Andersen analysis: IRS virtual currency guidance clarifies tax treatment of 'hard forks' and 'airdrops'

To begin, whether a 'hard fork' will result in gross income and a reporting obligation for a U.S.-taxpaying virtual currency owner will depend on whether the taxpayer has, in the IRS's view, received new units of currency in the process.

A 'hard fork' is a 'blockchain technology' term that is used to describe the instance when a virtual currency on an existing distributed ledger undergoes a protocol change that results in a permanent diversion to a new distributed ledger.

This diversion results in a 'fork', similar to a fork in a road, which creates separate paths in the blockchain – one for the previous protocol, and a path for the new one.

Looking at the bigger picture, we can see that the IRS's recently-published revenue ruling and frequently-asked questions (FAQs) are consistent with earlier IRS guidance, Notice 2014-21, released in 2014, which indicates that virtual currency is subject to the same general principles applicable to the tax treatment of transactions involving other types of property.

A taxpayer would not have a gross income recognition event as the result of a hard fork of a virtual currency they own, unless the taxpayer receives new units of the virtual currency, the IRS concludes, in Revenue Ruling 2019-24.

Therefore, gross income and a tax reporting obligation would arise upon the receipt of new virtual currency, including an 'airdrop' following a hard fork.

Hard forks and airdrops

A hard fork can result in the creation of a new virtual currency that is subject to the new protocol, while the existing or “legacy” virtual currency remains subject to the previous protocol.

An example of a virtual currency resulting from a hard fork is Bitcoin Cash.

At the time of the fork, owners of Bitcoin were considered to also possess the same number of Bitcoin Cash units. The Bitcoin Cash units were then subject to different rules than those applicable to Bitcoin, such as the allowance of larger blocks in the Bitcoin Cash blockchain. This could allow the Bitcoin Cash blockchain to process transactions faster than the Bitcoin blockchain.

A hard fork can be followed by an airdrop – which occurs when units of the new virtual currency are distributed to the owners of the legacy virtual currency.

An airdrop can occur in isolation, or in connection with a fork.

Virtual currency from an airdrop is generally deemed to be received by the taxpayer on the date and time it is recorded on the "distributed ledger", if the taxpayer is able to exercise dominion and control over the virtual currency.

'Dominion and control'

The IRS's latest revenue ruling explains that the tax treatment of hard forks depends on whether the owner of the original virtual currency has received new units of virtual currency. A taxpayer does not receive the new virtual currency after an airdrop, if the taxpayer is unable to exercise dominion and control over the new virtual currency.

For example, no gross income would arise if the new virtual currency is airdropped to a virtual currency exchange that does not support the new virtual currency and, as a result, does not credit the new virtual currency to the taxpayer’s account.

However, gross income and a reporting requirement does arise if the taxpayer later acquires the ability to transfer, sell, exchange or otherwise dispose of the new virtual currency.

If the hard fork results in the taxable receipt of new virtual currency, the taxpayer’s gross income and basis in the new virtual currency is its fair market value at the time the airdrop is recorded.

Property Transactions

The IRS's FAQs are consistent with the guidance in Notice 2014-21, i.e., that virtual currency is subject to the same general principles applicable to the tax treatment of transactions involving other types of property.

This holds true for virtual currency that is exchanged for other property, received as a gift, or donated to charity.

However, some of the new FAQs specifically address issues unique to virtual currency.

For example, a U.S. taxpayer who sells, exchanges or otherwise disposes of virtual currency without specifically identifying the units is obliged to use the "First In First Out" (FIFO) accounting method, to determine the taxpayer's basis in the virtual currency for which the disposition occurs.

Under FIFO, the taxpayer sells, exchanges or otherwise disposes of virtual currency units in the order in which they were originally acquired.

The FAQs provide that a taxpayer may identify a specific unit of virtual currency, either by documenting the specific unit's unique digital identifier, such as a private key or public key and address; or by records showing the transaction information for all units of a specific virtual currency held in a single account, wallet or address.

The taxpayer's books and records must show (1) the date and time each unit was acquired; (2) the 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.

The FAQs advise that no taxable event arises when a taxpayer transfers virtual currency from one wallet, address or account owned by the taxpayer to another.

Additionally, the FAQs also indicate that whether or not a transaction involving virtual currency is taxable is not dependent upon the receipt of a Form W-2, Form 1099 or other informational return.

The takeaway

Whether a hard fork results in gross income for the vitual currency's owner (and  U.S. taxpayer), in the end, depends on whether the owner/taxpayer is deemed to have received new units of virtual currency as a result. Gross income does not arise as a result of a hard fork of a virtual currency if the taxpayer does not receive new units of the virtual currency.

However, gross income and a tax reporting obligation do arise as a result of an airdrop of a new virtual currency. 

The revenue ruling is consistent with guidance released in 2014, that virtual currency is subject to the same general principles applicable to the tax treatment of transactions involving other types of property.
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The above article was adapted from a piece originally published on the website of Andersen Tax LLC, which was written by Joe Gill, a managing director in Andersen’s New York office, where he focuses on the taxation of financial instruments.  The opinions and analyses expressed in it do not necessarily reflect those of Andersen or any affiliate thereof, and are subject to change at any time. Any suggestions contained herein are general, and do not take into account an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change.
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