Omri Marian is a professor of law at the University of California, Irvine. He contributed to several projects on the taxation of cryptocurrencies at the American Bar Association Section on Taxation. The views expressed are his own and do not constitute tax advice.
The following article is an exclusive contribution to CoinDesk’s Crypto & Taxes 2018 series.
If you owned bitcoin on July 31, 2017 (and did not dispose of it), by the end of the next day you also owned (or at least you were entitled to claim ownership of) an equal amount of bitcoin cash.
If bitcoin owners in the U.S. instead got cash (the old-fashioned kind) that day, there is no question they would have to report those greenbacks as taxable income on their 2017 tax returns. So what about the receipt of bitcoin cash? Is that taxable?
Unsurprisingly, the Internal Revenue Code (IRC) does not directly address the tax treatment of cryptocurrencies in general, or of hard forks in particular. All we currently have is the guidance issued by the IRS in 2014, which does not address these cryptocurrency creation events.
When legal doctrine is lacking, lawyers and judges sometimes look for analogies, trying to find the most analogous transaction for which clear tax treatment does exist. Unfortunately, this methodology provides little help in the case of hard forks.
There is not one good hard-fork-analogous transaction in the law, for which the tax treatment is clear. Though, there are many reasonable analogies to choose from.
Thus, taxpayers who received forked coins in 2017 face significant uncertainty this filing season. My purpose here is to explain why the tax treatment of hard forks is uncertain, and to call for the IRS to issue guidance addressing such issues.
Hard forks, hard questions
The basic framework prescribed by the Supreme Court is that taxable income includes any “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.”
The first of the three requirements (“accession to wealth”) is likely met in a hard fork. When an owner of bitcoin receives bitcoin cash, she receives something of value. The other two requirements (“realization” and “complete dominion”), present much tougher questions to answer in the context of hard forks.
Consider realization first. The realization requirement is part of the bedrock of our income tax system, prescribing that taxable transactions are only those in which a taxpayer receives something “materially different” from what the taxpayer already had.
Is bitcoin cash materially different from bitcoin? Or was the potential of hard forks always factored into the ownership of bitcoin? Is the receipt of bitcoin cash something new? Or is it just evidencing something bitcoin owners always had?
One argument is that owning bitcoin cash is different from the original bitcoin, because otherwise why go through the trouble of a chain split, if not to create a new coin with different properties?
On the other hand, minerals are materially different from the land they are extracted from, yet it is quite clear that if you own land, you don’t have to report income from the minerals you extract unless you actually sell them.
The problem, however, is that the reason it is clear minerals are not taxable until sold is that we have regulatory guidance that says so.
In addition, it is rather tenuous to analogize hard forks to mineral extraction. The land and the minerals have always been materially different. An owner of the land does not create the minerals, but extracts them. Bitcoin owners just received bitcoin cash on account of owning bitcoin, and got to keep both. They did not extract anything from anywhere.
Chain splits vs. stock splits
It is therefore easy to see why hard forks are sometimes analogized to proportional stock dividends or stock splits, in which each shareholder receives additional shares on account of owning the original shares.
Stock splits are generally not taxable events under current law. Again, we have clear legal doctrine that says so. It is also unclear whether the analogy to stock splits is a good one. In a stock split, the old and new stock still represent ownership interests in the same asset (the corporation). A chain split creates a new coin with different properties than the old one, separate ledger, and a new independent market.
Taking a conservative approach
In the absence of guidance, the more conservative approach would be to take the position that a hard fork is a realization event (read: taxable). But even if one decides to take such a conservative approach, two important questions remain: When exactly did realization happen? And how much income was realized?
That is, if one decides to report the receipt of bitcoin cash (or other forked coins) as income, what is the amount of income one should report? It is here that the question of “complete dominion” becomes relevant.
The realization amount is generally determined at the time realization happens, meaning when the taxpayer acquires “complete dominion” over whatever it is the taxpayer realized. Under the legal doctrine of “constructive receipt,” realization happens at the time income is “made available” to the taxpayer.
For example, you cannot avoid reporting income on a check payment you received by not depositing the check. Thus, since coin owners theoretically become entitled to claim the new coin at the time of the fork, there is a reasonable argument that realization happened at that time.
If realization happens at the time of the fork, there is a reasonable argument that the value realized is zero. This is so because at the first moment a new coin is created, there is still no market for it. Price discovery takes time.
Thus, for example, the receipt of bitcoin cash is akin to a taxable event in which one received zero dollars.
There is a reasonable counterargument, however: There were futures traded online on the price of bitcoin cash, implying that it had value at the very first minute of its creation.
But such futures were traded on platforms that are not so-called “established exchanges,” which the IRC sometimes relies on for purpose of determining market value of assets. The tax value at the time of the fork thus remains a mystery.
Moreover, when an owner holds an original coin in a wallet maintained by an intermediary (such as Coinbase), the timing of realization is unclear. In that case, the owner may not be able to claim the new coin until the intermediary decides to support it.
By the time the intermediary decided to credit the owner’s wallet with the new coin, price discovery is completed in the market, and the amount realized is whatever amount credited by the intermediary to your wallet.
There is, of course, a counterargument here, as well: One could always withdraw cryptocurrencies from a wallet maintained by an intermediary that is not going to support the forked coin, and claim the forked coin outside the intermediary. Thus, under the constructive receipt doctrine, there is still an argument that realization happened at zero value.
Need for clarity
To summarize, under current law it is not at all clear whether a hard fork constitutes a taxable event.
Even if one takes a conservative approach that it does, it is not clear what is the amount realized, namely, the amount that taxpayers must report in income.
Given that several hard forks happened in 2017, it is absolutely imperative that the IRS issue guidance soon on the tax treatment of hard forks.
Whether the IRS can actually do so, is a different question: The agency may have bigger fish to fry now, like dealing with the massive new tax legislation passed recently.
Held-out hand image via Shutterstock