The IRS released long-anticipated cryptocurrency transaction characterization and reporting guidance in the form of Rev. Rul. 2019-24 (the revenue ruling) and a Q&A-style guide on October 9, 2019.
The guidance arrives concurrent with many crypto investors receiving letters from the IRS requesting information related to their crypto transactions. The IRS guidance may prove useful for taxpayers seeking confirmation about the validity of prior reporting positions and guidance about documenting anticipated crypto transactions, however, many unanswered questions still remain.
Taxpayers had previously relied on five-year-old Notice 2014-21 for basic characterization guidance for cryptocurrency transactions; the notice asserted the IRS’s position that cryptocurrency was considered to be property in the hands of the taxpayer and would be treated as a capital asset for US tax purposes. Accordingly, as a capital asset, crypto wouldn’t be treated as a form of fiat currency or money. The notice, while fairly basic, was the sole US-tax authority guidance available for taxpayers and tax advisors for the five years prior to the release of the revenue ruling and the Q&A.
The revenue ruling builds on the basic concepts provided in the notice by providing guidance on hard forks, air drops, and additional technical matters such as valuation and tax basis.
Hard Forks
Rev. Rul. 2019-24 addresses several issues pertaining to so-called hard forks. The revenue ruling defines a hard fork as a split in cryptocurrency existing in the distributed ledger as a result of a protocol change. In other words, a hard fork is a change in the blockchain due to the creation of a new, distinct, and separate cryptocurrency.
Often a hard fork is accompanied by what the IRS refers to as an airdrop. Essentially, an airdrop is the creation of new units of the new cryptocurrency created by the hard fork, and the distribution of these units to taxpayers who also hold the original cryptocurrency, usually in a pro-rata fashion.
However, not every hard fork is accompanied by an air drop.
In determining whether and when a holder of cryptocurrency should recognize taxable income as a result of a hard fork, an airdrop, or both, the revenue ruling focuses on whether the taxpayer has “dominion and control” over the new units of cryptocurrency.
To illustrate these principles of dominion and control, the government provides two fact patterns resulting in two different conclusions.
- In the first example, a hard fork occurs, but the subject taxpayer doesn’t receive any of the new cryptocurrency—in other words, there’s no airdrop—and the revenue ruling concludes that the taxpayer doesn’t realize taxable income under section 61 because there is no “accession to wealth.”
- In the second example, a taxpayer does receive new and assessable crypto assets as a result of a hard fork. In the second instance, the taxpayer has realized income under section 61 because there’s an accession to wealth—the taxpayer has received a valuable asset that presumably has a saleable value.
As the second conclusion explains, the ability of the taxpayer to dispose or transfer the new asset resulting from an airdrop provides the taxpayer with dominion and control over the new cryptocurrency, and the taxpayer should recognize ordinary income in that year. The basis of the airdropped coin is the fair market value of the airdropped coin the moment it is recorded on the distributed ledger.
The issue of valuing a crypto asset that may not have a developed market at the time of the air drop isn’t addressed in the revenue ruling, although some guidance may be found in the Q&A. This could potentially become a problematic issue as it’s common for the tradable value of crypto assets to fluctuate widely over relatively short periods of time.
The question of dominion and control is therefore determinative as to whether the taxpayer derives income from an airdrop. The revenue ruling provides a taxpayer won’t have dominion and control over cryptocurrency where the exchange holding the taxpayer’s wallet doesn’t support the new cryptocurrency resulting from the airdrop. A potential implication of this conclusion is that if airdropped currency became supported by the taxpayer’s wallet, the taxpayer would have income at the moment the exchange begins to support the new cryptocurrency.
Further, the revenue ruling provides while a taxpayer may not have dominion and control over airdropped cryptocurrency not supported by their exchange, a taxpayer has constructive receipt over cryptocurrency that is received prior to the airdrop being recorded on the distributed ledger—the receipt occurring when the taxpayer has the ability to move, transfer, or dispose of the new coins. However, the revenue ruling doesn’t discuss how value is to be determined by the constructive receipt of an airdropped crypto asset that isn’t recorded on any ledger; presumably it’s not tradable.
Technical Matters
The IRS also released guidance in the form of a Q&A to describe certain technical tax matters of cryptocurrency transactions, such as:
- Determining tax basis
- Computing gain and loss
- Determining fair market value
Notice 2014-21 defined convertible virtual currency as property for US tax purposes. For this reason, the Q&A generally refers taxpayers to existing IRS publications regarding the taxation of property-related transactions as addressed in Q2.
Consistent with the notice, the Q&A confirms that trading cryptocurrency for another cryptocurrency or fiat currency, or disposal of the currency by using it to pay a service provider, will result in a taxable event for US federal tax purposes. Additionally, where a taxpayer receives cryptocurrency in exchange for services, the taxpayer should recognize ordinary income equal to the fair market value of the cryptocurrency in USD at the moment of receipt.
