By: Jonathan Wolnik
On October 9, 2019, the Internal Revenue Service (“IRS”) issued its first guidance on virtual currency in several years, consisting of Revenue Ruling 2019-24 and a question-and-answer document. The new guidance focuses on properly reporting a variety of virtual currency transactions for tax purposes. The guidance also includes how “hard forks” and “airdrops” are taxed. Those taxpayers using virtual currency that are otherwise unfamiliar with the concepts discussed in this blog should be working closely with their professional tax advisors to ensure proper reporting and compliance.
The IRS defines virtual currency as a digital representation of value, other than a representation of the U.S. dollar or a foreign currency, that functions as a unit of account, a store of value, and a medium of exchange. Cryptocurrency is a type of virtual currency that uses cryptography to secure digital transactions recorded on an electronic “distributed ledger”, such as blockchain. In very simple terms, a distributed ledger is a database maintained and updated by independent network participants to account for cryptocurrency transactions.
For U.S. tax purposes, virtual currency is taxed as property even though there is no physical manifestation of value as with tangible currency. The general tax principles applicable to property also apply to virtual currency. This means that when virtual currency is sold, capital gain or loss must be recognized by the seller. Therefore, taxpayers must track their basis (generally the fair market value of the property at the time it was acquired) in the virtual currency and must determine its fair market value during any given transaction. Capital losses, if any, are subject to limitations on deductibility. Transferring virtual currency to another in an “arms-length” transaction constitutes a sale.
The new IRS guidance indicates that when an employee is compensated with virtual currency, they receive property in exchange for the services rendered and must recognize ordinary income on the transaction. Further, the compensation paid to the employee in the form of virtual currency is subject to all relevant employment taxes (i.e., federal withholding, FICA and FUTA). The virtual currency is valued at its fair market value, measured in U.S. dollars, at the time of receipt by the employee. The payor is also deemed to be “selling” its property, requiring it to recognize capital gain or loss on the transaction as well.
The same tax treatment applies to independent contractors who are paid in virtual currency. Contractors must recognize ordinary income at the fair market value of the virtual currency received, measured in U.S. dollars as of the date of receipt. Further, such remuneration to the contractor is subject to self-employment tax.
A “hard fork” is unique concept to the new digital ledger technologies that are rapidly becoming available to the public. A hard fork occurs when a cryptocurrency undergoes a protocol change causing a permanent diversion from the original distributed ledger. In other words, a hard fork occurs when the ledger technology is updated, and transaction recording diverts because of a radical change in the programming protocol. For example, the imposition of a new rule on the ledger may cause a hard fork. The hard fork may produce the creation of a new cryptocurrency on a different distributed ledger, further resulting in the existence of both a legacy distributed ledger and a new distributed ledger for the cryptocurrencies.
An “airdrop” is a method of distributing cryptocurrency to the distributed ledger across multiple layers of taxation, according to the IRS. It is essentially the transfer of cryptocurrency to an owner’s virtual wallet or address, and accounts for the path the cryptocurrency takes to arrive at its destination. As the IRS states, “A hard fork followed by an airdrop results in the distribution of units of the new cryptocurrency to virtual addresses containing the legacy currency.” If a hard fork is followed by an airdrop, the taxpayer will have taxable income in the taxable year that he or she received the cryptocurrency. When cryptocurrency is received in an airdrop following a hard fork, the taxpayer must recognize ordinary income equal to the fair market value of the new cryptocurrency when it is received. Cryptocurrency is deemed to be received when the new cryptocurrency is recorded on the distributed ledger, provided the taxpayer then has dominion and control over the cryptocurrency such that the taxpayer can transfer, sell, exchange, or otherwise dispose of it. Such attributes are the hallmarks of dominion and control for tax purposes. The taxpayer’s basis in such new cryptocurrency is the fair market value reported for federal income tax purposes. All of these points and measurements are extremely important for tax purposes.
As a contrast, a “soft fork” occurs when a distributed ledger experiences a protocol change that does not result in a diversion of the ledger such that no new cryptocurrency is produced. The taxpayer remains in essentially the same position he or she was in prior to the soft fork meaning there is no imputed income to the taxpayer and therefore, nothing to report subject to income tax.
Virtual currencies remain in their infancy as do the electronic transaction ledgers but can quickly become complicated. However, the IRS position on taxation remains crystal clear and straightforward. Earlier this year, the IRS began sending notices to taxpayers owning virtual currencies who potentially failed to pay the associated taxes. The IRS Commissioner made it clear that the IRS is expanding its efforts to capture taxes owed on virtual currency. The IRS is actively using data analytics to track compliance and is also obtaining customer lists from various virtual currency trading platforms, all released pursuant to court orders. Taxpayers are cautioned to be diligent and forthright in reporting their virtual currency activity to avoid complications with the IRS. Claims by a taxpayer that they did not understand the rules is not sufficient defense when the IRS challenges a taxpayer’s position. Failure to properly report and pay taxes associated with taxable virtual currency transactions is sure to result in penalties and interest being assessed.