Temporary rules from the IRS on the tax treatment of 2017 cryptocurrency “hard forks” would be welcome, but it’s unlikely the agency will issue guidance anytime soon, tax practitioners told Bloomberg Tax.
The American Bar Association Section of Taxation requested a temporary “safe harbor” for 2017 hard fork transactions in a March 19 letter. A hard fork occurs when there’s a change to the software of a digital currency that creates two separate versions of the blockchain. For example, there are three official versions of bitcoin: bitcoin (BTC), bitcoin cash (BCH), and bitcoin gold (BTG).
To date, the Internal Revenue Service has published very little guidance in the cryptocurrency space, “so I can’t imagine that this late in tax-filing season,” the agency would decide to issue a ruling on hard forks, said Evan Fox, practice leader in the Digital Asset Advisory Services group at Berdon LLP in New York. Notice 2014-21, which explains that virtual currencies are “property” for federal tax purposes, is the only guidance from the IRS.
The hard fork issue is something that could potentially affect millions of taxpayers, said Bryan C. Skarlatos, a partner at Kostelanetz & Fink LLP in New York. “Because forks occurred for the first time in 2017, affected taxpayers need fast guidance now so that they can prepare their 2017 tax returns,” he said in an email. The filing deadline for 2017 tax returns is April 17, with an extended deadline in October.
“It would, of course, be fantastic if they did” provide some direction, Fox said. “It would just go against everything we’ve seen from them on the crypto asset space before.”
The IRS told Bloomberg Tax in an email that it has received and is reviewing the ABA tax section’s letter but didn’t disclose whether it plans to issue guidance or adopt the group’s recommendations.
From the agency’s perspective, it doesn’t necessarily need to issue near-term guidance, said Brian Kristiansen, a partner at Friedman LLP in East Hanover, N.J., who provides tax consulting to blockchain and cryptocurrency companies. “Time is on their side,” he said. Generally, the IRS has three years after a tax return is filed to audit a taxpayer. “If you don’t report it, then you’re possibly underreporting,” he said. Meanwhile, “they have all the time in the world.”
Kristiansen said he expects that the agency will wait until it has a clearer understanding of how cryptocurrencies work before issuing more definitive rules.
Taxable Event, Zero Basis
After a hard fork takes place, the original owner of the cryptocurrency retains its interest in the original coin but also has the right to use the forked coin.
In its letter, the ABA tax group said that based on previous court cases, a reasonable argument could be made that the ability to use both the original and forked coin represents an accretion of wealth, meaning the taxpayer should treat the fork transaction as a realization event whereby gain is recognized and reported to the IRS.
The group also suggested, however, that the deemed value of the forked coin at the time of the realization event be zero, which would also be the taxpayer’s basis in the coin. This approach would essentially allow the taxpayer to defer payment of taxes until he or she sells the forked coin, but at the time of the sale, that person would have to recognize 100 percent of the gain.
The ABA group gave two reasons for this zero basis approach—the first being that the cryptocurrency market is complex and it can be difficult to determine the value of the forked coin at the time of the split. Even well-established cryptocurrencies like bitcoin may have different values on different exchanges at the same time.
The tax section also said that at the moment the hard fork occurs—the first moment at which an owner of the original coin may obtain an interest in the forked coin—"the forked coin arguably has no market value because it has not been previously traded and it is not clear whether a market will emerge for the coin.”
Fox and Kristiansen both agreed that a hard fork should be a taxable event and that the zero basis approach would be good for taxpayers. However, Fox said he doubts the IRS would adopt that recommendation. “I think that asking the IRS to permit a zero value really seems like wishful thinking,” he said.
The more likely scenario is that the agency would ask taxpayers to pinpoint the day they got access to their forked coin and take an average price on that day—or over several days since there can be significant price fluctuation at the beginning of a fork—and report any gain as ordinary income, similar to the treatment of most dividends, Fox said. “That would result in the new basis of the asset being the amount of income you picked up.”
Mary Conway, a partner in Davis Polk & Wardwell LLP’s Tax Department in New York, disagreed with the ABA tax section’s conclusion that a hard fork should be treated as a taxable event.
Hard forks are inherent in cryptocurrency assets and the purchaser buys into that from the beginning, Conway said. The only realization event that should occur is at the time the original or forked coin is sold, she said.
Conway used the example of a farmer with a cherry tree as an analogy. A cherry tree is more valuable to the farmer when it produces cherries, but it always had the inherent ability to do so, she said. “The cherry tree is going to grow, it’s going to produce branches, it’s going to produce leaves, and it’s going to produce cherries. And the cherries could even be picked. But none of those things is a taxable event,” Conway said. “The taxable event is the sale of the cherries.”
Lucy W. Farr, also a partner in Davis Polk’s Tax Department in New York, said the ABA group’s argument that a hard fork is a realization event because there’s an accretion of wealth wrongly assumes that the value of the original coin remains at historical levels and that there’s largely a consensus among investors to continue to use that coin, which may not be the case.
Treating the hard fork as a taxable event and the gain on the forked coin as ordinary income could be very “distortive,” she said. If a substantial amount of the value “goes off” with the new coin, the original coin could have a loss at the time of the split, Farr said.
Better Safe Than Sorry
Fox said that in the absence of IRS guidance, he would recommend a conservative approach to the hard fork issue.
“I would probably suggest that taxpayers come up with a number and report some type of income,” he said. Otherwise, it’s possible that the IRS could deem what the taxpayer did as improper, subjecting him or her to underpayment penalties and interest, he said.
Kristiansen said he’s taking a similar approach, in addition to adding footnotes and disclosures to his clients’ tax returns to inform the IRS of the position being taken. “We’re just being very forthcoming; telling them everything.”
To contact the reporter on this story: Allyson Versprille in Washington at firstname.lastname@example.org