The Internal Revenue Service (IRS) has issued some guidance regarding cryptocurrencies on October 9, 2019, with the release of Revenue Ruling 2019-24. Revenue Ruling addresses the hard forks and airdrops taxes. IRS has also released a draft of updated Form 1040, schedule 1, and FAQs (Further Asked Questions) on transactions of Virtual currencies. According to the IRS, virtual currencies are now taxable, just like other transactions. IRS describes the virtual currency on its official website, “Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value.” Cryptocurrency also comes under the virtual currencies that use cryptography to secure transactions occurring and recording on a distributed ledger such as a blockchain. The IRS had also released a notice in 2014 that the cryptocurrency will be treated as property but didn’t provide any significant guidance regarding that notice. And then, the notice left many unanswered questions, so, in the newly released guidance, the IRS discussed only two situations; Hard forks and Airdrops.
What are Hard forks?
When a cryptocurrency on a distributed ledger, such as a blockchain, undergoes a protocol change resulting in diversion from a distributed ledger, sometimes creating a new cryptocurrency is known as a hard fork. You may understand a hard fork with an example of receiving a new credit card when the older one was compromised, stolen, or lost. When you will report about your credit card, you will get the new one with a different number, and the bank will deactivate the older card. This whole process of using the same bank’s credit card but no longer able to use an older one is known as a hard fork.
You can also understand it in terms of shares. Suppose you have invested and received ABC company’s shares to become a shareholder, but the ABC company merged with another company to create a corporation named XYZ corporation. Now the shareholders of both companies will receive XYZ corporation’s shares in exchange for their older shares. The older shares are of no value now, and this process of swapping shares is known as a hard fork.
However, all the examples we discussed are of the physical world, while cryptocurrency exists electronically, and the chances of the hard fork are more there. In the world of cryptocurrency, the most popular example of the hard fork is when the Ethereum blockchain included the Distributed Autonomous Organization. It happened in 2016 when an error occurred in the blockchain code of DAO, and someone stole $45 million from the DAO. So, the DAO changes the cryptocurrency by creating a new one and saying the older one is now worthless. So, the thief got no advantage of stolen cryptocurrency.
Before understanding Airdrop, you need to know about wallet addresses; it’s the place where people store their cryptocurrency just like a normal wallet, and an airdrop occurs when the cryptocurrency is shared to the wallet addresses of multiple taxpayers.
IRS Revenue Ruling and guidance
IRS describes two situations in the Revenue Ruling 2019-24
- “A hard fork of a cryptocurrency where the taxpayers recover no new cryptocurrency.”
- “A hard fork of cryptocurrency followed by an airdrop of a new cryptocurrency where the taxpayer receives new cryptocurrency.”
Form 1040 Schedule 1
Instead of Revenue Ruling 2019-24, IRS has also released an updated Form 1040, Schedule1. Moreover, Additional income and adjustment to income are also released by the IRS, demanding details about the virtual currency’s financial interests. The Form includes many questions, such as, “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency? If your answer to this question is No, then you don’t have to file Schedule 1.”