IRS inaction on cryptocurrency can hurt taxpayers, but Congress can help

Taxpayers who want to do the right thing and pay their fair share of taxes from cryptocurrency transactions are getting little help from the IRS. As Bloomberg recently noted, even “hedge funds investing billions of dollars in cryptocurrencies don’t know if they’re calculating their taxes correctly.” One acute open question is how to treat hard forks.

One way to address this problem would be for Congress to create a safe harbor for taxpayers filing returns in the absence of guidance, which would protect taxpayers from penalty assessment while they wait for the questions above to finally be answered. The safe harbor can expire upon the issuance of specific and adequate guidance from the IRS.

Is a hard fork an income event? Assuming it is, what constitutes the taxable event? Is it when the hard fork happens? When that taxpayer takes possession of the forked coins? Or when they dispose of them? What’s the holding period, and what’s the proper basis? We’ve got thoughts on all these questions, but putting aside the substantive issues for a moment, it’s important to acknowledge that, as top tax practitioners have previously [PDF] noted [PDF], the uncertainty that taxpayers face is the result of a troubling dearth of guidance from the IRS.

In the absence of useful guidance, taxpayers have filed their returns in a state of genuine confusion about the state of the law. Unfortunately, this puts them at risk of being assessed penalties on top of their tax liability, should they get the law wrong. It would be unconscionable for the IRS to issue guidance answering these open questions and retroactively penalize those taxpayers who didn’t correctly guess what the answers would be

Taxpayers can already argue their way out of penalty assessments by showing that they took a reasonable tax position based on existing law and regulations. However, because cryptocurrencies are so new, there aren’t a lot of legal precedents for taxpayers to rely on, even if they wanted to figure out for themselves what a reasonable tax position might be.

Additionally, not everyone has access to a legal library or a good lawyer. Until the IRS starts to give clear answers to basic tax questions taxpayers have about cryptocurrencies, taxpayers who take a shot at reporting their cryptocurrency-derived income shouldn’t be hit with penalties on top of their tax liability. This is especially true for taxpayers who have a record of paying their taxes on time when the rules are clear.

It’s important to note that taxpayers who hold cryptocurrencies usually have little control over when forks occur. Furthermore, after a hard fork takes place, holders of the original token are entitled to claim the resulting new tokens––but many people never do. Some never realize the hard fork took place, because they don’t keep up with cryptocurrency news. Some can’t be bothered to go through the bureaucratic process of contacting their cryptocurrency exchange to take control over the new tokens. And some don’t have enough technical knowledge to claim the tokens by engaging directly with the blockchain itself.

Ultimately, a situation may occur in which a taxpayer has legal rights to tokens created by a hard fork, but never did anything to cause the fork, never exercised his legal rights after the fork, never took control of newly created tokens, and quite possibly, wasn’t even aware of his claims to this strange new property. This taxpayer would rightfully be puzzled should the IRS accuse him of failing to report income realized through his ‘receipt’ of legal rights in these new tokens. As a result, even taxpayers who don’t report their cryptocurrency-derived income should be given a second shot at paying their taxes––without being assessed penalties for failure to report––given that it’s not legally clear or intuitively obvious when taxpayers actually realize income from unusual events like hard forks.

Taxpayers can only comply with the law when the law is clear. Until the IRS issues the sorely necessary guidance that tax practitioners has been clamoring for, confused taxpayers shouldn’t be penalized for being justifiably uncertain about how to report their cryptocurrency-derived income. Now is the time for Congressional action to protect taxpayers since the IRS has announced it will mount an audit campaign targeting cryptocurrency investors.