Stevie D. Conlon, Anna Vayser and Robert Schwaba examine IRS Rev. Rul. 2019-24 and an accompanying FAQ dealing with cryptocurrency taxation and close by examining recent enforcement efforts in the arena of cryptocurrency taxation.
On Wednesday, October 9, 2019, the IRS issued two important releases addressing certain tax questions related to virtual currency sold, exchanged or received by taxpayers: Rev. Rul. 2019-24, regarding the tax consequences of hard forks, and a Virtual Currency FAQ (the “Virtual Currency FAQ” or the “FAQ”) containing 43 questions and answers. The last substantive virtual currency guidance issued by the IRS was Notice 2014-21, over five years ago.
Although both new items are consistent with existing law in many respects, they have been controversial, possibly because they result in tax consequences undesirable to taxpayers. Many taxpayers may also find this guidance inconsistent with their prior tax reporting (or lack thereof). Moreover, Rev. Rul. 2019-24 has been questioned because of flaws in its technical description of blockchain ledger processes relating to hard forks and because of its implicit retroactive effective date. As a result, opposition by taxpayers, their advisors and other stakeholders seems likely.
This article analyzes Rev. Rul. 2019-24 and the Virtual Currency FAQ. However, an overview of important developments occurring earlier in 2019 provides context for the unfavorable reception of this guidance.
Challenges and the state of prior guidance
The IRS issued Notice 2014-21 in 2014 to address certain issues relating to virtual currency taxation. However, practitioners and taxpayers found that Notice 2014-21 did not address several significant tax issues and sought additional guidance.
Two significant tax developments occurred during 2017. Calendar year 2017 saw a substantial run-up in market values of various virtual currencies. For example, Bitcoin prices started 2017 at a per-coin price of $963.66 and reached a price per coin of $20,089 on December 17, 2017. As a result of these drastic price increases, the value of many taxpayers’ holdings of Bitcoin and other virtual currencies increased dramatically during 2017 and “paper fortunes” were made. If taxpayers sold any of their virtual currency holdings during 2017, it is possible they realized substantial tax gains.
In addition, two significant “forks” of Bitcoin occurred in 2017: the “hard fork” of Bitcoin into Bitcoin and Bitcoin Cash in August 2017 and the hard fork of Bitcoin into Bitcoin and Bitcoin Gold in November 2017. Immediately following the forks that made them available to direct holders of Bitcoin, Bitcoin Cash and Bitcoin Gold coins had listed market values of $294.60 and $394.04, respectively. It is important to note that Notice 2014-21 did not address the tax consequences of hard forks and no interim guidance was issued by the IRS prior to the issuance of Rev. Rul. 2019-24 in October 2019.
In early 2018, there was anecdotal reporting that few taxpayers had reported taxable gains from virtual currencies on their 2017 tax returns. The IRS took notice and quickly issued an announcement that “virtual currency transactions are taxable by law just like transactions in any other property,” additionally warning of potential tax penalties, interest, or even criminal charges for tax evasion or the filing of false returns. Advisors and other tax practitioners appeared to continue to push back on the taxability of coins received in hard forks. Some practitioners argued that court cases concluding that the birth of livestock acquired by purchasing pregnant horses or cows were or could be controlling to conclude that hard forks did not give rise to taxable income. Some taxpayers may have been unmoved or unaware of the 2018 IRS Announcement and simply did not report virtual currency sales or hard forks on their 2017 tax returns. Others may have believed, or continue to believe, that they do not need to report taxable income relating to virtual currency transactions such as sales or hard forks unless and until the IRS issues specific guidance addressing tax issues that were not addressed in Notice 2014-21. Consistent with this view, a bill has been introduced in Congress to provide that hard forks would not give rise to reportable taxable income unless the IRS issues specific regulatory guidance addressing the taxation of hard forks.
10,000 IRS cryptocurrency letters mailed to taxpayers in the summer of 2019
Beginning in July and into August 2019, the IRS sent approximately 10,000 taxpayers one of three distinct letters, referred to as Letter 6173, Letter 6174, and Letter 6174-A. Letters 6174 and 6174-A require no taxpayer action, but notify recipient taxpayers that the IRS is in possession of information suggesting the taxpayer may have held cryptocurrency and that the taxpayer should ascertain their filing compliance. Letter 6173, on the other hand, requires that the taxpayer either declare, under penalty of perjury, that their filings were correct, or file any necessary amended or delinquent returns. These letters are consistent with the 2018 IRS Announcement, demonstrating an escalation of concern regarding whether taxpayers were properly reporting virtual currency-related taxable income and capital gains on their tax returns. It is believed that many (if not all) of the taxpayers receiving letters were identified through an IRS summons of a cryptocurrency exchange (Coinbase). More clearly than any prior action, these letters demonstrate just how serious the IRS is about virtual currency reporting compliance.
What is a “Hard Fork” and what is an “Airdrop”?
The technology underlying virtual currency is called blockchain. Each block of data in the blockchain is linked together. The rules governing a particular blockchain are referred to as a protocol. Sometimes the protocol is changed. This often occurs for technological reasons driven by concerns about security, speed, or the addition of new functionality. When a protocol is changed, new blocks using the new protocol may no longer link to old blocks created before the protocol change. This can create a split in the chain, like a fork in a road. Sometimes the old chain continues and new blocks that comply with the old protocol continue to be added to the original chain, while new blocks governed by the new protocol are added to the new chain.
