Hard Forks and Airdrops: IRS Guidance on When Holders of Cryptocurrency Need to Pay Taxes

Hard Forks and Airdrops: IRS Guidance on When Holders of Cryptocurrency Need to Pay Taxes

This October the IRS released its first guidance regarding the tax rules on cryptocurrency in 5 years. The ruling discusses how the IRS treats “hard forks” and “airdrops” in cryptocurrency, an area with a lot of uncertainty. Specifically, we have lacked guidance on how or when the movement through these unique avenues of cryptocurrency fall under gross income according to Internal Revenue Code § 61, making them taxable. This IRS revenue ruling carries more weight than a normal comment or guidance.

To understand this guidance, it is first, necessary to define and differentiate hard forks and airdrops. Cryptocurrency is held on distributed ledgers that can sometimes go through protocol changes. When these protocol changes happen, a new branch of cryptocurrency splits off an existing one. This is a hard fork. Owners of the original cryptocurrency do not gain any wealth or income through a hard fork, and so there is no tax event or gross income to tax when there is just a hard fork. An airdrop is an event that sometimes follows a hard fork where owners of certain accounts receive new currency if their accounts qualify. Because there is an increase in wealth in the event of an airdrop, the IRS considers this receipt of gross income a taxable event. While not exclusively connected, an airdrop of the new cryptocurrency often follows a hard fork.

In the revenue ruling the IRS discusses how the income gained from an airdrop will be taxed. The date of the receipt of the new cryptocurrency is received in an airdrop is the date that the owner gains dominion and control of the cryptocurrency. “Dominion and control” mean that the owner can transfer, spend, sell, move, or do whatever they want with the cryptocurrency. The concept of dominion and control is important because the taxable amount from the gross income following an airdrop is the fair market value of the new cryptocurrency at the date the owner gains dominion and control.

An example given by the ruling contrasts when a taxable event occurs and when there is no taxable event. When there is simply a hard fork, not followed by an airdrop, there is nothing to worry about for the owner (as far as taxes go) because there is no increase in wealth. On the other hand, when there is a hard fork followed by an air drop in which the owner gains 50 units of the new cryptocurrency, the owner has gained wealth, and so the value of the newly acquired cryptocurrency is taxable. The owner gains dominion and control over the new currency at the same time as the airdrop in the example, and so the fair market value on that date is used to determine the taxable value of the gross income.

In summary, when an owner receives new cryptocurrency through an airdrop, the value of the gross income from the new cryptocurrency is the fair market value at the time that the owner gains “dominion and control” over the currency and the receipt of this value is taxable. If an owner does not gain any cryptocurrency, then there is no taxable event. A hard fork is not a taxable event itself, but the airdrop that commonly follows the hard fork is. The main thing to remember is that if your wealth increases, you will be required to pay taxes on that increase.

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