Cryptocurrency (such as Bitcoin) is a type of virtual currency. It is an emerging area, and as such, comes with an enormous amount of uncertainty when it comes to the US tax treatment of transactions involving its use. On October 9, the Internal Revenue Service (IRS) issued Revenue Ruling 2019-24 providing much awaited guidance about the tax treatment of certain cryptocurrency events – specifically, “hard forks” and “airdrops”. The Ruling will appear in the Internal Revenue Bulletin IRB 2019-44 dated Oct. 28, 2019. The IRB is the “official source” for IRS information and once in the IRB, it means you can rely on it!
Revenue Ruling 2019-24 enhances the very basic guidance on the tax treatment of virtual currency issued by the IRS five years ago (See Notice 2014-21). My earlier blog post details the US tax implications of cryptocurrency as well as the earlier IRS guidance. FBAR issues with regard to cryptocurrency are another matter altogether. My blog post here, discusses the FBAR issues.
IRS is on the Trail
Simultaneously, with issuance of the new Revenue Ruling, the IRS updated its Virtual Currency Transactions frequently asked questions to reflect it. Taxpayers and practitioners have been anxious for more complete guidance on the tax treatment of virtual currency and its many new and developing types of transactions. In fact, Congressional lawmakers requested that the IRS provide some definitive guidelines as well as a comprehensive virtual currency strategy that would be less confusing to taxpayers than the current guidance. IRS is obviously taking steps. You can read more here.
The IRS is very serious with its crackdown on virtual currency and in July started sending letters to taxpayers who may not have been in compliance with regard to their use of virtual currency. There is now a checkbox at the top of Schedule 1 which appears on the early release draft of the IRS Form 1040 for the 2019 tax year. It asks taxpayers about financial interests in virtual currency and its language closely mirrors that used on the Form which asks taxpayers if they have an interest in any foreign financial account. More information and links to the draft IRS Form Schedule 1 and Instructions are here.
A few definitions and concepts will be helpful in order to more fully understand the IRS Ruling.
“Cryptocurrency” is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. A distributed ledger is used to record, share, and synchronize transactions. A transaction involving cryptocurrency that is recorded on a distributed ledger is referred to as an “on-chain” transaction; a transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction.
A “hard fork” is unique to distributed ledger technology. It occurs when cryptocurrency on a distributed ledger undergoes a change that results in a permanent diversion from the existing distributed ledger. The shift may result in the creation of an entirely new cryptocurrency. Simply put, two different blockchains and two different cryptocurrencies can result from the hard fork. After the hard fork has occurred, events involving the “new” cryptocurrency will be recorded on the “new” distributed ledger, whereas events involving the original (or “legacy”) cryptocurrency will continue to be recorded in the original distributed ledger.
An “airdrop” occurs when any cryptocurrency organization distributes a cryptocurrency token or coin, usually for free, to a large number of its current wallet addresses. Airdrops are primarily implemented for promotional purposes and to gain attention. This type of publicity of course, increases the likelihood of new followers, resulting in a larger user-base and a wider disbursement of coins. Just like the real world, hype and buzz play an important role in the world of cryptocurrency! So, simply put, an airdrop is a promotional tool that may get people interested in a cryptocurrency. But, air drops raise US tax issues and even if received for “free” may come with a hidden price tag.
“Gross income” includes all accessions to wealth under the US tax laws. Gross income means all income from whatever source derived, including gains from dealings in property. Under Internal Revenue Code Section 61, all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion, are included in gross income unless the law provides a specific exclusion (example, receiving a gift of $1 million is clearly an accession to wealth, and a nice one at that. However, the tax law excludes gifts from gross income; they are not taxed to the recipient).
“Constructive receipt” is an important concept in the crypto tax world. Understanding this concept will greatly assist in understanding the IRS ruling. Generally speaking, “constructive receipt” means a taxpayer will be taxed on income when it’s made available to him and when he has dominion and control over it. This doctrine prevents artificial shifting of the time income is received for tax purposes. As the IRS puts it, a taxpayer may not “turn his back on income” to avoid being taxed.
The relevant IRS Treasury Regulation defines constructive receipt as follows:
“Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.”