Disagreements about technological enhancements led to, for example, the Bitcoin Cash and Bitcoin Gold forks. Because hard forks often arise due to technological (or ideological) reasons, the details are technology-focused. Explanations of these events are often simplified for ease of understanding; however, such simplifications can be imprecise.
In Rev. Rul. 2019-24, a hard fork is said to occur “when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger.” The notice goes on to say that “[a] hard fork may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger.”
Rev. Rul. 2019-24 also defines an airdrop as “a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.” Rev. Rul. 2019-24 further states that “[a] hard fork followed by an airdrop results in the distribution of units of the new cryptocurrency to addresses containing the legacy cryptocurrency. However, a hard fork is not always followed by an airdrop.”
Following these definitions, Rev. Rul. 2019-24 provides two examples. In Situation 1, taxpayer A holds 50 units of a cryptocurrency which experiences a hard fork that creates a new cryptocurrency. The new cryptocurrency “is not airdropped or otherwise transferred to an account owned or controlled by” taxpayer A. In Situation 2, taxpayer B similarly holds 50 units of a cryptocurrency which experiences a hard fork that also creates a new cryptocurrency. By contrast, on the date of the hard fork taxpayer B receives an “airdrop” of 25 units of the new cryptocurrency to taxpayer B’s distributed ledger address. Taxpayer B also has the ability to immediately dispose of the airdropped cryptocurrency.
Rev. Rul. 2019-24’s definitions of hard fork and airdrop, even in combination with the two provided example situations, do not perfectly align with the way these cryptocurrency transformations occur in the real world. Hard forks generally follow two patterns, “upgrade” and “divisive.” If a hard fork is an upgrade, the community as a whole adopts the new protocol(s). If a hard fork is divisive, the community divides, some using the blockchain following the original protocol, and some using the blockchain following the new protocol. Since cryptocurrencies lack centralized authority, community consensus will largely determine whether a fork is an upgrade or is divisive. After the event, if only one chain exists, the fork was an upgrade; if two chains exist, it was divisive.
Thus, several situations that are possible or probable from a technological standpoint might create unworkable or apparently unintended results under Rev. Rul. 2019-24. For example, Bitcoin Cash underwent a contentiously divisive hard fork in November 2018. At the time of the fork, one side introduced certain technological changes while the other rejected those changes in favor of its own suite of changes. At the time of the fork, one group’s project went by Bitcoin ABC and the other by Bitcoin SV. Eventually, exchanges settled on Bitcoin ABC as the inheritor of the Bitcoin Cash moniker; however, reaching such a consensus is by no means guaranteed in this type of event. Even where the community does reach a consensus, whether taxpayers are bound by third-party determination of which cryptocurrency is the “legacy” cryptocurrency for purposes of determining the income received in a hard fork is not addressed by the ruling or the FAQ. It also remains unclear which cryptocurrency would be considered “airdropped” in the terms of the revenue ruling if a consensus isn’t reached.
A relatively straightforward technological upgrade can also present problems. Recently, Bitcoin Cash underwent a hard fork consisting solely of technological upgrades. However, a single mining pool did not implement the new protocols and continued adding blocks under the old protocols. This has resulted in two chains and two ledgers, one under the old protocols without the upgrades, and one under the new protocols.
Rev. Rul. 2019-24
Rev. Rul. 2019-24 addresses two issues. First, does the hard fork of a virtual currency result in gross income under Code Sec. 61 when a taxpayer owning the forked virtual currency does not receive units of a new cryptocurrency? Second, does a taxpayer have gross income under Code Sec. 61 as a result of an airdrop following the hard fork if a taxpayer receives units of a new cryptocurrency in the airdrop?
The legal analysis of the Ruling is straightforward: Code Sec. 61(a)(3) provides that, absent some excluding provision, gross income includes all income, from whatever source derived, including gains from dealings in property. Therefore, any accession to wealth over which the taxpayer has dominion should be included in gross income.
The Ruling further provides that a taxpayer generally has dominion over cryptocurrency received via airdrop at the time it is recorded in the distributed ledger. However, taxpayers holding cryptocurrency via a third party may receive control of airdropped cryptocurrency later (and implicitly, at different values) or not at all. In the situation where a taxpayer receives control of airdropped cryptocurrency at a later time, the taxpayer is treated as receiving the airdropped cryptocurrency at the time the taxpayer acquires the ability to transfer, sell, or otherwise dispose of the airdropped cryptocurrency. Since virtual currency is property, the taxpayer’s basis in the new cryptocurrency received is equal to the fair market value of the virtual currency.
Returning to the examples outlined earlier, in the first, a taxpayer holds 50 units of a cryptocurrency which undergoes a hard fork without a distribution of new cryptocurrency. In the second, a taxpayer holds 50 units of a cryptocurrency which undergoes a hard fork with a distribution of 25 units of a new cryptocurrency. In the first example, Rev. Rul. 2019-24 holds that as the taxpayer has not received any new cryptocurrency or other cash or property, there is no taxable income. In the second example, the Ruling holds that when units of the new cryptocurrency are recorded on the distributed ledger, the taxpayer has dominion and control, and therefore taxable income and basis equal to the fair market value of the units of the new cryptocurrency received at the time of distribution.
