JONES DAY TALKS®: Hard Forks and Airdrops — The IRS Issues Cryptocurrency Tax Guidance
The IRS's first guidance on the taxation of cryptocurrency in five years provides some new insights, but also leaves several issues unresolved. Jones Day partner Lori Hellkamp discusses Revenue Ruling 2019-24, with particular attention to the tax treatment of "hard forks" and "airdrops," tips for remaining compliant, and the remaining questions relating to the taxation of virtual currencies.
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Read a full transcript below.
Dave Dalton:
The US Internal Revenue Service or IRS has issued long awaited guidance on tax considerations pertaining to transactions involving virtual currencies. This is the first guidance on the topic the IRS has released since 2014, but interestingly, the guidance raises as many questions as it answers. We have Jones Day partner, Lori Hellkamp here to explain. I'm Dave Dalton, you're listening to JONES DAY TALKS®.
Jones Day tax partner, Lori Hellkamp, practice spans a broad range of areas, including corporate and international tax, M&A and tax controversy. She has extensive experience in international tax planning, counseling and compliance as well as tax efficient structures for crossword transactions and restructurings and issues arising with foreign investments in the United States. Hey Lori, thanks for being here today.
Lori Hellkamp:
Oh, thanks for having me.
Dave Dalton:
We are going to talk about cryptocurrency and its tax implications. And the IRS recently dropped out a new guidance, we're going to talk about that in a second. Just to kind of get us rolling and make sure we're on the same page. Lori, tell us generally speaking, how are cryptocurrencies treated for tax purposes?
Lori Hellkamp:
Sure. So in 2014, the IRS made kind of a fundamental policy call that they wanted these types of currencies to be treated as property rather than true currency or even foreign currency. And that came with a host of tax implications not all of which are obvious or make sense when you actually start applying these principles to real life transactions. They really can have some unexpected results because I think so many people kind of conceptualize cryptocurrencies as a type of currency since they're used in transactions to buy and sell things. It's a little bit unexpected sometimes, the tax implications of using these property type coins in transactions that fundamentally feel like a currency. For example, let me put a little color on that. Every time you purchase a cryptocurrency, a coin, for example, you have to track that basis, you have to kind of keep tabs on how much you paid for it at the time.
And likewise, each time you then use that cryptocurrency, not just selling it necessarily, but you use it to buy something. For example, you actually have to recognize gain or loss for tax purposes at the instant of that purchase. And that's something that's kind of the most unexpected because normally buying something is not a taxable event. If you go to a retailer and buy a sweater, you don't pay tax on that, well, let's set aside sales tax, but there's no income tax that's recognized in that transaction. If however you paid with a cryptocurrency, it would actually be taxable to you again from an income tax perspective. Say it's a $100 sweater and you paid $10 for a cryptocurrency that the coin that you're going to use to buy that sweater, which is now worth a 100, but you got it last year and you paid $10 for it. So buying that sweater is actually going to result in a $90 taxable gain to you as the purchaser.
Dave Dalton:
Okay. I hadn't expected that at all, and I did do some research preparing for this. So as you said, when you buy something with normal currency, no one is worried about how the value of that currency may have fluctuated in the international monetary exchange or something in the meantime, but when you're using crypto, you have to account for the gain or I suppose, sometimes the loss in the value of that crypto currency from the time you acquired it, how you did, to when you used it to make that purchase. That's correct?
Lori Hellkamp:
Yeah, that's right. It's very unexpected and as you can imagine, there are still probably taxpayers out there who don't expect that answer, previously, there were lots of them. I think increasingly the IRS is trying to put out the word that that's how they view cryptocurrency. So more and more people are at least aware of this but your surprise is spot on because you just don't conceive of a transaction like that giving rise to a taxable result.
Dave Dalton:
Okay. So are all cryptocurrencies covered by that kind of guidance or arrangement in terms of you've got account for any escalation or decline in the value during the time you held it?
Lori Hellkamp:
The short answer is no. The IRS issued that guidance, they made that fundamental policy call in 2014 and in that guidance they spoke to only a specific class of what they call convertible virtual currencies. And those are basically kind of the digital representations of value, they can actually be exchanged into fiat currencies. Fiat currency of course being, the dollar, the yen, the Euro, the kind of state backed currencies. So there are cryptocurrencies that don't cleanly fall into that category, there are also lots of tokens that don't fall into that.
And there's this wider universe of tokens out there and they don't all just represent kind of intrinsic value like a Bitcoin or Ethereum you think of as currency that you can buy and sell stuff with. Tokens can have characteristics beyond just that kind of intrinsic value. You might be able to get services with them, they might represent an ownership stake in a potential project. There's all these tokens floating around in the world that we don't think are or were intended to be covered by that initial guidance. So really what we can say is we have guidance that convertible virtual currency is kind of that narrow class are clearly covered by that 2014 guidance. Everything else may or may not be, but probably isn't.
