When the IRS issued Revenue Ruling 2019-24 (the "Ruling") on the tax treatment of hard forks and airdrops of cryptocurrencies, many people believed that the Ruling would offer guidance on the tax issues of both hard forks and airdrops that the community of cryptocurrency users generally understand. Is that so? Many commentators and investors in cryptocurrencies say no (see e.g., Mathew Beedham, The IRS' Latest Cryptocurrency Tax Guidance Shows It Still Doesn't Get It). Eric Chason's new work, Cryptocurrency Hard Forks and Revenue Ruling 2019-24, 39 Va. Tax Rev. 277 (2019), is soundly in line with such criticism.
As an introduction, the Ruling is understood as the IRS’s response to tax issues arising from the hard fork of the Bitcoin blockchain that resulted in the creation of Bitcoin Cash, a new cryptocurrency. The hard fork resulted in a windfall to owners of Bitcoin, who, at the time of the hard fork, received one unit of Bitcoin Cash for each unit of Bitcoin owned. This hard fork resulted in many unanswered tax issues relating to such newly created cryptocurrency.
Before the Ruling was released, Chason published an article, A Tax on the Clones: The Strange Case of Bitcoin Cash, 39 Va. Tax Rev. 1 (2019), reviewed by Mirit Eyal-Cohen here. After the release of the Ruling, Chason followed up with this new article. This review focuses on his new work and the Ruling, and also discusses his previous work when necessary.
Read the holdings of the Ruling below:
- 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.
- 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.
First, the author correctly identifies that the Ruling's reference to an airdrop is misleading, because it does not describe the creation of Bitcoin Cash and it might not describe any actual cryptocurrency transactions. A hard fork creates a new cryptocurrency by replicating all past transactions of the original cryptocurrency. Owners keep their original units in the legacy cryptocurrency but also receive new units in the new cryptocurrency. The parties creating the hard fork take no additional steps to transfer the new units, such as airdrops. Airdrops could occur after a hard fork, but users receive such airdrops of new coins via smart contract features of the system (in addition to the units of new cryptocurrency via hard fork) when the developers believe it is necessary to promote the new cryptocurrency. For example, when Bitcoin SV was created, some exchanges airdropped coins into user wallets as part of the transition in order to promote and support the coin. As such, an airdrop is a “free” token giveaway. The author explains that promoters might give tokens away in order to raise visibility or jumpstart a new network for their tokens. Both hard forks and airdrops result in a user receiving free crypto assets. But there are major differences, such as the method of creation—replication of an existing blockchain or smart contract—and who gets the free crypto assets—that is, every owner of the legacy cryptocurrency receives a new unit of new cryptocurrency, whereas an airdrop can target select users for the giveaway for promotional purposes.
More fundamentally, the question then becomes whether there are any cases where owners of an original cryptocurrency do not "receive" units of a new cryptocurrency as a result of a hard fork. Again, a hard fork occurs when the developers of a cryptocurrency create a second branch of that currency using the same basic code. Often, a hard fork occurs after discussion among the developers of the cryptocurrency and the investing communities. If different factions wish to take the cryptocurrency in a different direction, a hard fork is to be considered. In the case of the hard fork of Bitcoin, the creators of Bitcoin Cash released software that replicated all past transactions of Bitcoin and recognized Bitcoin owners as owners of a new cryptocurrency, Bitcoin Cash. These owners did not have to take any affirmative steps to accept their Bitcoin Cash. As a result, the two forks of the cryptocurrency are not exactly the same; rather, the original currency typically goes on as it has before, while the new iteration adopts some different protocols and adjustments to the code. In such contentious blockchain fork, users of the original network would choose to use and spend tokens on either or both of the divergent chains. However, in other cases, users may not even be aware of one side of the fork and could continue transacting with whatever software they have continued to use as if nothing happened. In any case, users of the legacy cryptocurrency do receive units of a newly created cryptocurrency as a result of a hard fork, regardless of whether they are aware of the new fork or choose to use the new cryptocurrency. Such new cryptocurrency was created by a hard fork, and new units were not airdropped to anyone. The Ruling misleadingly described such event as an airdrop.
Let us step back and try to understand the Ruling in a way that if you receive cryptocurrency through an airdrop or hard fork, whether you asked for it or not, you are obliged to pay tax on it. Then, the Ruling is really about the timing of a taxable event. To be more specific, the Ruling provides that a taxpayer "receives" new cryptocurrency when the taxpayer is "able" to exercise dominion and control over the cryptocurrency, rather than when they actually "exercise" those rights through sale or exchange. I believe the Ruling attempted to address these events where certain Bitcoin owners did not know they owned a corresponding unit of Bitcoin Cash or where they did not have direct access to their Bitcoin Cash holdings for more than four months because the market, or the Coinbase exchange through which the new owners held their Bitcoin Cash, initially refused to support Bitcoin Cash and denied user access to Bitcoin Cash. Moreover, there has been no well-established market for the newly created cryptocurrencies for significant amounts of time. Due to the disapproval by the Coinbase exchange, the trading volumes in the early days of Bitcoin Cash were very low. The reported prices for the initial hours of Bitcoin Cash fluctuated wildly, ranging from $200 to $400 per unit over the initial five hours.
Hence, it is unclear when the new owners can exercise "complete dominion" over the property within the meaning of Glenshaw Glass. On the other hand, it is clear that the owners exercise "complete dominion" over the property when it is sold or exchanged. For these reasons, Chason explains that the Ruling seems to embrace an "immediate taxation" approach, which he rejected in his previous work. Instead, he proposes an "open transaction" approach, under which, as similar windfalls do not face immediate taxation for various valuation and administrative difficulties, recipients of new crypto windfalls would have ordinary income when they sell or exchange cryptocurrencies previously received in a hard fork. That is, income from crypto windfalls would be deferred until the subsequent sale or exchange. I think his proposal is reasonable as well as realistic, and would like to join him to urge the IRS to issue a new ruling to answer the precise timing and valuation of the new crypto windfalls, including both hard forks and airdrops—especially airdrops in general rather than peculiar semantics tagged along with hard forks.