Crypto-currency investment is a difficult subject matter to grasp. Even more difficult is understanding the tax implications behind it. If you have engaged in the mining or investment of crypto-currency such as Bitcoin, Ethereum, or one of the many others, you’ll want to understand how such activity affects your income taxes. If you have a significant amount invested in crypto-currency, you’ll want to iron out any outstanding tax questions with a tax attorney that has experience assisting clients with crypto-currency related issues. Today, we’ll be talking about the tax implications involved in a crypto-currency hard fork.
What is a hard fork?
In order to understand exactly what a hard fork is, it is critical to understand, at least at a high level, how crypto-currency works.
Crypto-currency is acquired in two different manners: by investing in it through an exchange such as Coinbase or by earning it through mining. Mining is the process whereby computers process complicated math equations to validate crypto-currency transactions and post them to the public ledger, called a blockchain. Those who perform the mining process are compensated in small amounts of crypto-currency.
Each type of digital currency is encrypted with its own code or software (hence the term “crypto-currency”). Computers that perform mining functions run the most up-to-date version of the software used to validate and post a particular crypto-currency’s transaction to the blockchain. A fork occurs when some of the mass amounts of miners implement different software to validate a transaction. One set of the computers continue to mine in the manner that they historically have (using the old software) and the other set of computers process and post transactions in a different manner (using the new software), creating a new blockchain (similar to the end of a fork where several tines separate from the neck).
Forks can occur for a variety of reasons, but most are commonly related to disagreements among the crypto-currency community about the way that transactions should be validated. When a group of miners decide to alter their software to reflect such a change, a fork occurs. After a fork, an owner of that particular crypto-currency has an ownership in the currency along the historic blockchain and the new chain caused by the fork. For instance, some Bitcoin Core (commonly referred to as plain “Bitcoin”) miners altered their software and the resulting hard fork created Bitcoin Cash. Immediately after the hard fork, a person that owned one Bitcoin also owned one Bitcoin Cash.
The new chain can become a new viable crypto-currency if it survives. Some digital currency exchanges do not support the new blockchain that results from the fork. In that situation, the investor cannot sell or otherwise cash in on the new currency acquired in the hard fork.
What are the tax consequences of a hard fork to the crypto-currency owner?
To many, the idea of crypto-currency is foreign and yields many unanswered questions. One of which is the correct tax treatment of an investor in a particular type of crypto-currency at the time a hard fork occurs. The landmark case Commissioner v. Glenshaw Glass Co. may be instructive in determining if the receipt of new crypto-currency as a result of a fork results in a taxable event.
- Accession to Wealth
The first prong of the Glenshaw Glass test is whether the taxpayer had an accession to wealth. Whether this prong is satisfied or not depends on the hard fork, itself. When a new crypto-currency is created as a result of a fork, it is very likely that it has no value at the time of the hard fork. Whether the price of the new crypto-currency increases or not cannot be determined at the time of the fork and will likely take time to determine.
Some past forks have yielded new crypto-currency that had been traded on a futures market before the fork and was available on digital currency exchanges within the same day of the fork. Others have never been supported by exchanges and have failed altogether.
Thus, whether an owner of crypto-currency has had an accession to wealth at the time of the fork depends on the facts and circumstances of the fork. If the new digital currency has an ascertainable value at the time of the fork, the IRS has a solid argument that the fork resulted in the taxpayer having increased wealth due to the fork. On the other hand, if a hard fork results in a digital coin that has no value until the market determines whether it should increase in value, the IRS will have a difficult time proving that the fork was a taxable event that yielded an accession to wealth.
- Clearly Realized
The second prong of Glenshaw Glass requires that the taxpayer clearly realize their ascension to wealth. Realization occurs when value of property is actually received by the taxpayer. The inability to take possession or control their new wealth delays the realization event until they can, if they ever do.
Owners of digital currency own their crypto-currency keys directly or through an exchange. At the time of a fork, the crypto-currency keys that are held directly allow owners to sell both the historic and new crypto-currencies immediately after the fork. Those who use a digital wallet through exchanges, such as Coinbase, have to wait until their exchange supports the new crypto-currency (if they ever do).