Dave Dalton:
Okay. Good enough. Okay. Let's move over to what prompted this conversation today. Okay. Back in the fall the IRS released a much anticipated new guidance, I guess, intended to help taxpayers better understand reporting obligations for transactions involving virtual currencies. That can be found at revenue ruling 2019-24 on the IRS website, we will also post that link at jonesday.com. Lori, this is the first update in five years, you mentioned the 2014 guidance. A couple of things, first of all, what did it tell us? And what's your preliminary reaction to what you read there?
Lori Hellkamp:
Sure. Yeah. This was a long awaited guidance, we'd been hoping for guidance because as you can imagine, a lot has changed since 2014. This is such a quickly evolving area, I mean, the number of coins and tokens out there have exploded since 2014 so guidance was desperately needed. The IRS issued something late last year and specifically it speaks to hard forks and the treatment of hard forks. I think maybe before I go into what the IRS said about that, maybe just for a second, we'll step back to clarify. So a hard fork, what we mean by that, a hard fork arises when there's basically a change to the underlying blockchain software that causes an incompatibility between the existing protocol and then a newly developed protocol and this causes the blockchain to be forked. I mean, we think of it like a fork in the road, right?
Dave Dalton:
Right.
Lori Hellkamp:
So each chain then going forward applies different rules to reviewing and verifying transactions on the block. And these protocol changes to the software can either be because there was technical divide among the network among the appropriate protocols or hard forks can be done intentionally because someone is trying to create a new cryptocurrency. This is all open source software that we're dealing with in the blockchain sphere, basically anyone with the technical ability and inclination can start their own cryptocurrency. So an example of a hard fork though, is Bitcoin. So Bitcoin went forked into Bitcoin and Bitcoin Cash in 2017, that's probably the best known example of it so far. And in a hard fork, new coins come to exist by virtue of the transaction ledger of the legacy network being copied to create this new and separate blockchain so this new currency going forward. So typically how this works is if you previously owned a coin of the original cryptocurrency which I'm going to call A, you'll now own that same coin but you'll also own one coin of new A.
So this is how the split happens, both the legacy and the new A will share all the block history, but going forward, they're going to reside on separate blockchains, quite literally a fork in the road. No coins are airdropped, however, in connection with this hard fork situation that I just described. An airdrop on the other side, and this will become relevant when we delve into the guidance, that refers to basically a distribution of a coin or a token, often a newly developed one to multiple wallet holders for free. So this is more in the marketing space that we see this, it's not related to a hard fork. Actually, the best analogy I've heard so far is, if you're in a grocery store or a big-box store and the employees are giving out samples, maybe you have a fourth of this cookie in the hopes that you'll buy the whole package of the cookies, that's what an airdrop is.
It's a marketing tool to intrigue you and interest you in whatever the new coins, the new tokens, the new services, whatever it is that are being developed, it's fundamentally pretty different than a hard fork. So this new guidance then, it appears to misunderstand the underlying technology and conflate hard forks and airdrops or at least it assumes that they necessarily happen in conjunction with one another so it's created a bit of confusion. Depending on how you read the guidance, it either appears to require or to not require immediate taxation of new coins resulting from a hard fork.
Dave Dalton:
That's a big deal. Either requires or it doesn't depending on your interpretation. Really?
Lori Hellkamp:
You're exactly right. The problem is that they essentially speak to facts that don't happen in the wild and give the tax results for that. So if you read it quite literally, it would seem to suggest that you're only taxable on a part fork if it is in conjunction with an airdrop, but again, those two things don't live together in real life. There might be one known kind of outlier example, but generally hard forks happen how I described them. So they're separate from airdrops, they're just different concepts, they're different things. So I think what the IRS was actually trying to say is that hard forks are immediately taxable, but yeah, a technical and literal rate of this might suggest that they're only taxable if you receive the new forked currency in connection with an airdrop, which again, doesn't really happen. So I think where this leaves us is they're almost certainly going to have to clarify the guidance and possibly even revoke it and reissue it, suffice it to say it's caused probably more confusion and created more questions than answers.
Dave Dalton:
Yeah. With all due respect to our friends at the treasury department and at the IRS, I mean, what's a taxpayer supposed to do right now. And trust me, Lori, if you're confused, everybody is confused. What's the taxpayer supposed to do at this point?
