How the IRS should revise its guidance on tax liabilities after a cryptocurrency hard fork or airdrop.

Disclaimer: The author and bridge21 do not provide tax, legal or accounting advice. This article is for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

The IRS released guidance yesterday on how to handle cryptocurrency hard forks and airdrops for tax purposes (skip to item 22 and read from there).

The troublesome part is the answer to Q22, bolded for emphasis.

Q22. One of my cryptocurrencies went through a hard fork followed by an airdrop and I received new cryptocurrency. Do I have income?

A22. If a hard fork is followed by an airdrop and you receive new cryptocurrency, you will have taxable income in the taxable year you receive that cryptocurrency.

The IRS is treating hard fork and airdrop events like taxable stock spinoffs in the United States, where the spun-off token is taxed as ordinary income, like a dividend paid from the pre-spun-off equity. Unfortunately, cryptocurrencies are not stocks, and the differences create a tax nightmare for token holders. Let’s focus on the two biggest problems.

The two biggest problems with the guidance

1. Cryptocurrency hard forks and airdrops aren’t voted on by shareholders or a board of directors with fiduciary responsibility before they occur. Anyone, anywhere, at anytime can hard fork a cryptocurrency and create an unplanned taxable event for a cryptocurrency holder. The guidance could be weaponized by exchanges, where a cryptocurrency exchange hard forks a cryptocurrency, lists the hard forked token on their exchange on the last day of a quarter, manufactures an inflated “fair market value” by pumping it with a modest amount of capital on low trading volume, and creates an a massive unplanned tax liability for a competing exchange that holds a large amount of the original cryptocurrency. This problem makes US based exchanges especially vulnerable to attacks by foreign exchanges, and puts them at a competitive disadvantage.
2. Cryptocurrency tokens don’t trade on a handful of highly regulated exchanges in New York and London. There are hundreds if not thousands of markets around the world where cryptocurrencies trade legally or illegally depending on where you live. The cryptocurrency holder may be unaware of a hard fork in a cryptocurrency they hold, or that the new token is trading at value somewhere in the world. This guidance creates an accounting nightmare, requiring holders to track hard forks and airdrops globally across hundreds or thousands of markets, many of which operate in a foreign language and don’t conform to US accounting standards. Donald Rumsfeld put it best; this guidance makes cryptocurrency holders liable for “unknown unknowns”.

How the IRS should handle tax liabilities for hard forks and airdrops

The IRS should treat hard forks and airdrops as a property purchase event on the hard fork or airdrop date with a cost basis of 0 for the hard forked or airdropped token, with no change to the cost basis of the parent token. The taxable event should occur when the token holder decides to sell the airdropped or hard forked token, not when the token is received.

While this approach would create a tax incentive to hold the airdropped or hard forked token because of the 0 cost basis, and sell the original cryptocurrency token because of the likely higher than 0 cost basis, it’s still a better approach overall because:

1. It eliminates the potential for exchanges to manufacture tax liabilities for competitors.
2. It eliminates the accounting nightmare of tracking hard forks and airdrops, and if they trade at value somewhere in the world.
3. It eliminates the need to establish a cost basis for a hard forked or airdropped token, ostensibly using the often inflated values these tokens have immediately after they begin to trade on various exchanges.

In closing, dear IRS, I hope you consider revising your guidance accordingly.

Will