There were 2,284 initial digital asset coin offerings in 2018 that raised a total of $11.4 billion, an increase of 13% from 2017.1 Based on this growth rate, it is clear that the digital asset space is continuing to expand despite the significant volatility in the overall market. But not all digital assets are directly bought or sold via an exchange: Airdrops and hard forks introduce another layer of complexity to this new market.
These new elements trigger a key question that every taxpayer who engages with the blockchain and digital asset marketplace should want to be answered: What do you do if you receive digital assets due to a hard fork or randomly receive digital assets in your wallet address from an airdrop?
An evolving ecosystem
Let’s start with some definitions. As the blockchain ecosystem and digital asset marketplace become saturated with new companies, these platforms and applications are striving for creative new ways to gain the attention of users. One of the primary methods companies have been using to do this is by giving away small amounts of their digital assets to the entire ecosystem, which is referred to as an airdrop.
An airdrop is the distribution of small amounts of a digital asset to the community for free. To qualify for the airdrop “one may need to hold a minimum quantity of the same, or another, a digital asset in his/her wallet, or may need to perform certain tasks that include posting on social media forums and filling out a request form,” according to Investopedia.
A hard fork is a change in the consensus rules of a blockchain at the protocol-level code that makes previously valid blocks/transactions invalid. This change is generally agreed upon by all participants who maintain a copy of the ledger and requires the compliant users to upgrade to the latest version of the protocol software.
As with any emerging technology, blockchains also come with their share of growing pains. The blockchain ecosystem may be one of open collaboration, but there are still unresolved issues around balancing decentralization, scalability, security, and privacy. This lack of resolution has given way to a difference of opinions on what are the best approaches to these concerns. When there is such a disagreement, participants sometimes opt to split from the standard chain and create their own “copy” with certain protocol-level code changes. The act of “hard forking” has become increasingly commonplace in the blockchain ecosystem, with well over 30 hard forks of the bitcoin blockchain occurring as of September 2018.2
Choices and their consequences
A hard fork is a permanent deviation from the previous version of the blockchain, and participants running previous versions will no longer be accepted by the newest version. When some participants refuse to upgrade, the hard fork results in two separately operating blockchains: the old version and the new version. When two separate blockchains continue to operate, users that participated on the “old chain” have their transaction history and wallet contents recorded on both the old version and the new version of the blockchain. This is referred to as a contentious hard fork. In the context of digital assets on a blockchain, this means that a participant will have an equal amount of the same digital assets on both chains at the point of forking, which may or may not have separate values, depending on the number of participants supporting the original and new blockchain.
In August 2017, for example, the bitcoin blockchain underwent a contentious hard fork, resulting in the creation of a new blockchain known as bitcoin cash. Not everyone in the bitcoin community supported the upgrades executed by the bitcoin cash team, and the two separate blockchains that emerged follow different strategies for scalability. When the bitcoin cash blockchain forked off, everyone who held bitcoin in a wallet prior to the fork had the ability to claim an equivalent amount of bitcoin cash as bitcoin in the wallet after the fork.
Tax implications for hard forks
The IRS has yet to release guidance regarding airdrops and hard forks. To date, the IRS has issued only one form of guidance related to digital assets—and that was in April 2014. In the absence of official, up-to-date guidance, there are two commonly reviewed approaches used to determine the tax treatment of hard forks. Which approach is taken depends on whether taxation is determined to be immediate or upon sale.
One major consideration to discuss before reviewing the approaches though is whether it is appropriate for the taxpayer to recognize taxable income at all based on the situation. Some tax specialists have concluded that the time when taxpayers should recognize taxable income is subject to when they are considered to have “dominion or control” of the digital assets, a designation that is not always clear. In some cases, for example, a taxpayer may not receive adequate notice that a hard fork has even occurred. In most situations, taxpayers should actively seek out situations where a hard fork has occurred and manually claim their hard-forked digital assets. Otherwise, they would have no dominion or control of them.
