Crypto creates a conundrum when the taxman cometh
New models, confusing rules make it hard not to get forked
The old saying about nothing being certain except for death and taxes has been resonating with the crypto community for some time. A lack of clarity around how to treat cryptocurrencies and whether existing rules can be applied to these new forms of money has caused consternation even for major players. Last week, Bloomberg looked at how hedge funds were struggling with tax issues. The IRS has yet to issue clear guidance on whether it accepts the Commodity Futures Trading Commission’s idea that cryptos are, in fact, commodities.
Realistically, even those who are putting millions of dollars at risk trading tokens are in a fog. For the individual investor that means if you aren’t bewildered, you ought to be. The good news is you have friends in (somewhat) high places aiming to help. The Washington, D.C.-based think tank/lobby group Coin Center seeks to: “educate policymakers and the media about cryptocurrency technology; engage in policy research to develop smart regulatory approaches … and advocate for those solutions in order to keep cryptocurrency networks open, decentralized, and permissionless.”
Two roads diverged in a wood
Coin Center raised concerns yesterday about a particularly thorny tax issue: hard forks. For those new to crypto, or unfamiliar with its ins and outs it’s worth briefly talking about what a fork is and why it matters. Here’s a paraphrase of Investopedia talking about hard forks:
A hard fork is a permanent divergence from the previous version of the Blockchain… a radical change to the protocol that makes previously valid transactions invalid. Any transaction on the forked, newer, chain will not be valid on the older chain. All nodes and miners will have to upgrade … if they wish to be on the new forked chain. This essentially creates a fork in the Blockchain, one path which follows the new, upgraded Blockchain, and one path which continues along the old path.
The most famous of these was the hard fork of Bitcoin Cash off the main bitcoin blockchain. A group unhappy with bitcoin fees and plans for scaling the crypto king to handle more transactions led to the 2017 fork of Bitcoin Cash, with larger block sizes to handle more data. The politics of the matter are almost irrelevant to investors, the reality is what happened next: Everyone who held bitcoin before the fork was granted Bitcoin Cash after it.
There are known knowns, things we think we know
But what does that Bitcoin Cash represent when it comes to tax time. The Coin Center folks ask some critical questions:
Is a hard fork an income event? Assuming it is, what constitutes the taxable event? Is it when the hard fork happens? When that taxpayer takes possession of the forked coins? Or when they dispose of them? What’s the holding period, and what’s the proper basis?
The IRS hasn’t answered these and even Coin Center admits that while it has opinions on the topic, those are less critical than guidance. Tax law is a funny thing. If you systematically avoid paying the taxes you owe, the IRS will tend to be very unforgiving, seeking to prosecute for you tax evasion. From there, you can wind up in prison.
On the other hand, if you make a good-faith effort to pay your taxes correctly, the typical worst-case scenario is less severe. Say you were calculating your taxes one year and you were unclear how some of your income should be treated. You do some research, maybe talk to an accountant, file a return. But then three years later the IRS audits you, finds you should’ve reported more income, and asks you to make good. They will charge you interest and penalties on the underreported income but they’re somewhat forgiving about the whole thing, even allowing you to pay over time as a matter of course.
Unfortunately, it’s not even simple to make a good faith effort with certain types of crypto transactions these days. And a concrete example will help explain. In July of 2015, if you held shares in eBay —then the owner of PayPal — you were entitled to shares in the payments company as it was spun off from the auction giant.
To keep the math simple, eBay granted each shareholder one share of the newly independent PayPal for each eBay share hold (they could’ve chosen different numbers so long as proportional ownership was maintained, of course). It was then up to eBay to explain what portion of the company was represented by PayPal after the split. And they did that formally with the IRS via a form 8937. (Incidentally, here’s the key part: “39.2706% of an eBay stockholder’s aggregate tax basis in his or her shares of eBay common stock immediately prior to the Distribution would be allocated to such stockholder’s shares of eBay common stock and 60.7294% would be allocated to such stockholder’s shares of PayPal common stock received in the Distribution.”)
This is critical in two ways (1) It means that the split itself has no tax implications for the individual. You owned a share of something, now you own two shares of two things, each of which represents a portion of the prior whole (2) when it comes time to pay taxes on the sale of either eBay or PayPal, you know what you paid for them original, using the formula as follows:
Total amount to purchase stock * portion allocated to the shares I’m selling now (eBay or PayPal) * (shares I’m selling / shares I have in total).
Or using numbers with a transaction involving 100 shares of eBay bought for $10 and a sale of 50 PayPal shares at $100 each
$1000 * .60% * (50/100) = $300 (your cost basis)
With the shares were worth $5,000 when you sold then, congrats you owe taxes on a gain of $4,700. (This is an example, please don't explain how implausible that is.)
A similar thing would happen if Microsoft decided to spin off its Xbox division as a separate company. That makes spin offs as simple for a tax accountant as something like a dividend. If Microsoft awards you $1 per share in dividends and you own 500 shares, you have $500 of dividend income, a slot on your return to report that, and an easily understood tax liability.
What about unknown knowns? The ones we know we don’t know
You might ask why we’re now talking about dividends when a fork of a crytpo currency and its blockchain sure looks like a spinoff. And the answer is sometimes when it looks like a duck, it’s in fact a platypus. Absent clear IRS rules, it’s possible that forks will eventually be considered dividend-like events. So a future Bitcoin Three Point Oh might spin off from bitcoin and award tokens that start trading at $100 each. If you received 20 of those, you’d be required to report $2,000 in dividend income.
But today, you might reasonably argue you can’t know what the IRS will do (hint: you can’t) and so you take the totally reasonable position that the fork was a spinoff. You look at the value of bitcoin the moment after the split (about $110 billion right now) and the value of both bitcoin and all of Three Point Oh (say it trades at a “market cap” of $40 billion. Then a little math tells you that 40/150 = your proportion of the holding in Three Point Oh and 110/150 = the bitcoin proportion. When you sell either of them, you use the formula above to figure the cost basis and Voila!
So the IRS historically has looked favorably on these kinds of things so long as taxpayers could argue they followed existing law and precedents “reasonably”. But here there are few examples to go by and even less law. And this example doesn’t even describe the worst of it. What if there’s a fork you don’t know about? (Very possible: Did you know there’s Bitcoin Private out there?) What if someone forks a coin, sets up trading on a third-tier exchange in Malaysia, and uses the coin’s near invisibility to create the impression it’s valuable — at least on that Malaysian exchange.
A young IRS examiner finds it, decides everyone who had some crypto token two years ago has lots of paper wealth, and then comes after them to collect. An individual might need a tax lawyer and might even get assessed thousands in penalties. Coin Center points out that perhaps they didn’t even lay claim to the forked currency at all, but they might have to pay.
As advocates for sensible crypto regulation, the folks at Coin Center want at least a “safe harbor” to be put in place for now, protecting crypto investors from future penalties for actions taken now and in the past. Unfortunately, to do that will require congressional action — a scarce commodity these days.
In the meantime, you can add tax risk to your list of concerns about investing in cryptocurrencies. That much, alas, is certain.
For more crypto insight and analysis from The Block, sign up for our newsletter at www.theblockcrypto.com!
