What is a hard fork, and why would it generate taxable income? From the government’s perspective, it’s an intriguing question because a hard fork carries the prospect of ordinary income. Many commentators have suggested that a fork likely generates taxable income. However, I think a hard fork is not taxable, absent an act of Congress.
What is a Hard Fork?
It’s not a utensil made out of titanium. Investopedia defines it as a radical change to the protocol for a cryptocurrency (whether Bitcoin, Ethereum, or another currency). You can think of it as the creation of a new version of the protocol software for the blockchain. The blockchain records all the transactions on the cryptocurrency. Following a split, traders and exchanges may abandon the old version. In that case, the new version simply replaces the old. Alternatively, the new version may split off as a competitor. Another possibility is that the new version never takes hold and fades away.
Bitcoin has undergone two hard forks already, leading to the creation of Bitcoin Cash over the summer and, more recently, Bitcoin Gold. But neither version of Bitcoin has come close to overtaking the original Bitcoin, leading to the creation of three alternative versions of Bitcoin. Yet another hard fork, the Segwit2x fork, is scheduled to take place in the coming days.
Is it a Dividend?
Some have compared a hard fork to a stock split or dividend, but the hard fork defies easy classification. A dividend is a distribution of cash to a shareholder. Following a hard fork, the holder of Bitcoin may possess new property, but there is no payment of cash. Moreover, the holder will not always be able to access or control the new cryptocurrency.
Following the Bitcoin hard fork, not all holders had access to Bitcoin Cash – it depended on how they held their Bitcoin. Holders who hold through an exchange may never have access if the exchange platform refuses to support the new protocol. And in other cases, the new cryptocurrency does not actually trade until weeks after the fork.
When the new protocol simply replaces the old, the fork is essentially like a software update. Even when a hard fork results in two distinct cryptocurrencies, there has been no distribution of value from the original cryptocurrency. Instead, the new version is more like a modified copy of the old.
Is it a stock split?
In a stock split, a corporation divides its existing shares into a greater number of shares. The shareholders still own the same percentage interest in the corporation before and after the split. Following the split, each share represents a smaller percentage interest in the corporation.
For example, assume a shareholder owns 10 shares that represent 10% of the company, because 100 shares are outstanding. Following a split from 100 shares into 200 shares, the shareholder holds 20 shares. But the shareholder still only owns 10% of the company.
A hard fork is not like a stock split: something entirely new is created. That new cryptocurrency may replace the old version, may be eclipsed by the old version, or both may co-exist side-by-side. But a fork is not a division of property.
Saving the best for last, is a hard fork the same as treasure trove? The Treasury Regulations define treasure trove as any found item that has value. According to the regulations, treasure trove is included in taxable income to the extent of its value in U.S. currency in the year it is “reduced to undisputed possession”. If you find a coin or jewelry, don’t forget to report it on your tax return! In the most famous case on this issue, a court held that taxpayers were taxed on the cash they found in a used piano.
Although finding cash in a piano doesn’t seem similar to a hard fork, in both cases there is a fortuitous acquisition of property. This strikes me as a closer analogy than a dividend or stock split.
But imagine that the original cryptocurrency Crypt has a value of $100 immediately before a fork. Following the fork, the new coin Crypt2 has a value of $95, while Crypt plummets to $5. It doesn’t seem right to tax the holder on the value of Crypt2 ($95), when Crypt2 is essentially just replacing Crypt.
There may be ways to mitigate such a harsh result. For example, taxpayers could allocate their tax basis to the new coin based on the combined value of the new and old coins. In the example above, that would allow them to allocate most of their tax basis to Crypt2. However, while this may mitigate the harshness of such a rule, it still doesn’t seem to be the right answer.
Deemed New Coin?
Another possible response is for the IRS to tax the holder on whatever coin has lower value after the fork. In other words, the coin that has higher value would represent a continuation of the old coin for tax purposes. The coin with the lower value would be taxable, even if this “new” taxable coin is actually the original coin.
The Treasury rules already provide a similar rule in the context of partnerships. Simplifying, when one partnership is divided into two, the “larger” partnership is treated as a continuation of the original partnership for tax purposes. Even if the larger partnership is a new entity, it is considered to be the same as the original partnership. The IRS could apply a similar rule to forks: the cryptocurrency with a lower value would be treated as a taxable “new” coin.
When and How Much?
If a hard fork is taxable, when will the IRS tax you and for how much? Surely the amount should be equal to the trading value of the cryptocurrency on the relevant date. But what is the best date?
Following the first fork, Coinbase announced it would not support Bitcoin Cash (the new currency). More recently, it has announced that it will allow holders to withdraw Bitcoin Cash only on January 1, 2018. It’s hard to see how Coinbase accountholders have “reduced” Bitcoin Cash to their possession when they can’t even access it until 2018.
In the piano case, one of the issues the court addressed was the proper year of taxation. The taxpayers argued they should be taxed in the year they bought the piano, because that year was closed under the statute of limitations. The IRS argued instead that it should be the year when the taxpayers actually found the cash in the piano. Based on Ohio state property law, the court decided in favor of the IRS and held it was the year of discovery.
State property law is not likely to be of much help in sorting out how cryptocurrency should be taxed. Instead, software algorithms are far more relevant! On the date of the Bitcoin Cash fork, the holders of Bitcoin became the undisputed holders of Bitcoin Cash, even if they could not immediately access or trade the new coin. Therefore, perhaps the IRS would say that the date of the split is the date of taxation.
Readers of my previous article may remember that a fully vested right to the receipt of property in the future can trigger current taxation, even if the taxpayer does not currently possess the property. The classic example is an escrow arrangement. However, at the time of the Bitcoin Cash split, it was not clear that all the holders of Bitcoin would ever control their Bitcoin Cash. Because Bitcoin is a decentralized system, each exchange decides on its own if it will support Bitcoin Cash.
Different holders might have access to the new coin on different days. If the date is different for different exchanges, then holders might be able to defer taxation by switching their accounts to different exchanges. But if holders are taxed on the earliest trading date, taxpayers might be taxed before they control the new cryptocurrency.
Lessons from the Notice
In Notice 2014-21, the IRS explained that transactions would not escape taxation merely through the use of virtual currency. You will be taxed when you exchange the cryptocurrency for goods or services, sell cryptocurrency for cash, or receive cryptocurrency for mining services. But the receipt of cryptocurrency as the result of a hard fork does not fit into any of these examples.
In the case of a hard fork, no service has been provided. There has not been any payment in exchange for property. And the investor did not acquire the new virtual currency for cash or property.
Stretching IRS Authority
The prospect of more revenue from taxing hard forks as ordinary income may be tantalizing. However, the Treasury and IRS would be better off taking a more conservative approach. After all, the Tax Court has delivered several recent stunning losses to the IRS.
In one case involving transfer pricing rules for stock-based compensation, the Tax Court invalidated regulations and criticized the Treasury for failing to provide support for its position. In another recent case, a foreign corporation won a tax case involving the US taxation of its partnership interest, leading the Tax Court to invalidate a decades-long IRS revenue ruling.
A hard fork defies easy analogy to a taxable event. After all, a hard fork is not like a cryptocurrency for services or property and does not seem very similar to finding cash in a piano. Issuing a ruling that a hard fork generates ordinary income seems to be crossing the line into creating law rather than interpreting it. For clarity on the tax treatment of a hard fork, we should wait for Congress to act.