Cryptocurrency: Hard Forks and Airdrops

by Matt Metras, EA – Oct 24, 2018

Hard Forks and Airdrops are both methods of acquiring new coins. They are similar, but have slightly different tax implications.

What is a hard fork?

A hard fork occurs when a single blockchain, bitcoin for example, splits into two separate blockchains going forward. The most well-known hard fork was bitcoin and bitcoin cash. Up until the block of the fork, both chains have a common historical ledger. After the fork, they exist independently of one another. There are multiple reasons for forking a coin, but it typically happens when two or more groups of miners want different things from a coin, and can’t agree on how to move forward. Typically during a hard fork, the holder (who controls their own private keys) of the coin will receive a proportional amount of the new coin (usually 1:1, but not always). This receipt of new coin has tax consequences.

So what are the tax consequences?

That’s a great question. No one knows for sure. The IRS did not cover this subject in it’s only cryptocurrency guidance, Notice 2014-21, so we’re left to interpret the existing tax code to force a square peg into a round hole in order to be tax complaint. There are basically three options, all of which with their own pros and cons. For each scenario, we will use an example of bitcoin and bitcoin cash, where the owner had 1 btc (value $2,871.30) and received 1 BCH (value $294.60). Let’s also assume the original basis in the bitcoin is $1000.

Option 1 – Stock Split

Basis treatment for stock split is governed by 26 CFR 1.358-2, and basically requires you to allocate the original basis pro-rata among the new total number of shares. This treatment assumes that the original shares have been diluted in value by the new shares. That is why this isn’t a perfect analogy for crypto. One issue here is how to determine value: when and by what method do you value the coin?

Notice 2014-21 states: “If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars at the exchange rate, in a reasonable manner that is consistently applied.”

This doesn’t give us much to work with. When BCH was first forked, there was only one exchange offering it, and the price fluctuated wildly. The problem of when you have constructed receipt also comes into play (see that section below).

Tax Treatment: Pro rate the basis ($1000) between the two coins at a percentage of their relative value (90.7% to BTC and 9.3% to BCH). The basis* of the BTC is now $907 and the BCH is $93. There are no tax consequences in 2017, unless one of the coins is sold before the end of the year.

Pros: No immediate tax consequences, complies with existing regs in defendable manner.
Cons: Complicated record keeping, dilution of original basis.

Option 2 – Treasure Trove

Some interpret a forked coin as being treated as a “Treasure Trove” Cesarini v. United States, 296 F. Supp. 3 (N.D. Ohio 1969), and requires you to report the fair market value of the new coin as miscellaneous income on Line 21 of the 1040 (Line 21 on the 2017 non-“postcard” form). The amount of recognized income becomes the basis in the new coin. This is the most conservative approach and would likely not be challenged by the IRS, as you are paying tax on income you might never actually see. This method also runs into issues with how to determine the value of the coin, and also makes constructive receipt more important as you may be taxed on forks you never wanted to “own.”

Tax Treatment: BTC basis remains at $1000, $295 is recognized as ordinary income and taxed at marginal rate. BCH basis is $295

Pros: Most conservative position, unlikely to be questioned by the IRS.
Cons: Complicated record keeping, paying tax on more income than necessary.

Option 3 – Zero Basis

This method advocates for assigning a basis of $0 to the new coin. The American Bar Association wrote a letter to the IRS in March 2018 advocating this position. The basis of the original coin would remain the same, and the fork would not be treated as income or have any basis. This greatly simplifies record-keeping, which in turn would encourage tax compliance.

Tax Treatment: BTC basis remains at $1000, BCH basis is $0. No income recognized until sale.

Pros: No immediate tax consequences, simplicity in record keeping, protection from unwanted coins diluting basis.
Cons: Possible challenge from the IRS.