A further technical matter covered by the Q&A is how one determines the fair market value of cryptocurrency. Q25 provides that, generally, the fair market value of cryptocurrency will be the amount recorded by the taxpayer’s cryptocurrency exchange in USD. Where a transaction isn’t actually recorded on the distributed ledger, the fair market value is the USD amount the cryptocurrency was trading for on the exchange at the exact date and time the transaction would otherwise have been recorded on the blockchain--as addressed in Q26.
Interestingly, when an exchange isn’t facilitating the transaction, the IRS will accept support of the fair market value as determined by a cryptocurrency explorer, which analyzes worldwide cryptocurrency trends and pricing and provides value of the coin at the moment of the transaction. Further, where a taxpayer cannot ascertain an explorer value, general valuation principles apply.
Information Reporting & Withholding
The new guidance in the revenue ruling and Q&A may usher in or confirm additional compliance burdens given the government’s clear interest in, and emphasis on, information reporting.
On October 8, 2019, the IRS released guidance under section 6045 of its priority guidance plan as it related to information reporting of virtual currency. Section 6045 relates to broker-dealers and defines a broker as a dealer, barter exchange, or any other person acting as a middleman in a property or services transaction.
Forthcoming guidance will presumably provide information on how cryptocurrency exchanges and other institutions would be included or excluded from the current definition.
Crypto transactions on foreign exchanges haven’t previously required reporting on Financial Crimes Enforcement Network’s (FinCEN) Form 114, Report of Foreign Bank and Financial Accounts. Additionally, cryptocurrency transactions didn’t create Foreign Account Tax Compliance Act (FATCA) reporting requirements. However, due to an apparent concern that investors may be motivated to take their cryptocurrency trading offshore by opening accounts with non-US exchanges, the IRS and FinCEN are reportedly considering whether such accounts should be required to report on Foreign Bank Account Reports (FBARs) and be subject to other FATCA reporting.
Unfortunately, neither the revenue ruling nor the notice provide guidance on whether or how cryptocurrency exchanges should report tax information to the IRS. This would seem to be an important issue, given the requirement under the revenue ruling for taxpayers to report income from trading and from airdrops. These items are expected to be covered in the near future according to the 2019-2020 Priority Guidance Plan.
Despite the relative lack of guidance around information reporting, the IRS recently released a draft version of the 2019 Form 1040, which includes a direct question of whether the taxpayer received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency during the 2019 tax year.
International Compliance – Value-Added Tax
Many jurisdictions other than the US federal government have been wrestling with questions regarding the taxation of cryptocurrency. The UK Commercial Court recently decided a case that may have implications as to whether cryptocurrency transactions are subject to value-added tax (VAT).
In Robertson v. Persons Unknown, the claimant asked for and received an Asset Preservation Order (APO) over more than £1 million worth of Bitcoin that had been stolen through a cyber-attack. An APO is generally made with respect to property, but English common law only recognizes two types of personal property:
- Physical things over which rights can be exercised
- Intangible rights against another person
Under this definition, neither type appears to apply to cryptocurrency. In Robertson, the claimant argued, and the Court effectively agreed, that cryptocurrency is a type of intangible asset, despite Bitcoin not clearly meeting the definition of intangible property. Accordingly, Robertson illuminated the stark legal uncertainty that affects cryptocurrency in jurisdictions worldwide and how its inconsistent treatment from jurisdiction to jurisdiction.
For VAT purposes, a fundamental question is whether the supply constitutes goods or services, and being unable to answer this question may create further VAT questions. The only clear guidance related to VAT and cryptocurrency from UK taxing authority, Her Majesty’s Revenue and Customs (HMRC), is in the form of Revenue & Customs Brief 9/2014, stating where Bitcoin is exchanged for sterling or other foreign currencies, no VAT will be due on the value of the Bitcoins themselves. In this respect, HMRC is treating Bitcoin as fiat currency, which appears to be contrary to the holding in Robertson that the cryptocurrency were effectively goods.
At this point, cryptocurrency remains outside the VAT net, but further guidance is expected from HMRC and other global taxing authorities, including the Organisation for Economic Co-operation and Development (OECD).
Moving Forward – Enforcement
On October 28, 2019, IRS Commissioner Charles Rettig stated that, given the new guidance, there is “no excuse for delinquency.” The Commissioner further stated the IRS has the technology to trace cryptocurrency transactions and had recently done so in a child exploitation case, leading to an arrest. Rettig stated the arrest should be considered a “message to the community” concerning the IRS’s technology and knowledge to determine cryptocurrency ownership on the blockchain, and, by inference, perhaps cooperation of the exchanges to provide information.
