Income Tax at a Fork in the Blockchain

October 5, 2017

Hardly a day goes by without hearing about “the next big thing.” For years, a repeat contender for that elusive, ethereal title has been Bitcoin. Whether Bitcoin really is the groundbreaking technology of tomorrow remains to be seen.

However, Bitcoin and its progeny are already raising important issues for everyone’s favorite government agency: the Internal Revenue Service.

If you haven’t already heard, Bitcoin is a cryptocurrency. The mysterious Satoshi Nakamoto outlined the innovative Bitcoin system in a white paper released in 2008. The paper describes Bitcoin as “[a] purely peer-to-peer version of electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution.” The payment system replaces trust in a third party, like a bank, with “cryptographic proof.” Essentially, all Bitcoin transactions are collectively recorded and verified through a public distributed ledger called a blockchain.
However, Bitcoin isn’t cash! At least to the IRS it isn’t. According to a 2014 IRS notice, “virtual currency” should be treated as property for US federal tax purposes. For example, if a taxpayer holds Bitcoin as a capital asset, they may realize a capital gain or loss from a Bitcoin transaction. The classification may seem unusual in light of Nakamoto’s original conception, but many Bitcoin enthusiasts agree with the sentiment. They see Bitcoin not as a currency but as an investment. The Bitcoin-as-cash holdouts have moved elsewhere.
The most recent Bitcoin controversy concerns the similarly named Bitcoin Cash. Bitcoin Cash is a separate cryptocurrency aimed at “fulfilling the original promise of Bitcoin as ‘Peer-to-Peer Electronic Cash.’” Bitcoin Cash was created on August 1, 2017, via a fork with the original Bitcoin protocol. Basically, the proponents of Bitcoin Cash modified the underlying mechanics of the Bitcoin software, causing a split of the aforementioned ledger into two blockchains with a shared history. Bitcoin persists while Bitcoin Cash develops in parallel.
Blockchains with a shared history bring special consequences. At the time of the split, everyone who owned Bitcoins attained an equivalent amount of Bitcoin Cash. Immediately, Bitcoin Cash started trading for about $290 per token. So, if you owned more than a tiny fraction of a Bitcoin on August 1, you might have incurred a substantial gain! What will the IRS have to say about that? And where did this value come from?
The primary concern here is income tax. Your taxable income is your gross income minus any deductions. The tax code wields a broad definition of “gross income,” which includes “all income from whatever source derived.” Commissioner v. Glenshaw Glass Co., a landmark tax case, assures us that “instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion” contribute to income. Thus, the sudden influx of Bitcoin Cash seems like income. It provided every Bitcoin holder with an accession of wealth embodied in a valuable and tradable digital asset (with the notable exception of owners that could not access their Bitcoin Cash due to their holding method).
This windfall to Bitcoin investors has been described as “free money.” Some have compared the situation to Cesarini v. United States, a notable case in which a couple were taxed on the discovery of $4,467 inside a piano purchased at auction. The lesson: “treasure troves” count as income. Is Bitcoin Cash a treasure trove?
What if the notion of “free money” is too good to be true? It has been suggested that Bitcoin Cash’s value is derived from a loss in the value of Bitcoin. If so, then perhaps a fork in the blockchain is somewhat like a stock split (despite the obvious lack of a corporate context). The IRS doesn’t approach a stock split as a loss of value on old stock offset by the income of new stock; the only tax consequence is a reallocation of your tax basis. If Bitcoin Cash represents a diversion of value from Bitcoin, then maybe a basis distribution between the two assets would be a fitting solution.
However, unlike a stock split, the fork hasn’t left us with a clear understanding of Bitcoin Cash’s value. Its value may be the independent result of its own qualities or other market forces. Additionally, both cryptocurrencies are so volatile that any assessment of the their relative value could be too speculative to be meaningful. Treating Bitcoin Cash as “free money” may be the most administratively appropriate strategy, if not simply the most true to its nature.
Either way, Bitcoin has certainly raised some interesting questions.