*Holding period

The scenarios above are overly simplified and do not include one important component, holding period. “Basis” is made up of two pieces, the acquisition cost (covered above) and the acquisition date. Assets held for at least one year and one day are eligible for preferential long term capital gain treatment. So determining holding period is crucial in cryptocurrency transactions. From a technical perspective a forked coin is both something new and something old. From the time of the fork, the new coin is clearly something different from the original, but prior to the fork it isn’t as clear. The blockchain of the new coin is dependent on all prior blocks of the original coin, and wouldn’t exist without that history.

An argument can be made that what is now called Bitcoin Cash always existed as BTC before the fork. For simplicity, lets say the only difference between BTC and BCH was the 1MB and 8MB block size, respectively. At the time of the fork, if more miners had supported the 8MB block size, we would be calling that “Bitcoin” and the 1MB coin of the fork would be called something else. Suffice it to say, there is no easy answer to this question. Is the fork more like the fruit of the tree? Or is it more like a transporter clone of Commander Riker. In both cases, there is something new, yet the original is still in tact. So was it always part of the original, or not?

Constructive Receipt

Another nuance in this calculation is “constructive receipt.” The IRS defines Constructive Receipt: Income is constructively received when an amount is credited to your account or made available to you without restriction. You do not need to have possession of it. Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations (emphasis mine). The most common analogy is if you mail me a check, while it is in the mail service I do not have constructive receipt, but if it is delivered to my mailbox, I DO have constructive receipt, even if I don’t go and get it out of the mailbox for a week.

So when it comes to forks, this can be a major issue. When a fork is developed, when you actually have access to it can depend on where your original coins are stored. Your wallet or exchange may have delayed support for the forked coin or no support at all. Bitcoin Cash for example was forked on 8/1/17, but Coinbase users didn’t have access to BCH until the following year. That clearly represents a “substantial restriction.” What if all you need to do is download the software for a new wallet? Is that analogous to just going going to the mailbox?

Unwanted Forks

In the 10 months following the Bitcoin Cash fork, Bitcoin has had another 44 hard forks. All but four of them have turned out to be worthless. However, following the rules laid out in Option 1 and Option 2 above, all 45 of these forks would need to be tracked, and in option 2, recognized as income. This represents a substantial compliance burden for the average bitcoin user. Additionally, if forced to recognize these coins as income, it is possible the taxpayer would have phantom income they have to pay tax on. In theory, they would recognize a capital loss in an equal amount when they dispose of the coin, but that brings us to another issue. What if you can’t dispose of the coin? If there is only one exchange for a coin, and it collapses, you technically own a coin that you recognized income on and can’t sell. You could “abandon” the coins, but a mechanism for that isn’t recognized for tax purposes. At the very least, under option 1, every fork dilutes the basis of your original coin a little bit more each time, having a negative tax consequence on your holdings. It is conceivable that if option 1 or 2 were the method chosen by the IRS, a malicious actor or group could fork an coin, and set up the only exchange with arbitrarily inflated prices. That coin would then need to be recognized for tax purposes.

All of these issues make the constructive receipt of the coin that much more crucial when it comes to forks. Do I actually ever own “Bitcoin Pizza” if I didn’t want it, never attempted to access it, or didn’t even know it ever existed?

So What Do You Recommend?

So it should be pretty clear by now that I support option 3. However, every situation is nuanced and should involve a more in-depth discussion around the technical aspects and your own personal risk tolerance. It’s also crucially important to consistently treat all forks the same way. Looking at both the current fork AND the long term scenario will both come into play when deciding on a treatment method. Contact us to set up a consult to discuss your own situation.

Airdrops

Airdrops are another method of acquiring new coins. However, they are not typically the result of a hard fork, which alters the tax treatment slightly. Sometimes you must sign up to receive an airdrop and sometimes they just show up in your wallet.

How are air drops different?

Constructive Receipt is again a factor here. If you don’t regularly check your wallet, you might not even know you received an airdrop. Because this is not a coin you were always holding, airdrops may be more analogous to found money, which would make Option 2 the most logical treatment. This is substantially more likely if you filled out a request for a specific token’s airdrop. However, typical airdrops are very low dollar value ($5 or less most of the time), making comprehensive record keeping impractical. This is again another area that would greatly benefit from additional IRS guidance.

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