An Open Response to the Internal Revenue Service Regarding Recently Published Tax Guidance for Digital Assets
Author’s Personal Note:
I am not a proponent of classifying all digital assets as real property on which gains are taxed as gross income. I believe cryptocurrencies such as bitcoin or ether should be classified as foreign currencies. Other cryptocurrencies, which behave more similarly to securities, should be classified and taxed as such. Those that behave as collectibles, should be taxable as real property and others similar to gift cards, perhaps not taxable at all.
That said, given the current blanket treatment of digital assets, I thought it important to emphasize their differences, highlighting scenarios in which taxation assessments can be messy, yielding unreasonable or impracticable tax burdens. I should also mention that I am a supporter of a limit under which transactions are non-taxable, for example spending bitcoin on coffee. The United States is in an interesting position in history, harboring many who contribute to this fundamentally new ecosystem of commerce and finance. I worry that regulators are creating unnecessary barriers that will thwart further development and incentivize innovators to go elsewhere.
While a concerted effort by the IRS to provide clarity regarding the taxation of crypto assets is appreciated, there is a misunderstanding of key fundamentals regarding how open-sourced, decentralized cryptocurrency protocols function. As a result, the provided guidance adds confusion and unnecessary headaches for taxpayers wishing to comply with current US tax codes. Further still, in certain scenarios, current guidelines may result in taxpayers’ liability for gross income that is either unreasonable or simply impracticable.
The publication’s most serious error is conflating the terms airdrop and hard fork. There is a significant difference between these two events. They are not related, nor are they concurrent. Each event must be addressed separately with regard to how taxation is determined; lack thereof will cause confusion and unnecessary (and potentially illegitimately expensive) burdens on taxpayers.
An example of this misunderstanding can be seen in the publication, which states, “A hard fork followed by an airdrop results in the distribution of units of the new cryptocurrency to addresses containing the legacy cryptocurrency. However, a hard fork is not always followed by an airdrop.” This statement is incorrect, and alludes to the fact that the IRS doesn’t fully understand the events on which they wish to provide guidance.
The guidance is too generalized to handle the multitude of different scenarios that can occur at and after the time of an airdrop or hard fork. In some cases, reporting requirements are unclear. In what follows, I will provide clarity around key concepts and terminology, then outline several scenarios which highlight the ambiguities and frustrations taxpayers are met with when following the current guidance. Finally, I will provide suggestions to redress the IRS’s guidance in an effort to foster a more coherent and practicable policy that eliminates unreasonable reporting requirements and lowers barriers to compliance.
Note: For simplicity I will use the term “coin” to refer to both cryptographic coins and tokens, though there is decidedly a difference.
Address — A unique virtual identifier to/from which coins can be sent, akin to a bank account number.
Transaction (txn) — The transfer of a balance of coins from one address to another (potentially among addresses owned by the same taxpayer).
Protocol — A set of rules used to validate transactions.
Blockchain — Digital transactions recorded over time, grouped into blocks, which are cryptographically linked to previous blocks in the chain. (See Fig. 1)
Network — Connected computers individually running a copy of the protocol for a particular blockchain.
Full Coin Ownership — The full control and authority to transact at the protocol level without reliance on a third-party custodian.
Double Spend — The ability to validly transact the same coin twice.
Hard Fork — A division amongst users supporting the network of the original protocol resulting in two blockchains running separate protocols, but which share a common history up until the point of the fork. (See Fig. 2)
Splitting Coins — The action of transacting coins held prior to a hard fork on both blockchains after the fork occurs, effectively claiming ownership of an equal number of coins on both chains (as opposed to an airdrop, in which an arbitrary number of coins can be delivered)
Airdrops — The distribution of coins to existing addresses of a blockchain by third parties, often without permission from or awareness by the address owner. It is analogous to owning a traditional bank account that accepts deposits in any form of (fiat or crypto-) currency, except the account owner is not necessarily alerted when a deposit occurs and will only be able to spend the balance if he/she knows that it exists in the first place.
*Note: Blockchains are generally run by a distributed network of users, all agreeing to the rules for validating transactions as they are broadcast to the network. Blockchains necessarily maintain a state of account balances over time. A snapshot of these balances is updated as each new block is added to the growing history of state changes.
Hard forks may allow users to double spend coins that they fully owned prior to the fork. One portion of the network agrees the first transaction is valid and the other portion agrees the second transaction is valid. In contrast, airdrops assign ownership of an arbitrary number of new coins to addresses that already exist, with no consent from the owner.
The following are five examples which, under the current guidelines, would yield unreasonable and/or impracticable tax burdens. For simplicity, all dollar values are denominated in USD.
