The IRS has published a Revenue Ruling and FAQs clarifying some long-standing virtual currency questions.

By Brian C. McManus, Elena Romanova, Stephen P. Wink, Sam (Seung Hyun) Yang, and Deric Behar

On October 9, 2019, the US Internal Revenue Service (IRS) issued its first guidance on the tax treatment of cryptocurrencies in at least five years. The guidance includes Revenue Ruling 2019-24 (Ruling) and a set of frequently asked questions (FAQs) for taxpayers who transact in virtual currencies and hold them as investment. The guidance supplements Notice 2014-21, which explains that virtual currency is treated as property for federal income tax purposes. The Ruling addresses whether a taxpayer holding a cryptocurrency has taxable income as a result of a “hard fork” with and without an “airdrop.” The FAQs provide guidance on the calculation of value and of tax basis of virtual currencies in various situations.

When You Come to a Fork in the Road …

The IRS guidance on hard forks and airdrops takes the form of a Revenue Ruling rather than a Treasury Regulation, and therefore is the IRS’s authoritative interpretation of existing law (on which taxpayers may rely), rather than a new law. The Ruling does not include an effective date for the application of this interpretation, and therefore applies to transactions that happened before the issuance of the Ruling as well as to future transactions.

The Ruling provides that a cryptocurrency investor does not have taxable income if a hard fork occurs and the holder does not receive any new cryptocurrency units. The Ruling describes a hard fork as “when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger.”

By comparison, a cryptocurrency investor in a hard fork must report taxable income if such investor receives new cryptocurrency units via an airdrop and can sell those new units or otherwise control them. The Ruling describes an airdrop as “a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.” (For further information, see Latham & Watkins’ The Book of Jargon — Cryptocurrency & Blockchain Technology.) According to the Ruling, investors should treat the receipt of such cryptocurrency units as ordinary income (even though the old cryptocurrency is held as a capital asset). The amount of income to be recognized is equal to the fair market value of the received cryptocurrency units at the time the airdrop is recorded on the distributed ledger. Critical to the Ruling is the notion of the taxpayer’s “dominion and control” over the forked units and “the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency.” The taxpayer is taxed therefore not on the hard fork or the airdrop in itself, but on actual receipt by the taxpayer of the new units of virtual currency.

A Nickel Ain’t Worth a Dime Anymore

An exchange of virtual currency for other value, such as other virtual currency, fiat currency, or property may result in a taxable capital gain or loss. Thus, knowing the cost basis of what is exchanged, and the fair market value of what is received, is essential to calculating and reporting a capital gain or loss on such transactions.

Cryptocurrency investors are not unfamiliar with persistent price volatility, with the value of cryptocurrencies changing by the minute. In addition, cryptocurrency valuation data sources are not always consistent. Determining accurate fair market value to calculate the amount of reportable income and cost basis of cryptocurrency, therefore, presents unique challenges.

For these matters, the IRS has chosen to provide guidance to taxpayers in the form of FAQs, which are considered less authoritative than a revenue ruling. The FAQs stipulate that the fair market value of cryptocurrency traded on an exchange is the amount at which it was recorded as received on the distributed ledger in US dollars; if the received amount was not recorded, then the fair market value of cryptocurrency received is the value of the cryptocurrency at the date and time of the transaction. The IRS allows taxpayers to use the values provided by blockchain explorers, which gather data from various exchanges and compute the value at a specific date and time.

The FAQs also give much-needed guidance on how to compute the cost basis of cryptocurrencies, which generally includes “the amount you spent to acquire the virtual currency, including fees, commissions, and other acquisition costs in U.S. dollars.”

You Can Observe a Lot by Just Watching

The Ruling and FAQs are important not only for cryptocurrency investors but also for current or prospective dealers, exchanges, and custodians, as they provide a preview of how the IRS might treat virtual currency transactions in general. It may only be a matter of time before new, additional information reporting requirements are imposed on virtual currency exchanges or other intermediaries.

The IRS’s newly published guidance applies the principles of existing law to an asset class that has only come into existence in the past decade, and has only gained some form of prominence and use in the past five years. Thus, because of the novel nature of the cryptoasset class, the Ruling and FAQs may be uniquely vulnerable to challenge by taxpayers in court in the absence of tax legislation addressing cryptocurrencies.