Challenges with the IRS description of Hard Forks and Airdrops
As noted above, there are concerns that the definitions of hard forks and airdrops set forth in Rev. Rul. 2019-24 potentially oversimplify the issues. Some commentators have argued that such simplifications or inaccuracies nullify the validity of Rev. Rul. 2019-24’s holdings. Given that the Ruling is the stated position of the IRS, taxpayers and their advisors that consider dismissing Rev. Rul. 2019-24 based on this argument may be subject to heightened levels of scrutiny.
Revenue rulings and the facts typically set forth in IRS guidance, such as regulations, are routinely simplified. Such simplified discussions frame the relevant issues for taxpayers, practitioners and IRS personnel in understanding the holding or tax conclusion of the related IRS guidance. Such discussions are not intended to be overly granular. Moreover, there is the consideration of whether a more detailed discussion of facts is worthwhile as an expenditure of effort relative to the tax issue being addressed. With these ideas in mind, it seems a reasonable conclusion that the description of hard forks and airdrops set forth in Rev. Rul. 2019-24 is adequate to frame its applicable holdings (even though it is simplified).
L.E. Gamble & Rev. Rul. 86-24: Livestock divisions
L.E. Gamble and Rev. Rul. 86-24 have been referenced by some as supporting the nontaxable treatment of hard forks and airdrops. The Tax Court addressed the treatment of a taxpayer’s sale of a colt. The taxpayer had purchased several pregnant racehorses; after the foals were born, the taxpayer sold them. While the Tax Court addressed two different tax issues, relevant here is the issue of whether the taxpayer’s basis in one colt was zero or was a portion of the mother’s tax basis, as commentators have argued that a hard fork is similar in fact to the birth of livestock. The Tax Court essentially concluded that because the broodmare was bought while in foal, a portion of its purchase price was allocable to the colt. Therefore, the tax basis of the colt at the time of the sale was one-third of the price paid for its mother.
Rev. Rul. 86-24, 1986-1 CB 80, modified by Rev. Rul. 87-105, addressed the issues of determining the cost of “(1) non-purebred cows carrying embryos transplanted from purebred cows and (2) purebred calves under … circumstances” described in the ruling. In the facts described therein, both pregnant cows and cows that are not pregnant at the time of sale have readily ascertainable fair market values. Under the holding of the ruling, the relative fair market values of pregnant and non-pregnant cows are used to determine the portion of the purchase price paid that is allocable to the unborn calves and used to establish the basis in such calves when sold.
Although L.E. Gamble and Rev. Rul. 86-24 have been referenced by some as supporting the nontaxable treatment of hard forks and airdrops, the facts diverge markedly from most cryptocurrency hard forks; the purchasers of both the racehorses and the cows knew at the time of purchase that calves and foals were forthcoming. Additionally, the active markets for such animals provided separate values for pregnant and nonpregnant animals. They do not seem helpful in most cases, as cryptocurrencies are generally acquired at a time when the purchaser and community cannot be certain if or when a future hard fork or airdrop will occur.
Corporate Tax: Are cryptocurrencies analogous to stock? Should Subchapter C rules apply?
There are several special rules in Subchapter C of the Internal Revenue Code that provide for the receipt of stock or securities without the current recognition of taxable income at the time of receipt, provided various specialized requirements are satisfied. Accordingly, it should be considered whether cryptocurrencies can or should be treated as stock and therefore subject to these special Subchapter C rules. If not, is there another non-statutory tax regime that might apply to create a similar result?
Code Sec. 305, for example, provides for the receipt of stock dividends on a nontaxable basis under certain circumstances. Code Sec. 307 addresses the determination of basis of the stock or stock rights acquired in certain distributions, generally requiring some allocation of basis if the distribution is not immediately taxable. Code Sec. 355 provides for nontaxable distributions of stock in certain divisive reorganizations while Code Sec. 358 provides for related allocations of basis between the original stock held and the new stock received in the distribution. All of these provisions apply primarily to stock.
Some of the classic attributes of stock generally include voting rights and the rights to a shared appreciation in a business enterprise. Most cryptocurrency coins lack such rights; therefore, generally, cryptocurrency coins do not appear to qualify as stock for federal income tax purposes. As a result, the rules of Subchapter C, including the special rules providing for nonrecognition of gain or loss on certain divisive distributions, do not seem generally applicable to cryptocurrency. Tax classification of hybrid securities as either debt or equity in various entities, such as corporations or associations taxable as corporations, can be substantially more complex. However, even given such complexities, it seems unlikely that most cryptocurrency coins would be classified as stock for purposes of Subchapter C, either by the IRS or by courts.
Similarly, although blockchain-related “tokens” are not the primary focus of this article, they are related to cryptocurrencies because both are a product of blockchain technology. At least one commentator has questioned whether certain blockchain tokens are or should be treated like stock. Note that in 2018, there were substantial developments relating to whether so-called blockchain “convertible equity tokens” were subject to federal securities and/or commodities regulation. Thus, while more traditional cryptocurrencies such as Bitcoin seem unlikely to be considered stock, other blockchain technologies might exist in a much grayer area.
Although some digital equity projects have been proposed, publicly traded U.S. companies do not appear to have issued any equity interests existing solely or even primarily on a blockchain. In the summer of 2019 Overstock, Inc. (traded on the NASDAQ) announced a planned dividend of a digital stock, initially stated to be blockchain-based. Following scrutiny by the SEC, details have been released that call into question whether there would actually be a distribution of a digital stock.