So is the taxpayer responsible for taxes on unclaimed hard-forked digital assets? If a taxpayer did not claim his/her bitcoin cash from the fork by manually unlocking it or requesting it from an exchange, does he or she owe taxes on it?
Immediate taxation approach
If an immediate taxation approach is taken, a taxpayer would determine his or her basis using the market value of the forked digital asset at the point when the taxpayer begins to use or receives dominion or control of his or her new digital assets in his or her wallet. Using this technique can be difficult—forked digital assets are often not immediately traded on secondary exchanges. If they are, there can be significant price volatility between and within different exchanges. Accordingly, it would be difficult to determine the fair market value of the assets with any degree of accuracy. It also raises the question of whether there may be any discount if an entity’s management is unable to sell its entire position due to a lack of market liquidity.
It is worth noting that not all exchanges will support the trading of a forked digital asset. As such, a taxpayer may need to set up a wallet at another exchange that does support trading in order to exit out of the position. This also means that if the digital asset that is being forked is held on an exchange that does not support trading, the taxpayer may never even receive dominion or control of those digital assets as the exchange may not provide access to the forked digital assets.
An alternative approach is to tax the holder upon the sale of the digital asset and assume the holder’s basis of the forked digital asset is zero at the point when it is created. This would mean that the entire sales price of the digital asset would be taxed when sold at some point in the future. The American Bar Association supports this position, arguing that the deemed value of the forked coin at the time of the realization event would be zero.3
In the interest of remaining transparent and forthcoming with the IRS, taxpayers may consider determining a value for hard-forked digital assets and attempt to report some form of income. Otherwise, it is possible that the IRS could deem what the taxpayer did as improper and be subject to underpayment penalties and interest.4 This means that at the point of the realization event, a taxpayer would have to determine the fair market value of the digital asset and recognize this amount as a gain. Additionally, any gain would be reported as ordinary income, similar to the treatment of most dividends, which would result in the new basis of the asset being the amount of income picked up.
In both scenarios, the holding period in the forked digital asset would start on the day of the hard fork.
The ABA has written letters to the IRS recommending safe harbor for hard-fork transactions,5 of which are relatively common occurrences within the digital asset ecosystem. Additionally, the AICPA6 and the U.S. House of Representatives7 have written letters to the IRS asking for additional clarity on the taxation of digital assets.
Tax implications for airdrops
The value of tokens received in an airdrop is potentially an income realization event to the recipient. What is uncertain is when the income is ultimately recognized as taxable income. As previously stated, it is likely that taxpayers should recognize taxable income when they are considered to have dominion or control of the assets. This, too, is not always clear for airdrops, as many of the airdrops are unannounced or may be dropped into an incompatible wallet or an exchange wallet that does not provide ownership of them to the exchange account owner.
Once a taxpayer is considered to have ownership of, dominion over, or control of airdropped digital assets, it may need to be recognized as income.8 It is also common for airdropped tokens to not be listed on an exchange and therefore they do not have any market available price when the taxpayer receives them. Accordingly, it may be that there is little or no value for the airdropped tokens.
The IRS does not provide any guidance for purposes of determining the fair market value of these airdropped tokens. In the event of a taxpayer receiving airdropped tokens, the taxpayer must make a good faith effort through consideration of all relevant factors associated with the token’s properties, method of receipt, and public valuation visibility to calculate the value of such tokens received by airdrop.
Absent clarity, acting in good faith
As the IRS begins to clarify its stance around these two issues taxpayers will develop a better understanding of how to handle the reporting of these transactions. Participants in the blockchain ecosystem may notice these issues become increasingly prevalent as the space continues to grow.
It is important for taxpayers to stay aware of any updates and keep an eye out for any clarity from the IRS about the information the AICPA, ABA, and U.S. House of Representatives have requested. In the absence of this guidance, it is prudent for taxpayers to be conservative about the recognition of these situations and consult their personal tax accountant about the approach they are looking to employ.