23 Dec IRS Clarifies Tax Treatment of Crypto Hard Forks, Airdrops
The IRS has published its first guidance in five years for calculating taxes owed on cryptocurrency holdings. Cryptocurrency industry members have been eagerly awaiting this update since May 2019, when IRS Commissioner Charles Rettig said the agency was working on providing fresh guidance.
The IRS’ 2014 guidance left many questions unanswered, and the crypto market has grown more complex in the years since. As expected, the guidance notice addresses tax liabilities created by cryptocurrency forks, acceptable methods for valuing cryptocurrency received as income, and how to calculate taxable gains when selling cryptocurrencies.
“From the tax collector’s standpoint, this is the right answer,” commented Drew Hinkes to CoinDesk. Drew is a lawyer with Carlton Fields and the general counsel to Athena Blockchain. However, Kirk Phillips, CPA, said he was surprised that the guidance basically only addressed forks.
Resolving a long-standing question, the guidance says new cryptocurrencies created from a fork of an existing blockchain should be treated as “an ordinary income equal to the fair market value of the new cryptocurrency when it is received.”
In other words, tax liabilities will apply when the new cryptocurrencies are recorded on a blockchain if a taxpayer actually has control over the coins and can spend them.
The guidance further states: “If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency, whether through an airdrop (a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses) or some other kind of transfer, you don’t have taxable income.”
James Mastracchio, a partner at Eversheds Sutherland, told CoinDesk that this applies when there is a distinctly different cryptocurrency as a result of the hard fork.
The IRS language might create more confusion, added Jerry Brito, executive director at Coin Center. “While the new guidance offers some much-needed clarity on certain questions related to calculating basis, gains and losses, it seems confused about the nature of hard forks and airdrops. One unfortunate consequence of this guidance is that third parties can now create tax reporting obligations for you by simply forking a network whose coins you own or by foisting on you an unwanted airdrop.”
Individuals would be assessed income when they receive the asset, Hinkes noted. “Receipt is defined by ‘dominion and control’ … so it’s the ability to transfer, sell, exchange or dispose of the asset according to this guidance. The fear is that someone maliciously airdrops and tags you with a giant liability. But this fear is a bit oversold because you would only be liable for new income based on the fair market value of the asset when received, and most forks don’t start out with a high valuation.”
Phillips said it was possible that an individual with an Ethereum wallet, for example, could receive an ERC-20 token from an airdrop without realizing it. Depending on how the token’s value fluctuates, this may result in them having to pay income tax on an asset that was worth more when they received it than when they sell the asset. Philips added: “This can happen when coins hit a high-water mark of price discovery right after the airdrop event, and the heavy selling could sink the price to a level from which is never recovers.”
The issue has grown more salient in recent years as fights over protocol changes caused rifts in various crypto communities, which have led to splinter currencies like Ethereum Classic and Bitcoin Cash.
Holders of the original Bitcoin and Ethereum could automatically claim a like amount of the new coins, raising the question of whether and under what conditions they would owe taxes on the windfall. Thankfully, crypto holders and their accountants now have a roadmap.
The new IRS document also offers long-awaited clarification on how taxpayers can determine the cost basis, or fair market value, of coins received as income, such as from mining or the sale of goods and services. Guidance dictates that taxpayers should calculate cost basis by summing up all the money spent to acquire the crypto, including fees, commissions and other acquisition costs in U.S. dollars.
A third key issue addressed by the new IRS guidance is how to determine the cost basis of each unit of cryptocurrency that is disposed of in a taxable transaction, such as a sale. This is an issue because someone might buy Bitcoin in multiple transactions over a span of years. When they sold some of it, it was unclear which purchase price to use for calculating taxable gains. The value of the crypto purchased on an exchange is determined by the amount the exchange sold it for in U.S. dollars. Here, the income basis will include commissions, fees and other costs of the purchase.
If the crypto is bought on a peer-to-peer exchange, or DEX, it is possible to use a crypto price index to determine the fair market value. The IRS states that this can be “a cryptocurrency or blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates the value of the cryptocurrency at an exact date and time.”
The new guidance goes on to say that when selling crypto, taxpayers can identify the coins they are disposing of, either by documenting the specific unit’s unique digital identifier (e.g., private key, public key, or address) or by records showing the transaction information for all units in a single account or address. This information must show:
- The date and time each unit was acquired.
- Taxpayer’s basis and the fair market value of each unit at the time it was acquired.
- The date and time each unit was sold, exchanged or otherwise disposed of.
- 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.
The new guidance allows for “first-in, first-out” accounting or specifically identifying when the cryptocurrencies being sold were acquired. Mastracchio said, “Let’s say I bought my first unit at $5,000 and my second unit at $2,000, and then I sold one of my units. I can identify the unit or I can use ‘first-in, first-out.’ From a tax planning perspective, you may want to be specific about which unit you sold or use first-in, first-out because sometimes you want a capital gain and sometimes you might want a loss.”
In a disappointment to crypto users who like to spend their coins on everyday purchases, like a cup of coffee, the IRS said it would not create an exemption for transactions below a certain threshold.
Paying somebody for service will result in a capital gain or loss, which should be calculated as the difference between the fair market value of the services you received and your adjusted basis in the virtual currency exchanged.
Purchases of goods and services were deemed taxable when the IRS issued its original guidance in 2014, which said that digital currencies were to be treated as property rather than currency for tax purposes. This discouraged casual spending and made tax season burdensome for users who wanted to diligently report their obligations.
Written by Timothy Speiss, Co-Leader of EisnerAmper’s Personal Wealth Advisors Group and Vice President of EisnerAmper Wealth Planning LLC.
To learn more, contact Eric Altstadter, Partner, EisnerAmper by emailing Eric.Altstadter@eisneramper.com or calling 212.891.4058 or 516.864.8888.
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