Lori Hellkamp:
I think at this point you have to be reasonable, take consistent positions, act in good faith, document everything you're doing, especially document kind of how you're valuing things. But I mean, yeah, good faith effort. The IRS feels that these are reportable or at least the cryptocurrency transactions generally are reportable. So if you're doing nothing, that's probably a problem, if you're recording nothing, if you're doing nothing, that's an issue. But if you're trying to be compliant in a reasonable manner, you do it consistently and you document what you're doing and why you're doing it, you're in a better position than those who are doing nothing, which is going to be a problem.
Dave Dalton:
It makes Sense. For sure. That's always good advice, I think. Let's go back to airdrops for a second, the marketing airdrops you were talking about before. Talk about how they're valued for tax considerations, how would that come about? How do you know who tells you?
Lori Hellkamp:
That's a great question. And in fact, it's kind of the million dollar question now. Both for airdrops and hard forks, if they are, as I think what the IRS is trying to say, taxable immediately, so once you gain possession of them and can access those new coins, whether there are new forked coins or they're airdropped kind of marketing coins, and you have to value them in order to report them as taxable at that instant of receipt, you have to figure out how much they're worth. That is an incredibly difficult thing to do sometimes. Many new tokens that are dropped, well, they're speculative at best. I'm sorry.
Dave Dalton:
Well, forgive me for interrupting, but I'm thinking in context of things I am more familiar with, in an equity, a stock issue, right? If it's an IPO, let's say it is issued at 20 bucks a share, you buy at the IPO, you know what your cost basis is, I guess. If you sell it later for 25, that's a fair market, someone is willing to buy that from you for that price, you have a gain of five bucks. But how do you establish fair market value of a crypto that you receive by airdrop if there's no active market? How might that work, I wonder?
Lori Hellkamp:
You're exactly right. I mean, if there's no market for it yet, there may or may not be, most likely there's not. Most likely, I mean, in the case of marketing airdrops I would think that most of them are probably valueless, it just completely depends. But you're right, if there's no established market, no trading, it's very difficult to value something. So I think this is where we go back to that previous answer where, be reasonable, be consistent and document your valuation methodology.
Dave Dalton:
How might airdrops be taxed versus how hard forks might be taxed? Are there different approaches perhaps or different arrangements we should expect? How might that play out in the real world?
Lori Hellkamp:
Yeah, I think there are other approaches that can be taken for both and they can be consistent or not as between each other. But the IRS appears to be taking the position that they're basically taxable immediately, both the receipt of a new forked currency as well as an airdropped currency. But there are definitely other approaches, and other approaches that many practitioners have advocated for and indeed that other jurisdictions are already taking. And part of this is because it is so difficult to value new tokens upon first receiving them. The practical difficulties of valuing and complying with such rules is going to be not insignificant. Also because it's not clear that something new or that additional value is necessarily created in all of these instances. I mean, with the hard fork, for example, there's this great common analogy that you'll hear in the tax circles.
If a mare gives birth to a foal, so a baby horse, that's not usually a taxable event to the horses owner. So that's kind of where there's case law on that. There's obviously not case law yet on hard forks and their taxability, it's just all too new so we're struggling for analogies here and that's one that's kind of taken hold. Conceptually, anyway, I think it's clear that it's just not obvious that the new value is necessarily created in many of these situations. So that coupled with the difficulty of valuing coins or tokens on the front end really make a great case for considering another means of taxing these situations. I think the most obvious one is for it not to be taxable at the time of the fork, but then for the new currency, for the new crypto that you then hold, it'll have a zero basis, so it'll be like you paid $0 for it. So if and when you then sell it or use it in a transaction, it will become fully taxable when you actually know what the value is.
Dave Dalton:
I see.
Lori Hellkamp:
Alternatively, it could be nontaxable at the time of receipt, but then the basis that you had in that original legacy currency could kind of be allocated among the legacy cryptocurrency and the new one that was created in the fork.
Dave Dalton:
Right. Well, listening to you talk it dawns to me, we do a lot of podcasts and sometimes we're talking about artificial intelligence or robotics or blockchain and the regulations are always having a hard time keeping up, right? Because our technology tends to move along more quickly and for a lot of reasons. Well, I'm used to that but I'm not used to that when we're talking about finance or tax issues. Here we've got a brand new type of currency, medium of exchange if you will, that we just aren't sure how to tax it yet. We talked about not being able to regulate technology, here we've got something brand new that now the tax authorities are going to struggle with. This is new terrain for me and maybe for a lot of us, I guess.
Lori Hellkamp:
Oh yeah, absolutely.