Therefore, the crypto-currency owners who hold their ownership keys directly have full control of their new wealth (if any) immediately after the fork occurs. Crypto-currency owners with digital wallets through Coinbase or a similar exchange do not realize their new wealth (if any) until they receive the right to control the new crypto-currency once their exchange supports it. If an exchange never supports a newly created digital currency, a taxpayer has a strong argument that a realization event never occurred.
- Complete Dominion
The third and final prong of the test from Glenshaw glass requires a taxpayer to have complete dominion and control of the new money or property that they have acquired. Typically, this test is easily met with regard to crypto-currency owners who hold their keys directly as they are able to dispose of their interests in the new digital currency immediately. Those who use digital currency exchanges may not be able to exercise dominion and control of the new currency created by the hard fork if their exchange of choice does not support the new crypto-currency.
Are crypto-currency hard forks the same as stock splits?
The short answer to this question is no. Stock splits and crypto-currency forks may appear to be similar conceptually, but there are far more differences than there are similarities. A stock split is typically used to bring down the price of a publically traded stock to a price that is more accessible to investors. After a stock split, an investor owns the same amount of equity of the company in question, the number of shares being the only thing that increases. Described above, a crypto-currency fork results in the owner of a crypto-currency owning two different types of crypto-currency. At the time of a fork, it is relatively unknown how the market of the historic crypto-currency or the newly created crypto-currency will react. Market values of both crypto-currencies could plummet, skyrocket, or stay stagnant. It’s likely that the two will not trade at the same value. Thus for tax purposes, it is unlikely that a hard fork of crypto-currency would be treated like a stock split to the owner for tax purposes.
Capital Gain vs. Income
The Internal Revenue Code defines capital gain as gain from the sale or exchange of a capital asset. Although crypto-currency may be a capital asset in the hands of most taxpayers, a hard fork does not appear to be a sale or an exchange. Again, in a hard fork, owners of a crypto-currency receive a different type of crypto-currency only by virtue of owning their original crypto-currency. For that reason, it appears logical that the conferring of the ownership of a different type of crypto-currency would not be a sale or exchange and thus, taxed as income.
Conclusion
The particularity of the hard fork and the way in which a crypto-currency owner holds their digital currency play a roll in determining the tax consequences. See the helpful matrix below that summarizes the tax treatment of hard forks.
| Investor Holds Key or Exchange Immediately Allows Trading of New Crypto-Currency | Exchange Holds Key and Does Not Immediately Allow for the Trading of New Crypto-Currency | |
| Value of New Crypto-Currency Established at the Time of Fork (Through Futures Trading) | Likely an income inclusion. | Likely an income inclusion only when/if the digital currency exchange allows for the trading of the new crypto-currency. |
| Value of New Crypto-Currency Not Established at Time of Fork | Likely no income inclusion because although the taxpayer can trade/sell the new crypto-currency, it has no value at the time that it is received. | Likely no income inclusion as even if the new crypto-currency becomes traded on the owner’s exchange, without a positive value, the IRS will have a difficult time demonstrating that there was an accession to wealth. |
As the article above demonstrates, the tax treatment of crypto-currency is extremely fact-sensitive and not cut-and-dry. If you are unsure about how to treat your crypto-currency transactions, it is in your best interest to contact a tax attorney with experience in representing taxpayers who invest in Bitcoin and other digital currencies. Any uncertainty regarding a cryptocurrency tax position (our firm has identified several) should be adequately disclosed on the return taking the uncertain tax position to avoid penalties but could result in an audit.
The tax and accounting professionals at the Tax Law Offices of David W. Klasing have extensive experience representing taxpayers from all walks of like in a variety of tax situations. Don’t let your uncertainty about the tax treatment of your crypto-currency transactions keep you up at night. Contact the Tax Law Offices of David W. Klasing today for a reduced-rate consultation.
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