Taxpayer A self-custodies 10 tokens of ABC Coin prior to a hard fork with a cumulative market value of $1,000 ($100 per coin). After the hard fork, resulting in XYZ Coin, Taxpayer A is technically able to double spend her coins on both chains, but was not made unaware of the hard fork due to lack of sufficient commercialization by the group creating XYZ Coin. At the time of the fork, a small, obscure cryptocurrency exchange based in the foreign country of the group creating the fork, enables traders to split their coins and trade them for fiat or other cryptocurrencies. The market value at the time of the fork is established on this exchange to be the equivalent of $450 per coin, but quickly drops to $50 over the following weeks.
Taxpayer A becomes aware of the hard fork two months after the event occurs. At this time, when she tries to split her coins, the market value has fallen further still to $30. After successfully gaining full ownership of her XYZ coins, now worth a collective $300, she trades them on an exchange for USD. From Taxpayer A’s perspective, she has gross income of $300. Under the current guidelines, she actually has $4,500 in gross income; a nontrivially larger amount than she was able to actualize.
Taxpayer B custodies 1,000 of his coins for DEF Coin with a cryptocurrency holding company. An airdrop of UVW Coin is announced and will occur on Date 1. According the the protocol of the airdrop, each non-zero DEF Coin address will receive 0.05 UVW coins for every one DEF Coin it holds. The holding company chooses to support the airdropped coins, making them available in Taxpayer B’s account, giving him control to transact them.
Taxpayer B sees 50 coins in his account on Date 1 when the airdrop occurs. At this time, several exchanges chose to enable trading for UVW Coin. Trading of UVW Coin begins on Exchange A at a market price of $23 per coin. Trading on Exchange B begins at a market price of $32 per coin. Trading on Exchange C begins at $52 per coin, but Taxpayer B is not currently a registered user on Exchange C.
Wanting to maximize gains from the airdrop, Taxpayer B decides to open an account with Exchange C. The KYC process takes 4 days to approve his application. After successfully registering — now Date 2 — Taxpayer B sells his coins on Exchange C at a price of $20 per coin.
Since a reasonable market value was not established at the time of the airdrop, it is unclear to the taxpayer, under the current guidelines, if he is liable for gross income tax on $1,150 (Exchange A market value on Date 1), $1,600 (Exchange B market value on Date 1), or $2,600 (Exchange C market value on Date 1). Furthermore, he was not able to capitalize on the airdrop until Date 2, resulting in actualized gains being limited to $1,000 (Exchange C market value on Date 2).
Taxpayer C self-custodies 40 tokens of GHI Coin with a cumulative market value of $3,600 ($90 per coin). She is made aware that on Date 3 a hard fork will take place resulting in RST Coin. On Date 3, after the hard fork, RST Coin begins trading on exchanges at a market value of $45 per coin. Taxpayer C wants to gain from this opportunity, but quickly realizes current coin splitting methods for RST Coin come with substantial risk of permanently losing her original GHI coins. Taxpayer C decides to wait until safer methods are available and have been tested.
Six months later, on Date 4, Taxpayer C is made aware of a safe and proven method for splitting her coins. She is successful in doing so but the value of RST Coin on Date 4 has fallen to $30 per coin on an exchange. Furthermore, after the 3 days it takes her to sign up with an exchange and sell her RST coins, the price is now $28 per coin.
Given the risks, Taxpayer C was not reasonably able to gain full control of the new coins until a significantly later date than the hard fork. By that time, she is only able to derive $1,112 of value from the event. Under current guidelines, she is liable to pay gross income tax on $1,800 (market value of RST Coin on Date 3 when hard fork occurs). The $680 differential is an unreasonable tax assessment given the situation.
Taxpayer D self-custodies 18 tokens of JKL Coin with a cumulative market value of $5,400 ($300 per coin). A hard fork occurs, resulting in OPQ Coin, however Taxpayer D is never made aware of the event. OPQ Coin is a hobbyist project by a small group in a foreign country. The coin begins trading on the local exchange at a value of $525 per coin. The project quickly identifies a flaw in their programming and the price drops to $0 over the next several weeks as the project is abandoned.
From Taxpayer D’s perspective, no taxable event ever occurred. Under the current guidelines, Taxpayer D is liable for tax on $9,450 of gross income. Note that if enough scenarios of this type occur, by no fault of his own, Taxpayer D would necessarily have to sell all of his original coins with the sole purpose of paying tax burdens from obscure insignificant events in other countries. This is unreasonable and impracticable.
Taxpayer E self-custodies 26 tokens of MNO Coin. A hard fork occurs on Date 5 resulting in LMN Coin. Unaware a hard fork has taken place, at a later Date 6, Taxpayer E transfers her original coins to another address she owns, but does not retain control of her original address. She becomes aware of the hard fork several weeks later and is unable to split and claim her LMN coins. The cumulative, reasonably established market value of her LMN coins at the time of the fork was $4,000.
Under current guidelines, Taxpayer E is liable for tax on gross income of $4,000 for coins which were never in her dominion. This again is an unreasonable tax assessment.