The Subchapter C rules governing distributions and reorganizations are, in many cases, a refined extension of nontaxable treatment set forth in earlier case law. While it could certainly be argued that the general principles of such earlier judicially created law supports nonrecognition treatment in the case of divisive distributions of cryptocurrencies such as hard forks and airdrops, there are other judicially developed requirements that remain applicable to distributions of stock (such as the business purpose doctrine or the continuity of shareholder interest doctrine). The related question is which, if any, of these additional requirements would, should, or even could be imposed if nontaxable divisive distributions of cryptocurrency coins were allowed without a governing statutory or regulatory framework?
What is current law versus what the law could or should be
As a tax policy matter, and regardless of the state of current law, there are complex issues surrounding whether tax laws should provide for nontaxable distributions in connection with hard forks or airdrops. There could be policy reasons why certain distributions occurring in connection with hard forks or airdrops should be nontaxable to the recipient. However, business or ownership-based continuity requirements like those applicable to corporate divisive distributions do not seem strictly applicable in the context of cryptocurrencies or other publicly distributed blockchains. Code Sec. 305 type restrictions on the type of stock (or stock rights) distributed also seem inappropriate. Accordingly, it seems appropriate to ask what form any analogous limitations on cryptocurrency hard forks or airdrops should take.
Moreover, challenges relating to the determination of basis of any newly-distributed coin would need to be addressed. If distributions were to be treated as nontaxable, then logically, a method for allocating the taxpayer’s existing basis in the coin previously held between it and the new coin received would be needed. It seems problematic that difficulties in obtaining, or differences in, valuations used by different taxpayers could result in disparate basis allocations, which could create compliance challenges for both taxpayers and the IRS. Clear basis allocation rules like those set in Code Sec. 307 or Code Sec. 358 would be beneficial.
Virtual Currency FAQ
The virtual currency frequently asked questions (FAQs) expand upon the issues initially presented in Notice 2014-21 (Answers 35 and 36 were updated in December, 2019). They generally only apply to taxpayers who hold virtual currency as a capital asset, and range in scope from the very basic (“What is virtual currency?”) to more complex (“How do I determine my basis in virtual currency that I received as a bona fide gift?”).
The questions in the FAQ are organized to address several broad categories of issues. A discussion of key sections of the FAQ is set forth below.
Analysis of the FAQ
Computation of gain or loss on exchange of virtual currency
The determination of the value of cryptocurrency for purposes of computing gain or loss or basis is addressed in several answers set forth in the FAQ. Answer 19 begins by explaining that gain or loss on the exchange of property for virtual currency is the difference between “the fair market value of … virtual currency when received” and a taxpayer’s adjusted basis in the property exchanged. Answer 20 provides that the taxpayer’s basis in the virtual currency received “is the fair market value of the virtual currency, in U.S. dollars, when the virtual currency is received.”
Questions and answers 21 through 24 address the tax consequences of hard forks and are consistent with Rev. Rul. 2019-24.
Questions and answers 25 through 27 address valuation. Answer 25 provides that when cryptocurrency is received “in a transaction facilitated by a cryptocurrency exchange, the value of the cryptocurrency is the amount recorded by the cryptocurrency exchange for that transaction in U.S. dollars.” It further provides that if transaction is off-chain or not recorded on a distributed ledger, “then the fair market value is the amount the cryptocurrency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it had been an on-chain transaction.”
An “atomic swap” is a cryptocurrency exchange that is conducted directly between the parties where no exchange or intermediary acts as middleman. The FAQ refers to such a transaction as a peer-to-peer transaction. Answer 26 provides in part that “[t]he IRS will accept as evidence of fair market value the value as determined by 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.” This guidance is helpful because the peer-to-peer nature of such atomic swaps raise questions as to the fairness of such agreed-upon exchange prices.
Answer 28 provides that a taxpayer’s holding period for cryptocurrency received “begins the day after it is received.” This rule is consistent with the starting date for determining the holding period for property generally.
When a taxpayer holds homogeneous property (property that is the same other than its specific reference or ID number, such as stock or cryptocurrency coins) that has been acquired on different dates and at different prices (that is, different “lots” of such property), it is important to determine which particular lot is sold in order to determine the holding period and basis of the property sold to compute the amount of gain or loss recognized on the sale. Taxpayers and practitioners have raised concerns that taxpayers and cryptocurrency exchanges have been challenged to obtain records detailing the prices and acquisition dates of particular lots of cryptocurrency sold.
In the context of stocks and securities, Reg. §1.1012-1 sets forth rules regarding whether a taxpayer may use one of three different methods of lot relief: first-in, first-out (FIFO); specific ID; or averaging. Taxpayers and practitioners requested guidance regarding which methods were available for cryptocurrencies. This was of significance because of difficulties taxpayers were having tracking the basis of specific lots of cryptocurrency.
Answer 36 provides that taxpayers may use the specific ID method “if you can specifically identify which unit or units of virtual currency are involved in the transaction and substantiate your basis in those units.”
Answer 37 elaborates the details that a taxpayer must provide to identify a specific unit of virtual currency; a taxpayer can document “the specific unit’s unique digital identifier such as a private key, public key and address...” Alternatively, a taxpayer can identify a particular lot by records that “show (1) the date and time each unit was acquired, (2) your basis and the fair market value of each unit at the time it was acquired, (3) the date and time each unit was sold, exchanged, or otherwise disposed of, and (4) 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.”
