When the IRS issued guidance relating to bitcoin in 2014, it was a mixed blessing. On one hand, it helped cement cryptocurrency’s legitimacy. On the other, it placed cryptocurrency in a tax category that required complicated record-keeping even from taxpayers using bitcoin for ordinary spending. Last week, the IRS spoke on cryptocurrencies again, issuing an FAQ that gives some sensible and some quite confusing signals. The cryptocurrency world is far more complex than it was in 2014, and the regulatory picture has gotten more complicated, too. The IRS might have helped things by being consistent in its treatment of cryptocurrency as property.
It’s easy to forget or dismiss the possibility in 2013 and 2014 that government agencies would effectively outlaw bitcoin by treating it as a rogue technology. The ingredients for “crypto-prohibition stew” were all there: real and imagined illegal uses, risk-aversion among regulators, and vast discretion in regulatory agencies to write and enforce laws. But a good deal of politicking, favorable Senate hearings, and accommodating pronouncements from the IRS and the Financial Crimes Enforcement Network situated bitcoin and cryptocurrency as officially acceptable.
That doesn’t mean the government wouldn’t drape it in red tape. By designating digital currency as property rather than currency, the IRS required taxpayers to track capital gains or losses on cryptocurrencies each time they were spent. That is a tremendous burden on regular use, and it disappointed those pressing for cryptocurrency to quickly become a new form of cash. Subsequent events have validated the IRS’s approach to bitcoin, as bitcoin’s technical functioning has pushed it from the cash category into something more like “digital gold.”
Much of the new IRS FAQ solidifies the tax treatment of cryptocurrency as property. If you are paid with it, you have taxable income. If you hold it and then sell it at a gain or loss, you have capital gains or losses. To determine your tax liabilities, you must assess the dollar value of your receipts and the basis, or cost, of the holdings you sell. This is where the IRS FAQ is sensible.
But where cryptocurrencies are technically unique, the IRS FAQ gets more than just a little bit quirky.
One issue it addresses is the taxation of coins acquired via fork or airdrop. A fork is when a blockchain splits into two versions with identical histories but differing transactions going forward. Each side of the fork will track transactions in a different cryptocurrency. Holders of one cryptocurrency at the time of the fork will have (or with some technical finagling, can have) two cryptocurrencies. This happened twice in 2017, with the creation of Bitcoin Cash and Bitcoin Gold as forks from the original bitcoin blockchain.
An airdrop is when someone (literally anyone) assigns cryptocurrency to the public keys (blockchain “accounts”) of any or all holders of a given cryptocurrency. It’s a way to try to jump-start a currency. In an airdrop, the controllers of the private keys associated with public keys that receive coins will (with some technical finagling) have control of the new cryptocurrency.
The IRS FAQ talks first about a hard fork in which the taxpayer “did not receive any new cryptocurrency, whether through an airdrop . . . or some other kind of transfer.” The phraseology is almost perfectly inscrutable. A fork and an airdrop are technically distinct events. A fork followed by an airdrop would just be a strange coincidence. And in all but the most unusual scenarios, a fork will give owners of preexisting cryptocurrency units of a new cryptocurrency that correspond to the old (again, after some degree of technical finagling). No airdrop required.
But then the IRS FAQ says that a hard fork followed by an airdrop produces taxable income in the year that the cryptocurrency is received. The IRS must be collapsing the concept of forks and airdrops into one. That’s the best way, I think, to understand the FAQ’s technical convolution. As a literal matter, though, it has left the question of what happens with forked cryptocurrencies unaddressed.
A new challenge arises in understanding what it is to “receive” new cryptocurrency. Cryptocurrency is “received,” the FAQ says, “when the transaction is recorded on the distributed ledger, provided you have dominion and control over the cryptocurrency so that you can transfer, sell, exchange, or otherwise dispose of the cryptocurrency.” That’s a conceptual morass.
An airdrop may be recorded on a single day in the present, but taxpayers may learn of it at varying times, or never. They may learn of airdrops after they have filed taxes for the year in which they occurred. Treating recordation as the taxable event will be difficult to administer.
And in a fork, one’s authority over new cryptocurrency is not the product of it being recorded on the new ledger. The new ledger is a copy of the old ledger, on which transactions were recorded at various points in the past. Hopefully and assumedly, tax liability for the new cryptocurrency is not backdated to earlier recording dates, requiring cryptocurrency holders to refile past years’ tax returns.
Then there is the “dominion and control” proviso. This has the strange effect of making tax liability turn on technical skill. I’ve talked of “technical finagling” several times above because technically skilled people can take control of forked cryptocurrencies relatively easily, while lesser cryptocurrency users may have to research the steps they must take in order to securely access the new cryptocurrency that exists out there for them.
In some forking scenarios, it is possible to create transactions on one chain that can be repeated, or “replayed,” on the other chain, moving cryptocurrency there contrary to the controller’s intentions. Different people have different capacities for exercising dominion and control of forked cryptocurrencies. They can transfer, sell, exchange, or dispose of new cryptocurrencies at different times, and sometimes never. That’s a confusing standard to administer.
Making forked or airdropped cryptocurrency taxable as income in the year received is also confusing — not in technical terms, but in terms of tax policy. The general rule is that income is taxed only when it is “realized;” that is, traded or sold, often at a market price and often for cash. In familiar analogies to forked or airdropped coins, such as breeding cattle or valuable items found on one’s land, tax liability accrues when such property is sold, not when it is received.
This is relatively easy to administer and it avoids a couple of odd possibilities. Taxing property when received can cause people to have tax liabilities imposed on them against their will, and it can cause them to have tax liabilities they cannot afford.
Perhaps the IRS is preparing to recognize that cryptocurrency is money. Perhaps it is coming around to thinking that receiving cryptocurrency is receiving currency that can be used to pay tax liabilities. That is a slender reed of credit to accord the IRS, though. A more sensible move toward spendable cryptocurrencies would be to allow a de minimis exception to capital gains tax liability for low-value cryptocurrency expenditures. Until the IRS is ready to move toward treating cryptocurrency as currency that way, it would have done better consistently treat cryptocurrency as property that isn’t taxable until profits on newly acquired units are realized.
Learn more: Bitcoiners acclimating to life on the fringe | The implications of accepting cryptocurrency for tax payments
The post The IRS’s confusing cryptocurrency FAQ appeared first on American Enterprise Institute - AEI.
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