IRS Cryptocurrency guidance answers some questions while raising messy new ones

Could it be possible for strangers to create tax obligations for cryptocurrency owners?

The IRS has finally released new guidance on cryptocurrency tax treatment and it’s a mixed bag with one very bad consequence. Last April, we published a report calling for guidance on basic questions. The IRS has answered these questions in guidance published today; some answers are good and some are bad. The bad consequence is that taxpayers will owe income tax every time someone hard forks a cryptocurrency they hold.

The Good:

Fair market value and basis cleared up: Taxpayers now have generally clear guidance on how to determine the basis for cryptocurrency they’ve purchased or otherwise received. Depending on whether its acquired on an exchange or through a peer-to-peer transaction on the blockchain, basis will be the amount you spent to acquire the cryptocurrency, the quoted price on the exchange, or fair market value as reported on an index. This generally matches the recommendations we made in our report.

Accounting standards clarified: Taxpayers can use specific identification or first-in-first-out accounting in order to calculate their gains or losses. This is good because prior to this guidance a pedantic reading of the law might have required taxpayers, whenever they disposed of cryptocurrency, to specifically identify exactly which unit of cryptocurrency they were spending and what the price of originally acquiring that specific unit was. This generally matches the policy we recommended we made in our report.

The Bad:

Any hard fork with new coins (e.g. Bitcoin Cash or Ether Classic) will create an income event for taxpayers: The new guidance suggests that a taxpayer will have taxable income the moment that new coins from a hard fork are recorded on the newly forked blockchain and the taxpayer has “dominion and control over the cryptocurrency so that [he/she] can transfer, sell, exchange, or otherwise dispose of the cryptocurrency.” That means that anyone who forks a blockchain can, without warning or notice, create new tax obligations for every holder of coins on the old chain. The same goes for airdrops. Any time someone airdrops a coin to an address over which you have dominion and control, they will create a tax reporting obligation on your part. This is a very bad result.

In our report we recommend that the IRS only recognize a taxable event when and if a cryptocurrency user exercises dominion and control over the new coins, not at the moment that they have dominion and control. Otherwise, merely having private keys controlling Bitcoin or Ether would trigger an income event if a third party forked those blockchains. You have keys that might be able to move potentially valuable new coins on that forked chain, but you may have no idea the fork even happened. It’s like owing income tax when someone buries a gold bar on your property and doesn't tell you about it. It's absurd and impossible to reasonably comply.

Just to illustrate, Jameson Lopp has some excellent questions that necessarily follow from this policy:

Here are two possible, contradictory incentives this policy might inadvertently create: Taxpayers may have an incentive to keep all their coins at exchanges and never hold their own keys so that they won’t face unwanted tax reporting obligations because according to the guidance a hard fork or airdrop is not an income event for persons who hold their coins at an exchange until (and if) the exchange supports the new chain and credits their account. On the other hand, because the value of a coin is typically zero at the moment of a hard fork (given there are no markets yet), then the reportable income would be zero, in which case taxpayers may be incentivized to always hold their own coins rather than end up with new coins from an exchange only after markets have developed and the income event could actually be substantial.

Hard fork and airdrop terminology is used incorrectly (Update: New explainer): Aside from offering bad policy on the question of hard forks, the guidance also doesn’t describe these events correctly. It suggests that some hard forks come with airdrops and some do not. However, airdrops and hard forks are distinct and unrelated terms that the IRS seems to be conflating. When there is a contentious hard fork new cryptocurrency will necessarily exist on both sides of the fork, no airdrop occurs. When a stranger decides to create new cryptocurrencies and allow people to claim them using private keys they already hold from other blockchains then an airdrop, definitionally, has occurred. This probably doesn’t matter much from a policy perspective, but it certainly doesn’t help with providing clarity and may belie continued misunderstanding from the IRS about how these technologies actually work.

What now?

Coin Center will need to take some time to figure out next steps but it’s unlikely we can fix these bad outcomes merely by seeking additional clarity from the IRS. For one thing, the IRS has generally answered all of our questions, we just disagree with some of the answers. For another, it is possible that the definition of income and associated case-law binds the IRS to the interpretation they have offered on hard forks. At the very least they can make a credible argument that they are bound by those definitions and any change would need to come from Congress. We’ll keep working on these issues and seeking a more reasonable outcome that does not leave otherwise innocent cryptocurrency users liable for income they don’t even realize they’ve received.