By: Eric P. Rothenberg, Esq. [Published Article]
For the first time since the IRS issued guidance in 2014 [See IRS Notice 14-21], the IRS has twice spoken on the subject of cryptocurrency despite Congress practically begging for guidance in September 2018 [See letter to the IRS dated September 19, 2018 from the House Ways and Means Committee]. And while the IRS did answer some questions, there are still far too many left out.
On October 10, 2019 the IRS released IR-2019-167 which they thought was “additional guidance”. It’s only a one-page release but it does reference new frequently asked questions [FAQ’s]. The FAQ’s on cryptocurrency comprise 43 questions. Nearly all of those FAQ’s are no news at all and merely state the obvious once the IRS declared in 2014 that cryptocurrency was considered by them to be “property” and not currency nor a security [See IRS Notice 14-21]. The FAQ’s can be found at https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions
In conjunction with the new FAQ’s, the IRS issued Rev. Rul. 2019-24 which deals with the tax consequences of a “HARD FORK” and “AIRDROP” to owners of crypto currency when those events occur. The Revenue Ruling does provide the IRS’s thinking and analysis on how they conclude that some of those events are taxable to taxpayers and is the basis of the answers in the FAQ’s dealing with those same events [see questions 21 to 24].
One of the more interesting FAQ’s is Question 42 [yes, second to last]. It asks where can a taxpayer get more information on tax treatments for cryptocurrency. The entire answer is “Information on virtual currency is available at Virtual Currencies www.IRS.gov/virtual_currency]. Many questions about the tax treatment of virtual currency can be answered by referring to Notice 2014-21 (PDF) and Rev. Rul. 2019-24. The link they provide just circles right around to the FAQs and the revenue ruling no essentially it adds nothing. So for now, in sum, the only available IRS guidance are those forty-three questions and answers.
Before I address the issues of hard forks and air drops, as discussed in Rev. Rul. 2019-24, I need to first explain what they are. First, a “hard fork” is a change in the way the blockchain ledger works. It is a change that can occur with ANY virtual currency and not just Bitcoin. It can occur where there is no exchange and there is just a blockchain ledger. Since this is a change in the protocol used by all miners of tokens or coins, they ALL have to know about the change and agree to use the new protocol. The change instituted is a change on the software protocols and once it happens, there is a “fork” in the protocol to allow the old currencies to stay and new currencies to use the new protocols. This is what happened to create both Bitcoin Cash, Bitcoin Gold but also other prominent but non-bitcoin forks. The forks can be created to protect chains that have security flaws, or were already hacked.
There are also “Soft Forks”. The hard fork results in two (or more) chains being created while the Soft Fork results only in one new chain with the old one going away. Soft forks, for example, were created on both the Bitcoin and Ethereum blockchains to implement new and upgraded functionalities that are also backwards compatible. Knowing the difference between a Hard Fork and a Soft Fork is very important because a soft fork is not a taxable event [See FAQ Question 29]. The IRS treats this as a mere change in the software [i.e. protocols] and therefore no new asset is created so no taxable event happened.
And then there is the “airdrop”. An airdrop is when virtual tokens or coins are passed down to the holders of record in a blockchain following a fork. The original coins are called “parent coins” and then new coins are often only airdropped to those who held on to their parent coins as a reward for the confidence and holding.
All right, what else can we mine [LOL] from the IRS FAQ’s? Let’s look closely at:
Question 35: “Will I have to recognize income, gain, or loss if I own multiple digital wallets, accounts, or addresses capable of holding virtual currency and transfer my virtual currency from one to another? No. If you transfer virtual currency from a wallet, address, or account belonging to you, to another wallet, address, or account that also belongs to you, then the transfer is a non-taxable event, even if you receive an information return from an exchange or platform as a result of the transfer.”
This question [excuse me] begs the question. Surely if you have Bitcoin on multiple digital wallets and you move them around there is not a tax consequence. But what we really want to know is if you move it an exchange and trade the coins for a different coin, is that a taxable event. The very next question mentions “one kind of virtual currency” but Question 35 doesn’t use that phrase to distinguish between different kinds of virtual currency so it doesn’t help the tax practitioner.
Question 36 and 37 deal with “specific identification” for sales or exchanges when you have different basis amounts for the same type of currency but purchased at different times. The IRS has now given us guidance and their requirements to do that. You do that by identifying a specific unit of virtual currency either by documenting the specific unit’s unique digital identifier such as a private key, public key, and address, or by records showing the transaction information for all units of a specific virtual currency, such as Bitcoin, held in a single account, wallet, or address. This information must 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 is very helpful to have at least their view of what is required since such guidance has been missing for many years.
It is quite interesting that Question 38 states that if you don’t use the specific identification method above, then you must use FIFO and apparently they are not open to using LIFO. There is no more information on that so while the IRS FAQ’s are not law, it does appear that there is no good reason why you cannot use LIFO.
Believe it or not, that’s it! There is no more guidance in their FAQ’s. I don’t know about other tax professionals preparing income tax returns for those who deal in cryptocurrencies, but in my practice, I not only see many other problems in reporting these transactions but there are still many unanswered questions. For ex., we must report on an FBAR when the taxpayer has accounts in exchanges in a foreign country and they exceed the threshold for reporting. But there are many exchanges that move around or, even more difficult, they have no country home and the exchange itself may be in multiple places and countries. A second example if when taxpayers engage in robot currency trading [software driven] and these are available on exchanges overseas as well. These large volume exchanges are very difficult to account for by the average taxpayer who comes to see me and is lost as to what to do. Another unanswered issue is that while the IRS is clear [in Question 22] that a hard fork followed by an airdrop is a taxable event, it doesn’t state clearly that an airdrop after a soft fork is non-taxable although it seems it clear is non-taxable.
With many of my own clients who filed with crypto in 2017, the IRS has sent out letters to check with 1099-K’s received from exchanges such as Bitcoin, to verify the return reported all amounts on the 1099-K. Because you could treat exchanges of cryptocurrency as a like kind exchange in 2017, I have reported some exchanges on Form 8949 for a sale of a capital asset but also in 2017 I reported many transactions on Form 8824 [Tax Free Exchanges] when the taxpayer traded currencies among various exchanges. The IRS sent out letters to my clients claiming that not all amounts from the 1099-K were reported, even though the bulk were reported on Form 8824. If you had a client that reported a real estate sale on Form 8824, it would not go on Form 8949 nor Schedule D but you would not get a letter from the IRS but now with their eyes squarely on reported of cryptocurrency sales, they haven’t figured out the connection between those two forms.
I trust now that the revenue ruling and FAQ’s are published, there will be future guidance on this but for now this is all we have to go on. In the future I expect there will be Tax Court cases coming up as well.
REFERENCES: Cryptocurrency [Bitcoin] and the IRS, by Eric P. Rothenberg, Sum News, 1/23/2018; Ohio Jumps into the World of Cryptocurrency, by Eric P. Rothenberg, December 9, 2018 Bank & Tradesmen