The IRS is attempting to apply archaic tax frameworks to new emerging asset classes that have unique characteristics to legacy assets, for which the tax code was written. Under Section 61 of the Code, “all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion, are included in gross income”. Provided the aforementioned scenarios, “clear realization of gains” is situational and should be taxed as such in accordance to Section 61.
According to the publication, “when a taxpayer receives property that is not purchased … the taxpayer’s basis … is the fair market value of the property when the property is received.” The nature of hard forks and air drops is such that in most cases, market value has not been reasonably established. New coins often lack liquidity necessary for functional tradability or a credible exchange to provide a reasonable market value.
In scenarios with market value ambiguities, or cases in which a market value cannot be established, an assessment of gross income is unclear. In Scenario 2, under the current guidelines, Taxpayer B is liable for one of 3 (and likely more) possible market values for the airdropped coins at the time of the hard fork.
It is clear from the scenarios that neither airdrops nor hard forks necessarily result in gains incurred by the taxpayer at the time of the respective event. Further, when they do result in gains, the gains are sometimes open to question. For this reason, taxpayers should not be liable to pay gross income taxes at the time of an airdrop or hard fork by default.
Definitive coin ownership and reasonably established market values are both critical in determining gross income. Current guidance fails to adequately provide a framework for how taxpayers should handle scenarios in which either or both of these elements are ambiguous. How can we expect them to comply with such regulations?
If a stranger leaves a suitcase of cash on your front porch and you reject its reception, you are not then liable to declare that cash as gross income and pay taxes on the event. Similarly, taxpayers should not automatically incur tax burdens as a result of a hard fork or airdrop. First, ownership must be definitively established by the taxpayer. Second, a reasonable market value must exist.
Transacting a coin establishes clear ownership of a particular coin. Transactions include splitting (transacting on both chains after a hard fork), selling or transferring a coin. Externally transacting a coin establishes a derivation of utility for that particular coin. External transactions are transfers to an account not under the taxpayer’s control. They include selling on an exchange or sending to merchants or external counterparts. It is at this time that a clear market value is established, either as market price when sold on an exchange or as agreed upon by each counterparty in a commercial exchange.
In an effort to simplify and clearly define a framework for cryptocurrency and digital asset taxation, I propose the following, concise update to the current policy.
Taxation of airdrops and hard-forks should be assessed at the time of the first external transaction following either event with a basis of $0 (unless a taxpayer paid to participate in an airdrop). This establishes realized and complete dominion over the assets, and provides a definitive value of gross income. This solution also solves problems with ambiguities in market value at the time of an airdrop or hard fork.
A decision tree is provided to determine at what point, if any, a taxpayer will incur gross income as a result of a hard fork or airdrop event. (See Figs. 3 & 4)
In each of the Scenarios outlined earlier, following this guidance and leveraging the decision tree makes clear when and what tax liabilities are incurred by a taxpayer. To address these individually:
Scenario 1: Taxpayer A is clearly liable to pay gross income tax on $300.
Scenario 2: Taxpayer B is clearly liable to pay gross income tax on $1,000.
Scenario 3: Taxpayer C is clearly liable to pay gross income tax on $1,112.
Scenario 4: Taxpayer D has not claimed his forked coins and is clearly not liable for any gross income tax related to the event.
Scenario 5: Taxpayer E has not claimed her forked coins and is clearly not liable for any gross income tax related to the event.
The IRS may respond that losses accrued between the time of an airdrop/hard fork and when coins are sold, may be recorded as a loss, written against the initial gains. This is unnecessary and for all previously stated reasons, can be an impracticable task as it relates to these specific events. The net result of the proposed guidance cancels out the need for this superfluous reporting.
As an aside, the proposed framework addresses the fringe case in which a hard fork or airdrop occurs at the end of a tax year, but the taxpayer is unable to capitalize on the event until the following tax year, if ever, causing potentially unjust gains without the ability to pair losses that follow. It also protects against attacks in which groups can exploit current guidance to cause irreparable damage to victims by inflicting unjust tax burdens.
A clearer understanding of hard forks and airdrops is necessary for the IRS to properly outline tax guidance on these events. Their most recent publication highlights that this is not the case. This letter has provided clarity on the events in question, explaining issues with current guidelines, and proposes a clear, succinct remedy to the situation.
There are many clear benefits to both the IRS and the taxpayers should this proposed guidance be heeded, least of which is a comprehensible, clear framework that allows for the proper and fair taxation of hard forks and air drops. The IRS benefits as well, as these guidelines are easier to explain, enforce and audit. I strongly encourage this letter be considered and circulated among the policy makers responsible for providing guidance on the taxation of cryptocurrencies and digital assets.
By Andrew Wertheim
Andrew is the Founder of Block City Labs, Research & Consulting Group and Block City Ventures, VC Firm. For questions, comments or collaboration, please don’t hesitate to reach out.