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Hard Fork Taxation: The Curious Crypto Conundrum

04.25.2018 | CryptoLogic

The realm of digital/crypto assets (“crypto”) is riddled with situations tangentially analogous to more well-settled, and regulated, activities. Through the spectrum of these developed activities, in conjunction with Revenue Ruling 2014-21, it is possible to derive some tax rules, or at least best practices, for crypto. Nevertheless, one specific fact pattern, quite unique to crypto, leaving the tax community confounded is the Hard Fork (HF).

A HF is a software “update” that introduces a new rule to the network that isn’t compatible with the older software. You can think of a HF as an expansion of the rules of the blockchain; for example, a new rule that allows block sizes to be 2MB instead of 1MB would require a HF. Nodes/Miners that continue running the older, legacy version of the software will see the new transactions as invalid. Contrast this with a Soft Fork, which is any change that is backwards compatible (Ex. Instead of 1MB blocks the new rule only allows 500K blocks, so all new blocks would fit inside the old rules and not be rejected). So, to switch over to the new chain and to continue to mine valid blocks, all of the nodes in the network need to upgrade to the new rules.

The first very public instance of a HF occurred on August 1, 2017 when Bitcoin Cash (BCH) was forked from Bitcoin (BTC). There have been numerous other HF’s but we’ll use the BTC/BCH example as illustrative of the tax complications from this point. At the time of the BTC/BCH fork, (most) holders of BTC were “credited” with an equal amount of BCH, and since BCH immediately traded at a non-zero value, investors did experience an accretion to wealth just by virtue of the HF. In actuality, however, the logistics of the split were far more burdensome.

Because of how blockchain’s operate, in order to have the automatic right to claim your BCH tokens, the BTC holder needed to have control over their “private key”. A long and complicated post will be forthcoming on public/private key asymmetric cryptography, but for now just know this: If you hold BTC on a crypto exchange, you do not control your private key. Many exchanges indicated they would credit user’s accounts with the BCH relative to their BTC balance, but there was no guarantee or timetable for this action. Thus, holders of BTC were advised before the HF to transfer their coins to a wallet where they held the private key.

So, you’re probably thinking that if a person did as advised and transferred their BTC to a wallet where the private key was controlled, the situation becomes much easier, right? Maybe a little, but barely. Depending on the specific wallet (there are numerous software wallets or hardware wallets), the ability to actually “split off” and claim/trade/sell the BCH token was not always the same. For example, the Trezor hardware wallet did not provide access to BCH at the same time as the Ledger hardware wallet. This likely occurred because the teams in charge of these devices often want to check the new blockchain for safety, etc, and have their own internal control processes. At some point, holding a private key more than likely provided access to the BCH, but the moment of accessibility is often hard to define. Furthermore, remember the people who left their BTC on an exchange such as Coinbase? As you may recall, Coinbase distributed the BCH in December of 2017, more than 4 months after BCH was (wildly) trading on the open markets. Given all this information, it behooves you to choose a moment to fairly value the distribution of BCH to each individual BTC stakeholder. Would you pick the first trade on August 1, 2017? Or when your specific hardware wallet posted BCH access was permitted? Or when Coinbase distributed their coins automatically? These three situations alone result in a highly different price per BCH. Now, with the valuation dilemma appreciated, the tax consequences are equally as ambiguous.

It should not be assumed the Internal Revenue Service (IRS) chose to deem a HF as tax-free simply because deriving the actual income amount would be too complicated (although this outcome isn’t impossible; the IRS does have a precedent set in Inaja Land, where complication led to deferral). After all, the IRS has a long history of treating any type of “free money” as taxable income. Gifts and inheritance are a narrow selection of scenarios free from tax. Well known, and common, situations to which HF’s can potentially be compared include cash dividends, stock dividends, PTP distributions, stock splits, debt modifications, and spin-offs. None are exactly like a HF, so which, if any, is most analogous and has principles that would best apply? Or should the IRS apply something completely different?