It should be noted that these rules are different from the specific ID requirements applicable to stock.
Answer 38 provides that if specific ID is not used, units of cryptocurrency “are deemed to have been sold … in chronological order…; that is, on a first in, first out (FIFO) basis.”
Though some commentators have suggested that averaging should be permitted, the FAQ does not permit the averaging of basis of lots of cryptocurrency. Because existing regulatory rules for basis averaging for stock are complex, implementing similar rules for virtual currency could be challenging.
Gifting and charitable contributions
The FAQ specifies that receipt of cryptocurrency as a bona fide gift does not deviate from the general rule that the recipient does not recognize income until disposal of the gift. The recipient’s basis also follows the general gift rule; use the donor’s basis or the asset’s fair market value at the time of the gift for loss calculations, and use the donor’s basis plus any gift tax paid for gain calculations. Similarly, the recipient’s holding period for the gift includes the donor’s holding period. Donors making charitable contributions of virtual currency do not recognize income, gain or loss as a result of the donations.
Reflections on the validity of the Rev. Rul. and the FAQ
Some commentators have raised a variety of issues with Rev. Rul. 2019-24 and the FAQ, both substantive and procedural. Procedural concerns include: the value of the FAQ as authority, if any; the appropriateness (or lack thereof) of the decision to employ a revenue ruling rather than a Notice; Rev. Rul. 2019-24’s effective date; and the appropriateness (or lack thereof) of sub-regulatory guidance in this arena generally.
What level of authority is Rev. Rul. 2019-24 and the Virtual Currency FAQ?
All IRS guidance is intended to, in some way, clarify federal tax laws that have been enacted by Congress and the President. In roughly descending order of precedence, the IRS issues: regulations (formal guidance with notice and comment); revenue rulings (official interpretations of existing statute, regulation, or other authority); revenue procedures (statements of procedures affecting the public); and private letter rulings (written statements directed to and intended for use by a specific taxpayer and explicitly without precedent for other taxpayers.) Additional guidance may come in the form of public statements such as technical advice memoranda, notices, announcements, IRS publications, form instructions or FAQs. The review and approval processes for different forms of guidance varies. Taxpayers and practitioners sometimes challenge IRS guidance on the basis that a particular form of guidance was inappropriate but was selected by the IRS to avoid more strenuous review and approval processes that apply to other forms of guidance. In recent years, there has been a greater emphasis on the appropriateness of the type of IRS guidance chosen.
Rev. Rul. 2019-24, like revenue rulings generally, appears to be intended as IRS interpretation of existing statutes and regulations as applied to virtual currency. As such, it does not include an explicit effective date and so is implicitly retroactive. This has been controversial. In addition, some have questioned whether a revenue ruling (rather than a regulation) was the appropriate form of IRS guidance.
The Virtual Currency FAQ, on the other hand, is probably meant to be a generally accessible resource readily available to taxpayers who may not have regular tax advisors or a sophisticated understanding of the intricacies of IRS guidance. As the Virtual Currency FAQ is not presented as a Notice or Revenue Ruling, it in no way binds the IRS or functions as precedent, although it does provide an understanding of the current IRS views on the issue.
Reg. §1.6662-4(d) delineates “substantial authority” in the context of reductions to assessments of substantial understatements of income tax. The list in the regulation of what constitutes “substantial authority” includes IRS information or press releases as well as notices, announcements, or other administrative pronouncements published in the IRB and does exclude treatises, legal periodicals, or legal opinions. Some have argued that, as the FAQ fits within none of the listed definitions of substantial authority under Reg. §1.6662-4(d), it has no value as authority, substantial or otherwise. Many of the answers in the FAQ, though, simply provide clarity through restatements of general tax rules that are applicable to virtual currency in much the same way as they are applicable to other types of property. Other answers in the FAQ represent logical conclusions from the initial premise that, as posited in Rev. Rul. 2019-24, a hard fork and airdrop result in income to the recipient. The FAQ also provides insight into the current IRS thinking about the issue.
Revenue rulings generally are intended by the IRS to function as interpretation of existing statutes and regulations, not as statements of new law. Given the previous guidance of Notice 2014-21 and general tax principles of accession to wealth, Rev. Rul. 2019-24 seems to express the IRS position that existing law treats virtual currency such as Bitcoin Cash received in a hard fork as more akin to found property than to pregnant livestock or a corporate reorganization.
As articulations of existing law (as opposed to the creation of new law or a change in position), statements that are appropriate for a revenue ruling should in most situations apply from the effective date of the existing law. As a regulation creates new law subject to a Congressional grant of authority or provides substantive interpretation of legislation, in most situations regulations should not apply retrospectively. Commentator concerns here are apparently fundamentally linked to the issue of the nature of the guidance provided by Rev. Rul. 2019-24; if one accepts that it discusses existing positions stemming from Notice 2014-21’s definition of convertible virtual currency as property or other aspects of existing law, the effective date isn’t an issue. If one takes the position that Rev. Rul. 2019-24 creates novel, substantive law or interpretation, it is.
