The Taxation of Hard Forks

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What are the tax implications of a cryptocurrency Hard Fork?  Does the holder of a cryptocurrency that undergoes a Hard Fork realize taxable income? If so, how does one determine the amount of the income and when, exactly, it is received?  These are not easy questions to answer.

What is a Hard Fork?

A Hard Fork—sometimes referred to as a “Chain Split” or “Coin Split”—occurs when a new branch of a cryptocurrency splits off from the original cryptocurrency.  The new branch shares a common history on the cryptocurrency’s blockchain (its ledger) up until the point of the split, and is thereafter maintained separately on the blockchain ledger.  “In other words, “the ownership history of both the original and forked cryptocurrency trace back to the same block on the blockchain, but going forward, the ledger of each cryptocurrency is independent (i.e., they are not interchangeable).”  American Bar Association, Tax Treatment of Cryptocurrency Hard Forks for Taxable Year 2017.

As a point of reference, two of the more notable Hard Forks were the August 1, 2017, Bitcoin split into bitcoin (BTC) and bitcoin cash (BCH), and the 2016 Ethereum blockchain’s Hard Fork in response to a hacking attack.

A Hard Fork results from a “change to the software of the digital currency that creates two separate versions of the blockchain with a shared history.”  Id.  The original owner of the cryptocurrency still maintains its interest in the original cryptocurrency, but also gains a right to the “forked” coin.  A Hard Fork is distinct from a “soft fork,” which involves changes to the relevant blockchain that do not involve splitting or branching the blockchain.

Notably, with a Hard Fork, the coin owner is required to take active steps to gain the ability to transact using the “forked” coin. Many owners will simply take no action to claim the new currency in light of security risks.

Hard Forks Raise Unique Tax Issues.

Does the holder of a cryptocurrency that experiences a Hard Fork realize income for federal income tax purposes?

To answer this question, we revisit first principles.  In the seminal case of Commissioner v. Glenshaw Glass, the Supreme Court construed the term “gross income” as it appears in the Internal Revenue Code.  The court gave a liberal, broad interpretation to the phrase, finding that it encompasses any “undeniable accession[] to wealth, clearly realized, and over which the taxpayer[] ha[s] complete dominion.”  This definition is broad, but it is not necessarily the end of the inquiry.

In the context of a Hard Fork, the Supreme Court’s holding in Glenshaw Glassimplies that the coin owner’s ability to use the “forked” coin might be viewed as a taxable accession to wealth.  But the fact that a taxpayer must take active steps to gain the ability to transact with the “forked” coin is important.  A taxpayer may deliberately never take such actions in light of security risks.  But rather than answer the question, this only raises another complex question: Does such a taxpayer, who has the ability to “claim” the Hard Forked currency, have “constructive” control over the coin such that the constructive receipt doctrine applies to cause a taxable event? The answer—as with so many things in the tax law—may depend upon the particular facts.

Treasury regulations under § 1.1001-1(a) define a realized gain or loss as, among other things,one from “the exchange of property for other property differing materially in either kindor extent.”  The Supreme Court’s decision in Cottage Savings Association v. Commissioner, shed light on the meaning of materially different in this context, defining materially different properties as those where “their respective possessors enjoy legal entitlements that are different in kind or extent.”  Does a Hard Forked currency meet this definition?

Or, looking at it from another perspective, should a Hard Fork be viewed as a non-realization event for tax purposes? One might view a forked coin as deriving from an original coin that simply always included the future possibility of generating a forked coin—something akin to a pro rata stock split, which the Supreme Court’s decision in Eisner v. Macomberfound to be a non-realization (i.e., non-taxable) event.  The argument would essentially hold that the possibility of a forked coin was capitalized into the market value of the underlying original coin, and the forked coin merely represents a portion of the value of the original coin.  Another potential analogy along the same analytical line is to the birth of young from livestock, which is generally not treated as a realization event under existing precedent.

These non-realization-event arguments might be bolstered by the fact that the Hard Forked coin’s owner continues to utilize the same private key that allowed access to transact with the original coin—and the fact that the ability to transact with both coins is, presumably, subject to verification by the same network of nodes on the relevant blockchain.

These are difficult questions.  And they don’t even begin to answer the further questions of when, if a Hard Fork gives rise to a realization event, income is realized and the valuation placed on that income.  Nor do they answer questions about the proper methodology to divide any basis between an original coin and a forked coin if a Hard Fork is not viewed as a realization event.

The ABA Weighs In

The debate over the tax impact of a Hard Fork has garnered a fair amount of attention.  The ABA Tax Section recently offered comments on the issue, urging the IRS to adopt a “safe harbor” that would provide the following rules in the context of a Hard Fork:

  1. Taxpayers who owned a coin that was subject to a Hard Fork in 2017 would be treated as having realized the forked coin resulting from the Hard Fork in a taxable event.
  2. The deemed value of the forked coin at the time of the realization event would be zero, which would also be the taxpayer’s basis in the forked coin.
  1. The holding period in the forked coin would start on the day of the Hard Fork.
  2. Taxpayers choosing the safe harbor treatment as set forth in the guidance would be required to disclose this on their tax returns.
  3. The Service would not assert that any taxpayer who availed themselves of the safe harbor treatment as set forth in the guidance has understated federal tax liability because of the receipt of a forked coin in a 2017 Hard Fork.
  4. The Service, with input from the Section and other stakeholders, will continue to develop its position regarding the tax treatment for future Hard Forks, and such position may be different from the one noted above and will apply prospectively.

The ABA explained that its proposed “safe harbor” would promote consistency and avoid difficult taxation questions:

This temporary rule has the benefit of encouraging consistency among taxpayers with respect to 2017 Hard Forks, avoiding difficult timing and valuation issues (including the ability of taxpayers to benefit from hindsight depending on how the values fluctuated during 2017), and providing information to the Service regarding holders of the original and forked cryptocurrencies. Although the treatment may result in capital gain as opposed to ordinary income treatment, it preserves the full value of the forked coin for taxation when the taxpayer sells it. In addition, it restarts the holding period, thus resulting in sales occurring within a year being taxed as short-term capital gains.

 

 

Concluding Remarks

 

A Hard Fork can give rise to difficult tax questions.  Does the holder of a cryptocurrency that undergoes a hard fork realize taxable income?  If so, how does one determine the amount of the income and when, exactly, it is received?  As the analysis above illustrates, many questions remain to be answered.

For other posts related to cryptocurrency taxation issues, see Bitcoin, Blockchain, and the Revolution to Come, Cryptocurrency—The IRS’s Next Big Crackdown, Cryptocurrency Regulation: Recent Developments, Bitcoin and Beyond: The Reality of Taxing and Regulating Virtual Currency

 

Taxpayers with cryptocurrency transactions should seek legal counsel regarding the tax impact under their specific circumstances.  Any advice or commentary offered above is merely for informative purposes and is not intended—nor should it be interpreted—as individual legal advice.

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