for all units of a specific virtual currency, such as Bitcoin, held in a single account, wallet, or address. This information must show (1) the date and time each unit was acquired, (2) your basis and the fair market value of each unit at the time it was acquired, (3) the date and time each unit was sold, exchanged, or otherwise disposed of, and (4) the fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.

Q38. How do I account for a sale, exchange, or other disposition of units of virtual currency if I do not specifically identify the units?

A38. If you do not identify specific units of virtual currency, the units are deemed to have been sold, exchanged, or otherwise disposed of in chronological order beginning with the earliest unit of the virtual currency you purchased or acquired; that is, on a first in, first out (FIFO) basis. [11]

While Revenue Ruling 2019-24 provides for potential taxation for a hard fork, the FAQ indicates that a soft fork will not be a taxable event:

Q29. Do I have income when a soft fork of cryptocurrency I own occurs?

A29. No. A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and thus does not result in the creation of a new cryptocurrency. Because soft forks do not result in you receiving new cryptocurrency, you will be in the same position you were in prior to the soft fork, meaning that the soft fork will not result in any income to you. [12]

The IRS points out that spending the cryptocurrency will result in taxable exchange of the currency—that is, the fact a holder does not receive legal tender for his/his cryptocurrency does not eliminate the tax impact:

Q13. Will I recognize a gain or loss if I pay someone with virtual currency for providing me with a service?

A13. Yes. If you pay for a service using virtual currency that you hold as a capital asset, then you have exchanged a capital asset for that service and will have a capital gain or loss. For more information on capital gains and capital losses, see Publication 544, Sales and Other Dispositions of Assets.

…

Q15. Will I recognize a gain or loss if I exchange my virtual currency for other property?

A15. Yes. If you exchange virtual currency held as a capital asset for other property, including for goods or for another virtual currency, you will recognize a capital gain or loss. For more information on capital gains and capital losses, see Publication 544, Sales and Other Dispositions of Assets. [13]

Similarly, an individual receiving cryptocurrency in exchange for services or a product will recognize income equal to the fair market value of the currency.[14]

However, transferring cryptocurrency from one digital wallet to another, or from one account to another will not result in a taxable transaction:

Q35. Will I have to recognize income, gain, or loss if I own multiple digital wallets, accounts, or addresses capable of holding virtual currency and transfer my virtual currency from one to another?

A35. No. If you transfer virtual currency from a wallet, address, or account belonging to you, to another wallet, address, or account that also belongs to you, then the transfer is a non-taxable event, even if you receive an information return from an exchange or platform as a result of the transfer. [15]

Conspicuously absent from the ruling or FAQ is any indication that the IRS will only apply this guidance prospectively—presumably the agency believes this information represents the state of the law as it has existed at least since Notice 2014-21 was issued.

The IRS also emphasized in the news release issued along with this guidance that the agency is taking steps to address prior noncompliance, noting:

The IRS is aware that some taxpayers with virtual currency transactions may have failed to report income and pay the resulting tax or did not report their transactions properly. The IRS is actively addressing potential non-compliance in this area through a variety of efforts, ranging from taxpayer education to audits to criminal investigations.

For example, in July of this year the IRS announced that it began mailing educational letters to more than 10,000 taxpayers who may have reported transactions involving virtual currency incorrectly or not at all. Taxpayers who did not report transactions involving virtual currency or who reported them incorrectly may, when appropriate, be liable for tax, penalties and interest. In some cases, taxpayers could be subject to criminal prosecution.[16]

[1] Revenue Procedure 2019-24, October 9, 2019, https://www.irs.gov/pub/irs-drop/rr-19-24.pdf (retrieved October 9, 2019)

[2] Frequently Asked Questions on Virtual Currency Transactions, October 9, 2019, https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions (retrieved October 9, 2019)

[3] Jake Frankenfield, “A History of Bitcoin Hard Forks,” Investopedia website, June 25, 2019, https://www.investopedia.com/tech/history-bitcoin-hard-forks/ (retrieved October 9, 2019)

[4] Jake Frankenfield, “Bitcoin Cash Definition,” Investopedia website, July 30, 2018, https://www.investopedia.com/terms/b/bitcoin-cash.asp (retrieved October 9, 2019)

[5] Revenue Ruling 2019-24, pp. 2-3

[6] Revenue Ruling 2019-24, p. 5

[7] Revenue Ruling 2019-24, pp. 3, 5

[8] Revenue Ruling 2019-24, pp. 3, 5

[9] Frequently Asked Questions on Virtual Currency Transactions, October 9, 2019, https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions (retrieved October 9, 2019)

[10] Frequently Asked Questions on Virtual Currency Transactions, October 9, 2019, https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions (retrieved October 9, 2019)

[11] Frequently Asked Questions on Virtual Currency Transactions, October 9, 2019, https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions (retrieved October 9, 2019)

[12] Frequently Asked Questions on Virtual Currency Transactions, October 9, 2019, https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions (retrieved October 9, 2019)

[13] Frequently Asked Questions on Virtual Currency Transactions, October 9, 2019, https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions (retrieved October 9, 2019)

[14] Frequently Asked Questions on Virtual Currency Transactions, October 9, 2019, Q&As 8, 9, 10 and 11, https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions (retrieved October 9, 2019)

[15] Frequently Asked Questions on Virtual Currency Transactions, October 9, 2019, https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions (retrieved October 9, 2019)

[16] “Virtual currency: IRS issues additional guidance on tax treatment and reminds taxpayers of reporting obligations,” IRS News Release IR-2019-167, October 9, 2019, https://www.irs.gov/newsroom/virtual-currency-irs-issues-additional-guidance-on-tax-treatment-and-reminds-taxpayers-of-reporting-obligations (retrieved October 9, 2019)