Additional enforcement efforts
On October 11, 2019, the IRS additionally issued a new draft Schedule 1 to Form 1040, explicitly providing for cryptocurrency disclosure. Taking its cue from the checkbox on Schedule B regarding financial interests in foreign accounts, the draft Schedule requires a taxpayer, under penalty of perjury, to check a box answering whether the taxpayer sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency in 2019. Notably, the terms “virtual currency” and “convertible virtual currency” have different definitions under Notice 2014-21. Strictly as written, this language could potentially require disclosure of virtual items beyond those readily convertible into fiat currency; whether such a literalist reading is intended or the final version of the Schedule would limit required disclosures to convertible virtual currency remains to be seen.
Rev. Rul. 2019-24 and the Virtual Currency FAQ are important new items of tax guidance, particularly given the many open questions relating to tax calculations and reporting for cryptocurrencies. Although this guidance is intended to be helpful, it is already clear that some taxpayers and their advocates disagree with it on various grounds. Whether such arguments will ultimately result in changes to applicable law remains to be seen; regardless, further contention seems likely, as Rev. Rul. 2019-24 and the Virtual Currency FAQ simply aren’t “the Droids” taxpayers are looking for.
- Stevie D Conlon is the coauthor of Principles of Financial Derivatives: U.S. & International Taxation (1999). The authors gratefully acknowledge the contributions of John Kareken, Cynthia Lapins, and Robyn Lang.
- Rev. Rul. 2019-24, IRB 1004.
- This article is an expanded adaptation of the authors’ whitepaper discussing similar subject matter. An alternative, abbreviated adaptation of the whitepaper was previously published as “IRS Releases New Cryptocurrency Tax Guidance,” J. TAX PRAC. & PROC. (January 7, 2020).
- Notice 2014-21, 2014-16 IRB 938.
- For example, additional guidance was requested regarding issues such as, but not limited to: proper determination of fair market value in cryptocurrency exchanges; concerns when different market makers quote different values; pre-2018 like-kind exchanges under Code Sec. 1031; whether Code Secs. 1091 and 1092 might apply to defer losses on sale or exchange; whether installment sale provisions might apply to defer the timing of recognition of gain; and requests for a de minimis rule. See American Bar Association, Section of Taxation, Comments on Notice 2014-21, Mar. 24, 2015, at 3. American Institute of CPAs, Comments on Notice 2014-21: Virtual Currency Guidance, June 10, 2016. See also, e.g., Nathan Richman, AICPA Suggests New Virtual Currency Advice from IRS, 159 TAX NOTES 1526 (June 4, 2018); Eric Yauch, Virtual Currency Guidance Needed for Compliance, Brady Says, 160 TAX NOTES 1927 (Sept. 24, 2018).
- January 1, 2017 listed open price and December 31, 2017 listed high price from coinmarketcap.com.
- The prices of Bitcoin and other virtual currencies plummeted the following year, falling to $3,191.30 per coin on December 15, 2018 (the listed low price from coinmarketcap.com).
- “Hard fork” is a technical term that is discussed more fully later in this article.
- Consistent with the facts regarding the known market values of Bitcoin Cash and Bitcoin Gold on the date of their respective hard forks, this article intentionally omits any discussion of whether cryptocurrency coins distributed via a hard fork or an airdrop have negligible value or the appropriate tax treatment for the receipt of property with negligible value. The values provided are the listed Open prices for the first day of trading for each cryptocurrency from coinmarketcap.com. These dates are August 1, 2017 and November 25, 2017, respectively.
- See, e.g., Evelyn Cheng, Barely Anyone Is Paying the Taxes They Owe on Their Bitcoin Gains, CNBC, Feb. 13, 2018; and Anna Irrera, Few Americans Reporting Cryptocurrency Trading to IRS for Now: Report, Reuters.com, Feb. 13, 2018.
- See IRS reminds taxpayers to report virtual currency transactions, IR-2018-71 (Mar. 23, 2018) (the “2018 IRS Announcement”). See also Stevie D. Conlon, Anna Vayser, and Robert Schwaba, If a Crypto-Tree Falls in a Digital Forest, Can It Give Rise to Tax Evasion?, 161 TAX NOTES 701 (Nov. 5, 2018).
- See, e.g., American Bar Association, Section of Taxation, Tax Treatment of Cryptocurrency Hard Forks for Taxable Year 2017, (Mar. 29, 2018).
- See, e.g., Id., at 10. Pregnant livestock remains an attractive analogy. See, e.g., David G. Chamberlain, Rodney P. Mock and Kathryn Kisska-Schulze, Disappearing Forks and Magical Airdrops, 165 TAX NOTES FEDERAL 791, 793 (Nov. 4, 2019) citing L.E. Gamble, 68 TC 800, Dec. 34,604 (1977).
- A decision not to report income from virtual currency transactions would seem inconsistent with the 2018 IRS Announcement; however, a more in-depth discussion of this topic is beyond the scope of this article. See IRS reminds taxpayers to report virtual currency transactions, IR-2018-71 (Mar. 23, 2018).
- See American Bar Association, Section of Taxation, Tax Treatment of Cryptocurrency Hard Forks for Taxable Year 2017 (Mar. 29, 2018).
- See H.R. 3650, Safe Harbor for Taxpayers with Forked Assets Act of 2019.
- IR-2019-132, July 26, 2019.
- www.irs.gov/pub/notices/letter_6174.pdf, www.irs.gov/pub/notices/letter_6174-a.pdf.