The stock split can be dismissed rather easily. Stock splits are non-taxable transactions, which merely change the amount of shares held by a taxpayer with a corresponding adjustment to the stock price (i.e., a 2 for 1 split gives a taxpayer twice the amount of shares, but the stock price also drops 50% so the net value held is the same). While, on occasion, a stock split does lead to distribution of a slightly different asset (such as GOOGL/GOOG or UA/UAA shares with different voting rights), on most occasions, the share count is increased and the amount of exactly similar shares is as well. Furthermore, in the case of a GOOGL or UAA, the underlying companies are still the same. In a HF, developer factions intended to separate themselves from the historic blockchain due to a differentiating factor. A stock split is too far reaching to be the basis for HF taxation.

For similar reasons, a stock dividend would likely not provide much tax guidance for a HF. In a HF situation, there is the creation of an entirely new asset; a stock dividend is of the same equity the taxpayer currently holds.

Partnership distributions are only tax free to the extent they are supported by capital account/liabilities or are a distribution of taxed earnings. Analogizing crypto to partnership taxation is equally unlikely.

A cash distribution from a corporation is taxable income to the recipient based upon the cash or the fair market value of property (such as stock) received. For all holders of stock, the distribution is received in cash on the same date with an amount that is certain. Whether the distribution is considered a taxable dividend depends on the earnings and profits of the distributing company. Logistically, on the declaration date of a dividend (usually a week or month before the cash is distributed), the stock exchanges automatically decrease the price of the equity by the amount of the dividend per share(rightfully or wrongfully, it’s what they do). The cash dividend is closer to the HF than either the stock split or stock dividend discussed above; however, the problem of fair valuation becomes the pressure point. For example, if the IRS were to pick the “opening trade” price (assuming this could be calculated across available exchanges), irrespective of HF coin access, it could significantly distort income.

Lastly, spin-off transactions can be both tax-free or taxable, depending on the facts and circumstances. For a spin-off to be non-taxable there is a rather stringent set of rules, which must be followed. Among these is the existence of an operating trade or business, which has existed for over 5 years. While a crypto HF would fail for many of the other reasons mentioned, this specific rule depicts the unlikelihood of a HF satisfying the tax-free spin-off regulations.

In light of the extreme ambiguity, it is quite difficult to pick which approach is “best” or grounded in the most sound tax rules. Even still, imagining a situation where the IRS permits deferral of income recognition for a HF is, in my opinion, unlikely.

Another question then arises as to whether a taxpayer should be permitted to allocate basis from the original asset to the HF asset. Typically, however, this type of action is grounded in specific tax law guidance or case law, which with respect to crypto is wholly unavailable. In a very limited set of circumstances, the taxpayer is permitted to decrease basis of the original asset by the value received and, assuming basis isn’t reduced to zero, report no income. However, this tax rule only applies when rights are given up for value and a basis allocation would be impossible or impracticable (i.e., situations such as riparian rights over land); again, this is nothing like a HF where the taxpayer now actually has more assets and rights than before. Hence, zero basis allocation to the HF asset is justified.

Finally, character of any income recognition must be considered. Revenue Ruling 2014-12 specifically designated virtual currency as property, eligible for capital gain treatment upon sale. However, a HF is not the sale of this property. Accordingly, in the absence of any specific guidance stating otherwise, the income reported from a HF should be characterized as ordinary income.

In summary, due to the many complications outlined, a very conservative approach is warranted, and advised, in order to avoid any tax penalties. Accordingly, when the taxpayer has dominion and control over the HF asset (as described in our BCH example above), they should check the price of such asset (perhaps using an average from Coinmarketcap.com’s history from such day), and report it as ordinary taxable income on Line 21 of Form 1040 (or Line 11 of a partnership). Dominion and control in this realm is defined as the taxpayer possessing the ability to access the coin, and depending on the wallet, the coin should be possible to discern. Purposely delaying access to defer income to a later time or claiming access was impossible because “you were on vacation and your Trezor was at home” are positions ripe for IRS penalty assessment.

Reporting income on a HF asset sets the basis of such asset at the income recognized, and the holding period begins the date of receipt as well.

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Note: The thoughts and opinions expressed here should not be taken as investment or financial advice. The goal of CryptoLogic is to educate and enhance interest in the crypto space or a particular asset. It is important that when considering your investment and financial situation, you do your own research and speak with your trusted advisors.