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How The IRS Plans To Tax Cryptocurrency Hard Forks And Airdrops

The IRS finally provided clarity on the tax treatment of hard forks and airdrops.

Cryptocurrency Fork:

  • A fork is an update to improve or change the blockchain protocols where virtual currency transactions are recorded.

A Hard Fork:

  • A blockchain coin or token is permanently split in two. The investor (holder of the cryptocurrency) now owns two blockchains and tokens:
    • These two blockchains and tokens have different values.
    • Are incompatible.
    • The original cryptocurrency is still recorded in the original blockchain ledger.
    • The new cryptocurrency has a unique value that is recorded in a new ledger following new rules.

Example: In 2017, Bitcoin used a hard fork to ‘create’ a new form of currency named Bitcoin Cash.

Airdrop

  • A form of cryptocurrency marketing – when a developer shares tokens with potential users and investors, typically free of charge to generate publicity and build a (new) loyal base of customers.

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The IRS View Of Hard Forks & Airdrops

Revenue Ruling 2019-24:

  • Hard forks and airdrops are taxable events.
  • Recipients must treat new cryptocurrency as ordinary income despite having no control over hard forks and did not intentionally acquire new coins.
  • The basis in the new cryptocurrency was its fair market value when received.

The crypto community responded with the argument that no tax should be assigned until the holder disposed of the cryptocurrency when he should be taxed on the resulting gain.

Memorandum from IRS Office of Chief Counsel 02-22-2021:

  • The memo dealt with the August 1, 2017, Bitcoin & Bitcoin Cash hard fork. Specifically, it handled the timing of the taxpayer’s recognition of the tokens they received for income-tax purposes
    • Taxpayers must recognize the fair market value of crypto tokens they ‘actually & constructively’ receive from hard forks & airdrops.
    • On the date, they acquire ‘dominion & control over the assets.
    • That is the moment they can sell, exchange or transfer new tokens.

As A Result

  • Bitcoin users had to recognize ordinary income equal to the fair market value of the new Bitcoin Cash Coins on August 1, 2017, when the hard fork happened.

But Exchange Users

  • The users of exchanges like Coinbase or CEX would only gain complete control over their new cryptocurrency after days, weeks, or even one year. Therefore, these taxpayers should wait until they can access, sell, transfer, or exchange their new currency before recognizing the income.

Please Take A Note

  • If the value of the new tokens increased between the date of the hard fork and the date they gained complete control, taxpayers have to recognize the higher amount of income.

The value of cryptocurrency is famously volatile. Therefore, an exchange user’s reportable income to when they gain complete control and dominion would typically be significant. This is a critical consideration for cryptocurrency users and taxpayers under the Biden Administration’s rising tax rates.

Example:

  • Profits from the sale or exchange of cryptocurrency are subject to capital gains tax.
  • The current top rate for capital gains tax is 20 percent for coins held longer than 12 months.
  • Biden plans to increase the top rate to 39.6 percent PLUS 3.8 percent Medicare tax.

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.

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