- See Coinbase, Inc., No. 17-cv-01431-JSC (N.D.Cal. Nov. 28, 2017); Stevie Conlon, Anna Vayser, and Robert Schwaba, Taxation of Bitcoin, Its Progeny, and Derivatives: Coin Ex Machina, 158 TAX NOTES 1001, 1015 (Feb. 19, 2018). See also Robert Green, Watch out Cryptocurrency Owners, the IRS Is on the Hunt, Forbes.com, Jul. 31, 2019.
- Similarly, statements made by IRS Chief Counsel Mike Desmond in October 2019 indicate that the IRS is considering expanding virtual currency information reporting to further address compliance concerns. Allyson Versprille, IRS Hopes to Tackle Information Reporting in Next Crypto Guidance, bloombergtax.com, Oct. 17, 2019.
- For example, some in the community may believe the size of each block of data in a blockchain is too small. A protocol change might support larger blocks that can hold more data.
- This can happen for a variety of reasons, varying from disagreement with the change to an inadvertent failure to update software.
- Rev. Rul. 2019-24, IRB 2019-44, 3.
- Note that there is a technological development community, a mining community, and a community of participants who have merely purchased the assets.
- See Christine Kim, Bitcoin Cash Just Split into Two Blockchains, coindesk.com, Nov. 15, 2018.
- These changes restored certain old protocols and increased the size of its blocks. Id.
- ABC and SV are both acronyms meaning, respectively, Adjustable Blocksize Cap and Satoshi’s Vision.
- Under the terms of the ruling, because Bitcoin ABC is the “legacy” cryptocurrency, holders of Bitcoin Cash should be considered to have received “airdropped” Bitcoin SV, and thus income in the amount of its fair market value.
- Many cryptocurrency miners pool their computing resources and share the rewards.
- William Foxley, As Bitcoin Cash Hard Forks, Unknown Mining Pool Continues Old Chain, coindesk.com, Nov. 15, 2019.
- Id. The majority of Bitcoin Cash users who have implemented the new protocol are working on a blockchain that has undergone, in the words of Rev. Rul. 2019-24, IRB 2019-44, “a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger,” which appears to have resulted in the “creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger.” Rev. Rul. 2019-24, IRB 2019-44, 2. Although it seems unlikely to be the intended result, a literalist reading of Rev. Rul. 2019-24 would seem to characterize this as a hard fork followed by an airdrop, which would result in taxable income for every holder of Bitcoin Cash that upgraded. This reading is likely too literal; Rev. Rul. 2019-24 specifically states that “a hard fork is not always followed by an airdrop.” However, the revenue ruling does not provide a mechanism to distinguish with authority which ledger and cryptocurrency are “legacy” and which are “new.” A related concern might be whether an event actually resulted in an airdrop or not, but Rev. Rul. 2019-24 seems to consider any hard fork resulting in two chains to involve an airdrop. See Nathan J. Richman, Taxpayers Never Have Control of New Coins Right After Hard Forks, 2019 TAX NOTES TODAY FEDERAL 234-4 (Dec. 5, 2019).
- Rev. Rul. 2019-24, IRB 2019-44, 1.
- Id., 4.
- See Glenshaw Glass Co., 348 US 426, 451 (1955). Rev. Rul. 2019-24 at 4.
- Id., 2.
- Id., 3. A thorough discussion of tax or other potential regulatory issues relating to the indirect ownership of cryptocurrencies through various intermediaries, such as cryptocurrency exchanges, is beyond the scope of this article. See generally Lee Sheppard, Cryptocurrency Customer Compliance, 165 TAX NOTES FEDERAL 709 (Nov. 4, 2019).
- Rev. Rul. 2019-24, IRB 2019-44, 3–4. This can result in a taxpayer having tax lots with substantially different basis as a result of the same fork event, depending on how the original coins were held.
- Note that FAQ A24 further provides that “your basis in that cryptocurrency is equal to the amount you included in income on your Federal income tax return.”
- Rev. Rul. 2019-24, IRB 2019-44, 3.
- Understanding the first example in the ruling, Situation 1, hinges on interpretation of precisely what the Ruling means by “legacy” and “new” distributed ledger and cryptocurrency. It seems unlikely that the Ruling is intended to create a rule that results in a technological upgrade being deemed a distribution of “new” cryptocurrency on a “new” distributed ledger. However, from a purely technological standpoint, a hard fork that is a technological upgrade might be understood to create a “new” distributed ledger distinct from the old ledger, with identical address holdings of a new, distinct cryptocurrency being traded instead of the old, legacy cryptocurrency. Automatic migration by wallet software may mask this from end users.
- Rev. Rul. 2019-24, IRB 2019-44, 5.
- See, e.g., David G. Chamberlain, Rodney P. Mock and Kathryn Kisska-Schulze, Disappearing Forks and Magical Airdrops, 165 TAX NOTES FEDERAL 791, 793 (Nov. 4, 2019).
- See, e.g., Rev. Rul. 2008-18, 2008-13 IRB 674; Proposed Reg. §1.305-3(e)(4) Examples 6(ii) and 7(ii).
- For a recent discussion of some of the technological issues, see Nathan J. Richman, Taxpayers Never Have Control of New Coins Right after Hard Forks, 2019 TAX NOTES TODAY FEDERAL 234-4 (Dec. 5, 2019).
- See L.E. Gamble, 68 TC 800, Dec. 34,604 (1977).
- Rev. Rul. 86-24, 1986-1 CB 80.
- Bittker and Eustice, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS, at §12.11 (Thomson Reuters/Tax & Accounting, 7th ed. 2015 with updates through November 2019).