Dave Dalton:
Here's one other thing too. You were kind enough to send over some notes for us to get ready for this conversation. And you mentioned, I'm sorry, I'm chuckling, but you said the guidance issued so far by the IRS is air quotes, sub regulatory, what does that mean? Sub-regulatory. I'm afraid I know what it means, I might not like it, but go ahead.
Lori Hellkamp:
No. It means what you think it means. Consider the laws and legal requirements that are imposed both in tax and just generally, there's kind of a hierarchy, right? I mean, there's different formats, so there's the constitution and then there's statutes and then there's regulations. There's kind of a list though, and some trump others, right? Sub-regulatory guidance means just what you think, it doesn't rise to the level of a regulation, it's less formal guidance, it hasn't been subjected to kind of the formal review process, it hasn't been subject to public comments, it's more susceptible to being challenged. Technically the IRS actually in the tax space isn't even supposed to seek judicial deference to its interpretations that are set forth only in sub-regulatory guidance. It means, you know what the IRS thinks and the position they're going to take so if you take a position that's contrary to the sub-regulatory guidance, you can expect it's going to get challenged on audit or if you take a different position but it's not kind of firm law in the sense that it would be if it were a statute or even published regulations.
And some of the guidance along with the revenue ruling they published late last year, they published some frequently asked questions on the website. Those are so informal that they technically can't even be relied on for penalty protection, so that's an issue. If you rely on those, fill out your tax form in a way that complies with those frequently asked questions and then end up having an issue, usually you can avoid penalties by saying, but I relied on this guidance published by the IRS, but it's got to be sufficiently robust guidance. And that frequently asked questions, as far as we're aware, to date aren't considered kind of sufficiently robust that taxpayers would be able to rely on them for penalty protection per se.
Dave Dalton:
Well, are we going to have to wait for case law to really clarify some of this, do you think?
Lori Hellkamp:
I think regulations would be a good place to start.
Dave Dalton:
Start with that first that's right. Yeah.
Lori Hellkamp:
Yeah. I'm not even going to be so greedy. Yeah. A statute would be great, statutes have been kicked around by Congress, they've never actually made it through though. There are some very common sense provisions that have been contemplated like a diminimous exception, because this is property. Think about it, you're supposed to be recording your basis and recording your taxable gain or loss on every single transaction, well, goodness, what if you buy a $4 cup of coffee or something, the compliance burden is not insignificant if you're following these rules as I think they're published right now. So Congress has at least toyed with the idea of a diminimous exception, it never made its way out of Congress though so it's not law, but gosh, wouldn't it be nice if it were.
Dave Dalton:
It sounds like it. It also sounds like this is very much a work in progress. Lori, what are the open issues remaining? And frankly, are we going to have to wait another five years? What do you think?
Lori Hellkamp:
I don't know. I'm hoping that they will fix the 2019 revenue ruling sooner than five years from now because that one really needs to be clarified and corrected. But great question. There are still a lot of open issues. I mean, there's so many things outside of just hard forks that we didn't talk about today that the tax treatment is uncertain. I mean, there's ICOs, there's mining income, there's all kinds of cross border considerations and applicable reporting requirements. There's still a lot of uncertainty about how exactly and when you're meant to report various transactions that are undertaken with cryptocurrencies, so yes, a lot of open questions. Although I will say at this point that the fact that there are so many open items hasn't necessarily stopped the government from moving forward with compliance enforcement. The government recently legally compelled one of the major cryptocurrency exchanges to turn over thousands of records and taxpayer information on many of its customers and their cryptocurrency transactions.
And last year, I think it was over 10,000 letters were sent out from the IRS to taxpayers based on the data they received that basically said, hey, we know you transacted in cryptocurrency and we think you didn't properly report it for tax purposes. So, yeah, there's different flavors of that letter that went out, but they went out. So I think this goes to also, yikes, there's a lot of uncertainty, but this is why at least a good faith effort to do something and keep records and report the best you can is the way forward for now, you certainly can't do nothing.
Dave Dalton:
Lori, thanks so much for being here today, this has been informative. Let's talk again, maybe later on this year, if you get a feel for where things are going or have some client experiences that might be useful for the audience, we'd love to hear more, fascinating area. I think we're going to be really busy.
Lori Hellkamp:
I think we are too. It's been my pleasure. Thanks Dave, nice talking with you.
Dave Dalton:
Take care Lori, you too. Bye. Visit the tax practice page at jonesday.com for Lori Hellkamp complete bio and her contact information. Also be sure to visit our insights page for great content, there you'll find other podcasts, videos, commentaries, alerts, newsletters, blogs, and other interesting information. Subscribe to JONES DAY TALKS® at Apple Podcasts and wherever else podcasts can be found. As always we thank you for listening, I'm Dave Dalton, we'll talk to you next time.
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