The Tax Court explained the doctrine of constructive receipt in Davis v. Commissioner, T.C. Memo. 1978-12 (1978). The issue was whether a taxpayer faced substantial limitations so the doctrine of constructive receipt would not apply. A check for severance pay was sent by certified letter and was available to the taxpayer at the post office on the last day of the tax year, 1974, after the mail carrier attempted to deliver it to her home earlier the same day. Since the taxpayer was not at home upon the first delivery attempt, the carrier left a note that the letter would be at the post office. The taxpayer picked up the check from the post office several days later, just after the start of the new tax year, 1975. Did the taxpayer constructively receive the check on the last day of 1974 such that she should have included the severance pay in her tax return for that year? Courts had previously held that when a taxpayer makes a decision to be unavailable to take delivery of a check, then the substantial limitations requirement will not be met and the taxpayer will be deemed to have had constructive receipt at the time of attempted delivery. The Davis court noted that the sender had specifically advised the taxpayer that the check would be arriving approximately two months later than the actual delivery date. Since Mrs. Davis had no notice to expect that the check would be delivered, it was not possible for her to have made a decision to be unavailable to receive it. It was not possible for her to have consciously “turned her back” on the income. The court determined that under the circumstances the taxpayer faced substantial limitations on the availability of the funds and as such, they were not constructively received in 1974.
Takeaways from the New Ruling
What did the IRS say in the new Ruling? Here are the takeaways:
A “hard fork” of a cryptocurrency which is owned by a taxpayer does not result in gross income to him if the taxpayer receives no units of the new cryptocurrency. However, taxpayers receiving an “airdrop” of units of a new cryptocurrency after a hard fork will have ordinary gross income as a result of the “airdrop”.
The IRS Notice explained that receipt of cryptocurrency from an airdrop is generally on the date and at the time it is recorded on the distributed ledger. However, a taxpayer may “constructively receive” cryptocurrency prior to the airdrop being recorded on the distributed ledger.
On the other hand, a taxpayer will not be treated as having received the cryptocurrency when the airdrop is recorded on the distributed ledger if the taxpayer is not able to exercise dominion and control over the cryptocurrency. (Refer above to the Doctrine of Constructive Receipt). For example, a taxpayer does not have dominion and control if the address to which the cryptocurrency is airdropped is contained in a wallet managed through a cryptocurrency exchange and the cryptocurrency exchange does not support the newly-created cryptocurrency such that the airdropped cryptocurrency is not immediately credited to the taxpayer’s account at the cryptocurrency exchange. If the taxpayer later acquires the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency, the taxpayer is treated as receiving the cryptocurrency at that time.
The Revenue Ruling provides two examples:
Example 1 involves a taxpayer whose cryptocurrency undergoes a hard fork, creating a new cryptocurrency. However units of the new cryptocurrency are not airdropped or otherwise transferred into an account that the taxpayer owns or controls. Since the taxpayer receives no units of the new cryptocurrency, that taxpayer does not at that point in time have gross income for tax purposes. In other words, the taxpayer is not in constructive receipt of anything.
Example 2 involves a taxpayer similar to the first, except that in addition to the hard fork, units of a new cryptocurrency are airdropped into the taxpayer’s distributed ledger address. This is a promotional gesture; the taxpayer receives the new cryptocurrency solely because he owns the legacy cryptocurrency at the time of the hard fork. The taxpayer is able to immediately dispose of the new units. In this case, because the taxpayer receives units of the new cryptocurrency, the taxpayer has an accession to wealth and ordinary income in the tax year in which the new cryptocurrency units are received. The amount of the ordinary income is the fair market value of the new units when the airdrop is recorded on the distributed ledger.
The Overseas American and Crypto
Americans living and working abroad may find it difficult to maintain a bank account in their country of residence due to the infamous “Foreign Account Tax Compliance Act”, FATCA. These individuals may more frequently turn to crypto-currency to handle payments as more and more goods and service providers are becoming happy to accept it.
Unfortunately, Americans overseas are already in the IRS cross-hairs with respect to their foreign assets or accounts. Adding crypto to the mix, may just make matters more precarious. In an attempt to track digital currency transactions, the IRS has entered into a license agreement to use software to identify the owners of digital wallets. Identifying crypto owners is really happening and the biggest criminal takedown involving Bitcoin just took place ….. if you think you are safe because you are using cryptocurrency, think again.
All of these developments clearly indicate that the area is heating up. All crypto transacations must definitely be handled with care.
Posted October 17, 2019
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