- Although cryptocurrencies generally seem unlikely to constitute a common business enterprise, some virtual currencies, such as Ripple, are far more centralized. See, e.g., Joe Liebkind, Why Some Claim Ripple Isn’t a “Real” Cryptocurrency, Investopedia.com, Dec. 14, 2017.
- David J. Shakow, The Tax Treatment of Tokens: What Does It Betoken?, 156 TAX NOTES 1387 (Sept. 11, 2017).
- See, e.g., Andrew Glidden, Transmogrifying Tokens: From Securities to Commodities, medium.com, Jun. 15, 2018.
- It now appears that the blockchain technology will provide a mirror to a traditional distribution system. See Letter re: Overstock.com, Inc. Dividend of Series A-1 Preferred Stock from Cliff Stricklin, Bryan Cave Leighton Paisner LLP, to Attn: Neelanjan Maitra, U.S. Securities and Exchange Commission (Sept. 3, 2019).
- See, e.g., Eisner v. Macomber, SCt, 1 USTC ¶32, 252 US 189, 40 SCt 189 (1920).
- There are third parties that provide matching services to identify and facilitate such atomic swaps. See William M. Peaster, The Best Decentralized Exchanges for Cryptocurrency Trading, blockonomi.com, July 26, 2019.
- Alternatively, Answer 26 further provides that “[i]f you do not use an explorer value, you must establish that the value you used is an accurate representation of the cryptocurrency’s fair market value.”
- See generallyCode Sec. 1223.
- SeeReg. §1.1012-1(c)(2), (3).
- Potentially complicating concerns include, but are not limited to: complexities arising out of a transition between another lot relief method and an averaging method; whether and how to segregate lots acquired before an averaging method became available; issues related to what could or should constitute an “account” for averaging purposes; and potential implications of allowing “account by account” or lot by lot selection of an averaging method.
- Code Sec. 102(a).
- If the recipient cannot substantiate the donor’s basis, the recipient’s basis is instead zero.
- See, e.g., Letter re: Recent Guidance on Cryptocurrency from Monte Jackel to Michael Desmond, Chief Counsel, Internal Revenue Service. Individual Raises Issues with Cryptic Cryptocurrency Guidance, 2019 TNTF 200-19 (Oct. 15, 2019). The initial two and final substantive concerns presented regarding Rev. Rul. 2019-24 compare the guidance to the taxation of corporate actions involving stock interests, which are governed by a detailed statutory, regulatory and judicial framework. No such framework yet exists for virtual currency, and no argument is presented that virtual currency explicitly or implicitly constitutes equity. Id., 2–3. The balance of the concerns focus on the nature of the income itself; first, is it potentially a gift, and second, absent evidence of a sale or exchange, what is the statutory basis for inclusion in income and how apposite were Rev. Rul. 2019-24’s citations to various portions of Code Sec. 61? See also David J. Shakow, Taxing Bitcoin and Blockchains: What the IRS Told Us (and Didn’t), 2020 TNTF 8-10 (Jan. 13, 2020). Note that this article also provides an excellent comparison between proof of work and proof of stake mechanisms.
- Id., 4–5.
- Note that certain federal tax laws delegate many of the rules and details to the IRS. One set of examples are the consolidated return regulations under Code Sec. 1502, which begins “The Secretary shall prescribe such regulations as he may deem necessary in order that….”
- See Understanding IRS Guidance – A Brief Primer, www.irs.gov/newsroom/understanding-irs-guidance-a-brief-primer.
- See, e.g., Chamber of Commerce, No. 1:16-cv-00944 (W.D. Texas, 2017).
- See, e.g., Policy Statement on the Tax Regulatory Process, available at https://home.treasury.gov/system/ files/131/Policy-Statement-on-the-Tax-Regulatory-Process.pdf (Mar. 5, 2019).
- Letter re: Recent Guidance on Cryptocurrency from Monte Jackel to Michael Desmond, Chief Counsel of the IRS and Ass’t General Counsel of the Dept of the Treasury, Oct. 15, 2019. Available at 2019 TNTF 200-19.
- SeeReg. §1.6662-4(d).
- SeeReg. §1.6662-4(d)(iii).
- For example, the gift and charitable contribution rules.
- See Linda Galler, Judicial Deference to Revenue Rulings: Reconciling Divergent Standards, 56 OHIO ST. L.J. 1037, 1044–1046 (1995).
- A thorough discussion of the appropriateness or applicability of various forms of IRS guidance is beyond the scope of this article; however, it is a contentious issue that is not unique to cryptocurrency taxation.
- “Virtual currency’ is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Notice 2014-21, IRB 2014-16, 1. “Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as ‘convertible’ virtual currency.” Id.
- For example, “virtual currency” could be read to include a variety of digital artifacts used only within electronic games, including even electronic cosmetic items. Players of one specific online game developed a secondary market using real-world currency to buy and sell hats that existed solely in-game; as of 2011, the market for these hats was valued at upwards of $50 million, but has since crashed. Owen Good, Analyst Pegs Team Fortress 2 Hat Economy at $50 Million, kotaku.com, Dec. 17, 2011. Patrick Kobek, The Overnight Collapse of Team Fortress 2’s Economy: How It Happened, thegamer.com, Jul. 28, 2019. This article does not address the appropriateness of taxing electronic gaming-related in-game awards or property.