Cryptocurrency holders could have to pay tax on coins they received unwittingly, or against their wishes, under recent IRS guidance.
If left unchanged, the policy may make it harder for people to meet their tax obligations—at a time when the IRS is ramping up enforcement to increase compliance in the crypto space, according to tax professionals.
The revenue ruling released Oct. 9 says users are required to pay income tax on new coins they receive following a transaction known as a “hard fork,” during which one cryptocurrency splits into two.
The IRS generally defines this distribution of new coins to multiple users as an “airdrop.” More commonly, however, the term is used in the industry to describe situations where a company gives cryptocurrency holders free coins as a way to market a new offering and build awareness among potential customers. These coins can often just appear in users’ wallets.
In some cases users are asked whether they want to accept the airdropped coins, “But in most of the cases you just get airdropped some coins out of nowhere,” said Shehan Chandrasekera, head of tax strategy for CoinTracker, a company that helps people manage and calculate taxes from cryptocurrency transactions.
For that reason, tax professionals have suggested that the IRS reconsider its current stance or create safeguards so that taxpayers aren’t forced to pay tax on coins they didn’t actually want and have no intention of using.
The concerns are valid, said Kristen Garry, a partner in the tax practice and head of the Washington office at Shearman & Sterling LLP.
The IRS could have avoided this problem altogether by treating hard forks as a division of property, requiring cryptocurrency holders to allocate their existing basis—the purchase price of the asset used to calculate capital gain or loss—between the original property and the airdropped property, Garry said.
“Then people could have been taxed when they sold or exchanged any of their coins,” she said.
Concept of Control
The concept of control is important in determining whether a cryptocurrency holder owes tax.
The IRS guidance treats taxpayers as receiving airdropped coins when they have “dominion and control”—defined as the ability to transfer, sell, exchange, or otherwise dispose of the coins.
Taxpayers may have to wait for an exchange to support the new airdropped coins before having their accounts credited—an example the IRS guidance gives of a situation where control is delayed.
Taxpayers won’t be treated as receiving the cryptocurrency until that amount is credited to them and they can transact with it, the IRS said.
Nicholas C. Mowbray, an associate at Baker & Hostetler LLP in Washington, said the IRS may want to take this concept a step further.
“The IRS should potentially reconsider whether ‘dominion and control’ is enough to give rise to income, or whether there should only be income where the taxpayer acts in a way that shows their intent to exercise dominion and control over a cryptocurrency,” he said.
The advocacy group Coin Center in an Oct. 9 blog post also said the IRS should account for a user’s intent to exercise control.
Under the current guidance, individuals may have to pay tax because of actions unknowingly taken by a third party, Peter Van Valkenburgh, director of research at Coin Center, said in the post.
Without a change, he said, “It’s like owing income tax when someone buries a gold bar on your property and doesn’t tell you about it.”
Despite some unanswered questions, IRS officials like Chief Counsel Michael Desmond say taxpayers should pretty much know how much tax to report.
The agency in 2014 said cryptocurrency is property for tax purposes and there are well-established rules for how to treat property, Desmond has said at recent conferences.
The biggest problem is that many people aren’t disclosing their cryptocurrency transactions at all, which they should clearly know is wrong, he has said.
There are probably two dozen issues that have been brought to the IRS’s attention—both as a result of and existing prior to the latest guidance, he said Oct. 22 at a conference in Beverly Hills, Calif.
An attendee during that conference asked Desmond if taxpayers can apply like-kind exchange principles to cryptocurrency trades occurring before 2018. A like-kind exchange is a tool under tax code Section 1031 that allows taxpayers to postpone paying tax on the gain of a sale if the proceeds are reinvested in similar property.
The IRS will need to perform more audits and see how people are applying that tool before reaching a conclusion, Desmond said.
The cryptocurrency industry will begin making decisions that account for potential tax consequences as the IRS’s stance on these issues becomes clearer, according to practitioners.
“For example, in the case of a hard fork event that will result in a new cryptocurrency, the nodes supporting the new cryptocurrency might consider the tax implications in determining whether to implement the fork in the current year or delay the event until the next tax year,” Mowbray said.