After nearly five years, the IRS has finally broken its silence on cryptocurrency by issuing Revenue Ruling 2019-24, which provides some clarification regarding the tax treatment of cryptocurrency. Previously, the IRS issued Notice 2014-21, which communicated the IRS's position that it treats cryptocurrency as property, rather than as currency, but it left many questions unanswered. This article summarizes what the IRS has told us and notes those items that still have not been addressed by the IRS. If you are involved in cryptocurrency investments, purchases, sales, or mining operations, these details are important because, as previously discussed, the IRS and United States Treasury Department are auditing taxpayers whom they believe to be involved in cryptocurrency, and the IRS has frequently warned that it intends to pursue criminal prosecution of those taxpayers that do not accurately disclose their cryptocurrency transactions.
Guidance from the IRS
We have two pieces of guidance from the IRS regarding cryptocurrency—Revenue Ruling 2019-24, and Notice 2014-21. Both are summarized below.
The IRS issued Notice 2014-21, Virtual Currency Guidance, on March 25, 2014. It describes how tax principles apply to cryptocurrency. The IRS has also published on its website a list of Frequently Asked Questions that expand on the notice, and it updated that list in December 2019. The notice addressed Bitcoin and therefore its guidance may be less helpful for other cryptocurrencies. The notice indicates that:
- Cryptocurrency is property rather than currency under section 988;
- Miners have income when they receive cryptocurrency because they are essentially being compensated for solving a mathematical problem; and
- Miners can be considered engaged in a trade or business.
It was no surprise that the IRS concluded that cryptocurrency should be treated as property rather than as currency under section 988. When Congress passed section 988, which deals with foreign currencies, the only currencies in existence were those from other governments. Even if it preferred to treat cryptocurrency as currency, the IRS does not have the authority to make that decision on its own without congressional approval.
Some have argued that the IRS's conclusion in Notice 2014-21 that miners have income when they receive cryptocurrency is unfair because many scenarios involving the creation of property do not result in taxation to the creator until the property is sold. For example, artists, farmers, fishermen, home builders, and virtually every other creator of property do not recognize income until the product created is sold. But a miner or system validator in cryptocurrency is taxed on his or her receipt of a reward, even if the reward is not a transaction fee but rather the creation of a new cryptocurrency token. Others have commented that there is nothing inherently unfair about this treatment because, unlike farmers, the reward comes from the cryptocurrency system at not from nature, like a crop. The system creates the reward, and the reward is provided to the miner or system validator, and therefore, they argue that it is no different than a customer that compensates a service provider by providing cash to the service provider. If a farmer gives their crop to someone who assists on the farm, the receipt of the crop is income to the assistor. No matter which side of the argument you find yourself on, the IRS has made it clear that it believes the receipt of a reward to be income to the miner or system validator. Although taxpayers may challenge the IRS's position through litigation, I am not aware of any reported cases to-date where taxpayer have done so.
Revenue Ruling 2019-24
The IRS's cryptocurrency revenue ruling addresses the tax consequences of a hard fork for those that hold cryptocurrency.
A hard fork is a change to the protocol of the blockchain. Blockchain technology allows a holder of coin to review the history of the coin. coin. When the protocol of the blockchain changes in a meaningful way, however, the old protocol continues to exist alongside the new protocol. This simultaneous operation of the old rules and new rules creates two separate forms of cryptocurrency than can be spent. A person that holds one unit of cryptocurrency before a hard fork will hold two units after the hard fork—one unit under the new rules, and one unit under the old rules.
