Anticipated IRS Virtual Currency Guidance Clarifies Tax Treatment of Hard Forks and Airdrops; Approach Consistent with 2014 Notice

Whether a hard fork results in gross income and a reporting obligation for the owner depends on if a taxpayer is deemed to have received new units of virtual currency. The revenue ruling and frequently asked questions (FAQs) are 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.

A taxpayer does not have gross income as a result of a hard fork of a virtual currency the taxpayer owns if the taxpayer does not receive new units of the virtual currency, IRS concluded in Revenue Ruling 2019-24. However, gross income and a tax reporting obligation do arise as a result of an airdrop of a new virtual currency, including an airdrop following a hard fork, if the taxpayer receives units of new virtual currency.

The ruling, along with a supplement to IRS’s FAQs, offers the latest guidance on virtual currency, since 2014 when the agency released Notice 2014-21.

Hard Forks and Airdrops

A hard fork occurs when virtual currency on an existing distributed ledger undergoes a protocol change that results in a permanent diversion to a new distributed ledger. The 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. A hard fork may 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, anyone owning Bitcoin also possessed 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.

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 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 FAQs further illustrate the guidance in Notice 2014-21 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 new FAQs specifically address issues unique to virtual currency. A taxpayer that sells, exchanges or otherwise disposes of virtual currency without specifically identifying the units, must use the first in first out (FIFO) accounting method. The units will be deemed to have been sold, exchanged, or otherwise disposed of in chronological order beginning with the earliest unit of the virtual currency that was acquired. In addition, 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. The FAQs provide 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 depends on whether a taxpayer is deemed to have received new units of virtual currency. 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. Gross income and a tax reporting obligation do arise as a result of an airdrop of a new virtual currency if the taxpayer receives units of the 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.