The Internal Revenue Service (IRS) has issued new guidance for taxpayers who engage in transactions involving virtual currency, including cryptocurrency. The new guidance, which is intended to help taxpayers better understand reporting obligations for specific transactions involving virtual currency can be found at Revenue Ruling 2019-24 (downloads as a PDF) and the frequently asked questions (FAQs) on the IRS website.
The Revenue Ruling focuses on the tax treatment of a cryptocurrency hard fork. In addition, the FAQs address virtual currency topics like basis, gain or loss on the sale of exchange of virtual currency, and how to determine the fair market value.
“The IRS is committed to helping taxpayers understand their tax obligations in this emerging area,” said IRS Commissioner Chuck Rettig. “The new guidance will help taxpayers and tax professionals better understand how longstanding tax principles apply in this rapidly changing environment. We want to help taxpayers understand the reporting requirements as well as take steps to ensure fair enforcement of the tax laws for those who don’t follow the rules.”
The IRS previously issued guidance in 2014 to taxpayers (downloads as a PDF) making it clear that virtual currency will be treated as a capital asset, provided they are convertible into cash. In simple terms, this means that capital gains rules apply to any gains or losses. (You can read more on the taxation of cryptocurrencies like Bitcoin here.)
The guidance in the most recent Revenue Ruling specific addresses two questions:
- Does a taxpayer have gross income under §61 of the Internal Revenue Code (Code) as a result of a hard fork of a cryptocurrency the taxpayer owns if the taxpayer does not receive units of a new cryptocurrency?
- Does a taxpayer have gross income under §61 as a result of an airdrop of a new cryptocurrency following a hard fork if the taxpayer receives units of new cryptocurrency?
Some definitions might be useful. A hard fork occurs when cryptocurrency on a distributed ledger (used to record, share, and synchronize transactions) undergoes a shift. A hard fork may result in the creation of a new cryptocurrency: what this means in simple terms is that two blockchains – and two currencies – could occur. Following a hard fork, transactions involving the new cryptocurrency are recorded on the new distributed ledger, and transactions involving the former cryptocurrency continue to be recorded in the prior distributed ledger.
Here’s where it gets tricky. An airdrop is a method of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers. If a hard fork is followed by an airdrop, units of the new cryptocurrency are distributed to addresses containing the legacy (former) cryptocurrency. But a hard fork is not always followed by an airdrop. And, a taxpayer may constructively receive cryptocurrency before the airdrop is recorded on the distributed ledger. The taxpayer does not necessarily have receipt – constructive or otherwise – of cryptocurrency when the airdrop is recorded on the distributed ledger.
Constructive receipt is an important concept. Think about it like this. Let’s say that your boss gives you a paycheck and you put it in your desk drawer, and then you quit and forgot about the check. You still got paid. The check is still taxable to you, even if you never take any steps to cash it (such as replacing the check). That principle is referred to as “constructive receipt” and it means that you are taxed on income when it’s made available. You cannot avoid tax by giving your paycheck to another person, squirreling away your check and not cashing it, or mailing it back to your employer. The IRS likes to say that a taxpayer may not “turn his back on income” to avoid tax.
In the case of virtual currency, if the taxpayer doesn’t have dominion and control over the asset, meaning the currency is not immediately credited to the taxpayer’s account at the cryptocurrency exchange, that creates a tax issue. If the taxpayer later acquires the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency, the taxpayer is treated as receiving the cryptocurrency at that time.
The Revenue Ruling makes it clear that a taxpayer does not have gross income as a result of a hard fork if the taxpayer does not receive units of a new cryptocurrency. The Revenue Ruling also makes clear that a taxpayer does have gross income – characterized as ordinary income – if, as the result of an airdrop following a hard fork, the taxpayer receives units of new cryptocurrency. In contrast, when a soft fork occurs (when a distributed ledger undergoes a shift that does not result in the creation of a new cryptocurrency), the soft fork will not result in income. You can find more details about basis and income following a hard or soft fork in the FAQs.
The FAQs also clarify some additional tax issues. The IRS had already confirmed that virtual currency is to be treated as a capital asset if it can be converted to cash. This means that capital gains rules apply to any gains or losses on the sale or transfer of virtual currency, and will be reported on a Schedule D. However, 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 (like a form 1099) from an exchange or platform as a result of the transfer.
In the FAQs, the IRS clarified that the receipt of virtual currency in exchange for performing services, whether or not you perform the services as an employee, results in income. Additionally, virtual currency received by an independent contractor for performing services constitutes self-employment income, measured in U.S. dollars as of the date of receipt, and is subject to the self-employment tax. Compensation for services paid in virtual currency, measured in U.S. dollars at the date of receipt, is subject to federal income tax withholding and employment taxes (such as Social Security and Medicare). If the cryptocurrency received is not traded on any cryptocurrency exchange and does not have a published value, then the value of the cryptocurrency received is equal to the fair market value of the property or services exchanged when the transaction occurs.
The same result is true if you pay for services (or goods) using virtual currency. When you make the payment, you will have a capital gain or loss. Your gain or loss is the difference between the fair market value of the services you received, and your adjusted basis in the virtual currency exchanged.
If you receive virtual currency as a gift, you will not immediately recognize income. You will only recognize income when you sell, exchange, or otherwise dispose of the virtual currency. For purposes of determining whether you have a gain, your basis is equal to the donor’s basis (meaning the cost attributed to the person making the gift), plus any gift tax the donor paid on the gift. For purposes of determining whether you have a loss, your basis is equal to the lesser of the donor’s basis or the fair market value of the virtual currency at the time you received the gift. If you do not have any documentation to substantiate the donor’s basis, then your basis is zero. Your holding period includes the time that the virtual currency was held by the donor. However, if you can’t substantiate the donor’s holding period, then your holding period begins the day after you receive the gift.
For donation purposes, if you make a gift of virtual currency to a charitable organization, you will not recognize income, gain, or loss from the donation. You will be entitled to a charitable contribution deduction equal to the fair market value of the virtual currency at the time of the donation if you have held the virtual currency a year or more. If you kept it for less than a year, your deduction is the lesser of your basis or the virtual currency’s fair market value at the time of the donation.
Finally, the FAQs make clear that taxpayers are required to maintain excellent records to establish positions taken on tax returns. This is always true, no matter whether you’re dealing with cryptocurrency, cash, or diamonds. You should maintain records documenting receipts, sales, exchanges, or other dispositions of virtual currency and the fair market value of the virtual currency.
The need for record-keeping is particularly acute since the IRS is targeting non-compliance through a variety of efforts, ranging from taxpayer education to audits to criminal investigations. In July of this year, the IRS began mailing letters to taxpayers who may have failed to report or misreported transactions involving virtual currency. Those taxpayers may be liable for tax, penalties, and interest. In some cases, taxpayers could be subject to criminal prosecution.