The IRS ruled in Revenue Ruling 2019-24 that if the hard fork results in the creation of a separate coin for those that held the currency before the hard fork (an airdrop of new coin), the hard fork results in income to the holder of the coin. The IRS's position generally makes sense because hard forks resulting in new coin generally add value to the recipient. For example, the recent hard fork in Ethereum to deal with the failure of The DAO did not eliminate the value of the old coin despite the creation of the new coin. When the hard fork took place, Ether (the new coin) was selling at $12.45 and Ethereum Classic (the old coin) was selling at $.75 and then rose to $2.85 within two days. The IRS's revenue ruling would treat Ether—the new, much more valuable Ethereum—as the airdrop, which is treated as income to the holder of the coin. The problem with this approach is that the new coin is generally the more valuable coin since it benefits from the improved characteristics, and that means that a holder will be forced to recognize ordinary income even if it intends to continue to hold both the new and old coin. The value of the old coin will likely decrease substantially, resulting in a large potential loss that, when sold, will probably create a capital loss, rather than an ordinary loss. This is an unfavorable mismatch in characterization that should be addressed by Congress.
Where the IRS Remains Silent
Blockchain is able to create value (like when it rewards validators), but because the blockchain has no owner, there is no way for the IRS to require that the blockchain report information to the IRS. The IRS is able to ensure that taxpayers report wages, investment income, sales of homes, credit card income, and cancellation of debt through information reporting requirements that require those that make payments to report the payments to the IRS. There are steep penalties when a payor fails to properly report payments on Forms W2, 1099, etc. The IRS has not yet created a similar information reporting mechanism that would help its enforcement efforts.
The IRS may impose reporting obligations on exchanges, which holders of cryptocurrency use to turn cryptocurrencies into fiat currencies, but it likely won't be able to create similar obligations on blockchains and actually enforce them.
Like Kind Exchange Treatment
Section 1031 provides an exception from the general rule requiring the current recognition of gain or loss realized upon the sale or exchange of property. Section 1031 is an important provision in determining the tax consequences of trading cryptocurrency in tax years prior to 2018 since the IRS has taken the position that cryptocurrency is property. The general authority for section 1031 like kind determinations suggests that it should apply to cryptocurrency transactions in certain situations. We know that section 1031 will not apply to 2018 and beyond because the Tax Cuts and Jobs Act limited its application to real property.
The IRS has not addressed whether section 1031 applies to cryptocurrency transactions, except to say that it depends on the facts. Christopher Wrobel, special counsel to the IRS associate chief counsel (income tax and accounting), said on November 15 at the American Institute of CPAs Tax Division meeting in Washington, D.C. “for pre-2018 years, we would not say necessarily that cryptocurrency is automatically not eligible for 1031 treatment.” He went on to say that [y]ou'd have to look at the individual transaction level to make a determination under 1031.” Although the application of section 1031 is important to every holder of cryptocurrency prior to 2018, we are unlikely to see guidance on the issue from the IRS since section 1031 treatment is no longer available. If the IRS challenges the application of section 1031 in its current waive of audits, we are likely to see the issue litigated, resulting in guidance through caselaw.
Enforcement Efforts Are Underway
The anonymity of the blockchain structure raises issues for regulators, like the IRS, because it potentially allows holders to hide assets until the coin is exchanged for fiat currency. The IRS has not been shy about communicating its intent to pursue cryptocurrency activity. On the criminal prosecution front, the Commissioner has repeatedly indicated that cryptocurrency investigations are underway by the IRS's Criminal Investigation Division. On the civil front, the IRS sent letters (Letter 6173, Letter 6174, and Letter 6174-A) to 10,000 taxpayers with known cryptocurrency transactions and it has begun audits of taxpayers with known cryptocurrency transactions.
Steps To Take If You Have Cryptocurrency
If you have cryptocurrency, you should be proactive steps to minimize potential civil and criminal exposure. If you have not reported your cryptocurrency activity, you should seek the guidance of a tax controversy attorney that understands cryptocurrency and can help you navigate the best approach to disclosure. If you reported your cryptocurrency activity, you should ensure that your treatment was appropriate by consulting with a tax attorney that understands cryptocurrency to ensure that you, and/or your tax return preparer, understand the constantly evolving positions of the IRS, and where you may have a reasonable basis to disagree with published IRS guidance.
If you have cryptocurrency, contact Brandon Keim's office at (602) 200-7399 to schedule a consultation.