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On October 9, 2019, the Internal Revenue Service (“IRS”) issued guidance relating to cryptocurrencies in the effort to educate taxpayers about their tax obligations with respect to transactions involving digital assets.1 This is the first comprehensive guidance the IRS has provided since 2014, when the IRS issued Notice 2014-12, explaining that virtual currency is treated as property for Federal income tax purposes.2
First, the IRS has made clear that taxpayers are required to report crypto-related income as part of their tax returns. A few days after the IRS issued its updated guidance, the IRS circulated a draft of the updated Form 1040, Schedule 1, Additional Income and Adjustment to Income form to tax software companies. The updated form includes the following section: “Taxpayers who file Schedule 1 to report income or adjustments to income that can’t be entered directly on Form 1040 should check the appropriate box to answer the virtual currency question. Taxpayers do not need to file Schedule 1 if their answer to this question is NO and they do not have to file Schedule 1 for any other purpose.”3 The IRS is expected to receive comments from tax companies regarding the updated form, and will likely modify it accordingly.
Air Drop and Hard Forks
Second, as part of the new guidance, the IRS has clarified that taxpayers are required to pay taxes on income that originates from a “hard fork.” According to the IRS, a hard fork “occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing ledger.”4 Additionally, taxpayers are obligated to pay taxes on an “airdrop,” which is a “means of distributing units of cryptocurrency to the distributed ledger addresses of multiple taxpayers.”5 The IRS explained that a taxpayer does not have dominion and control of the address to which the cryptocurrency is airdropped if it managed through a cryptocurrency exchange, and the exchange does not support the newly created currency. It is not until the taxpayer “acquires the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency” that the taxpayer is “treated as receiving the cryptocurrency at that time.”6
And third, the IRS guidance further clarifies that a taxpayers’ gain or loss is the difference between the fair market value of the property they receive and the adjusted basis in the virtual currency exchanged. Additionally, the value of the cryptocurrency purchased on an exchanged is calculated using the amount the exchange sold it for in U.S. dollars. In this instance, the income basis will include commissions, fees, and other costs of the purchase. Also, if the cryptocurrency is purchased on a peer-to-peer exchange, it is possible to use a cryptocurrency price index to determine the fair market value.
As cryptocurrencies continue to gain mainstream transaction, government agencies like the IRS have bolstered their efforts to ensure that individuals remain compliant with federal regulations. While this new guidance offers clarity on certain issues, it also presents additional questions, particularity with respect to airdrop and hard fork requirements. Despite this, one thing is clear—taxpayers are on notice and required to report crypto-related income. We will continue to monitor how the IRS treats cryptocurrencies as the digital asset sector continues to grow.
1 The IRS Notice 2019-24 can be found here.
2 The IRS Notice 2014-12 can be found here.
3 A draft of the updated Form 1040 can be found here.
4 The IRS Notice 2019-24 can be found here.