FORKING BELIEF IN CRYPTOCURRENCY: A TAX NON-REALIZATION EVENT.

• Author: Chamberlain, David G.

1. INTRODUCTION 652 II. MONEY Is A MEASURE OF BELIEF 655 III. HARD FORKS ARE A DIVISION OF BELIEF 658 IV. REALIZATION IS THE FOUNDATION OF THE INCOME TAX 665 V. DIVISION IS NOT REALIZATION 672 VI. THE SERVICE TAKES THE WRONG FORK 676 VII. REAL-LIFE FORKS ARE NOT ACCESSIONS TO WEALTH 681 VIII. DIVISION OF BASIS IS THE HARD PART 686 IX. CLOSING EXAMPLE AND CONCLUSION 695 X. EXHIBIT 698 I. INTRODUCTION

   Ever since The Economist extolled Bitcoin as "digital gold" in 2013, (1) cryptocurrency has been seen as a strange and mysterious development in both money and technology. Cryptocurrency hard forks, where one currency splits and becomes two, may seem to be the most mysterious phenomenon of all. Certainly, "fiat" currencies like the U.S. dollar and other national currencies are incapable of duplicating such a feat. (2) In light of the extreme novelty, it is not surprising that the treatment of hard forks has generated much confusion and controversy in the tax world. That confusion is quite apparent in Revenue Ruling 2019-24 (Ruling), (3) the latest guidance from the Internal Revenue Service (Service). The facts and analysis in the Ruling show a fundamental misunderstanding of how forks work. (4) This confusion inevitably leads to an incorrect holding that hard forks are realization events that produce gross income subject to the income tax.

   However, cryptocurrency in general--and hard forks, in particular--are by no means beyond comprehension by the lay person. Once their true "essence" is understood, (5) the proper treatment of hard forks is not a difficult problem at all. With billions of dollars at stake, this is not an arcane question. (6) Moreover, it is a question well worth studying as it implicates the "realization" doctrine, which lies at the very heart of income tax theory and practice. Solving the problem requires close consideration of the lessons of the key Supreme Court cases Eisner v. Macomber (7) and Glenshaw Glass. (8)

   Like fiat currency, cryptocurrency is only valuable if people believe it is valuable and are willing to use it in transactions. For example, if someone is willing to sell me a car worth $32,000 for five bit-coins, that is a clear indication that the currency has value. Indeed, the total "market capitalization" of all cryptocurrency at any point in time is a viable measure of people's aggregate belief in cryptocurrency. (9) Absent a change in people's level of excitement about cryptocurrency, all that a hard fork can do is divide the amount of belief in the original currency between the two currencies resulting from the fork. If news of a particular fork gets people excited about cryptocurrency, the combined value of the coins may increase. On the other hand, if a particular fork causes people to lose confidence in cryptocurrency, the combined value may decrease. (10)

   In all cases, the true essence of the fork is a division of each coin of the original currency into two coins of the resulting currencies, much like a subdivision of real property divides a single parcel into separate lots. While each currency--like each real property lot--has its own characteristics, the division itself is not a realization event and is therefore not taxable. The central premise of the realization principle is that appreciation in the value of an asset is not included in gross income until there is a sale or other disposition of the asset. While it is open to dispute whether the realization requirement is mandated by the Constitution, it is clearly the foundation of the income tax system as designed by Congress. (11) In a hard fork, as in a real property subdivision, the asset owner does not give up anything and does not receive anything from a counterparty. Therefore, there is no sale or disposition that can "unlock" any unrealized gain or loss in the cryptocurrency coins. Gain or loss is not realized--and therefore should not be taxed--until one or both of the resulting coins is sold.

   The Service's Ruling fails to recognize that the essential nature of a hard fork is a division of property. Most scholars writing on taxation of hard forks make the same mistake. (12) In fact, they do not analyze hard forks within the framework of property-related events, whether they be dispositions or mere reconfigurations of the property. For example, the Ruling identifies one of the resulting cryptocurrencies as the "new" currency and treats the coin owner's "receipt" of new coins as an "accession to wealth" that is fully taxable. The Ruling does not take into consideration the amount of the original coin's unrealized gain--or indeed whether there is any unrealized gain at all. The Service does not try to characterize the type of income involved, but other scholars use various analogies, including in-kind dividends, found property, and unsolicited samples. (13) All of these approaches miss the mark: neither resulting currency is actually new; no coins are actually "transferred" or "received"; and there is no accession to wealth. (14)

   Once it is understood that a hard fork is a division of an original coin into two resulting coins, the only difficult question is how to allocate basis between the two coins. Caselaw provides three unsatisfactory approaches: an allocation based on relative values at the time the original coin was acquired, an assignment of zero basis to one of the two coins, or an "open transaction" approach that assigns basis only when one of the coins is sold. (15) The better approach, drawn by analogy from specific statutory provisions relating to corporate taxation, is to allocate basis in proportion to relative values of the two coins at (or near) the time of the hard fork. (16) Unfortunately, this approach is also problematic due to difficulties of valuation. I propose a method whereby the Service publishes allocation percentages for all forks occurring during the year in a manner similar to the publication of applicable federal rates for interest. This allocation would either function as a safe harbor or, potentially, be made mandatory through a new Treasury regulation.

   This Article works its way through the important issues in nine parts. Part II explores the nature of money and how cryptocurrency fits in. Part III is a brief primer explaining key aspects of cryptocurrency algorithms and the forking process. Part IV demonstrates that the realization principle forms the foundation undergirding the U.S. income tax system. Part V analyzes tax authorities proving that hard forks, like other property divisions, are not realization events. Part VI considers where the Service (and others) have gone wrong in their approaches to taxation of hard forks. Part VII uses two real-life hard forks to illustrate the central insights of this Article. Part VIII puts forward my proposal for allocating basis between the cryptocurrency coins resulting from a hard fork. Finally, in a concluding example, Part IX contrasts the Service's method and my proposed method in the context of one of the real-life forks.

2. MONEY IS A MEASURE OF BELIEF

   Cryptocurrency has many skeptics. While I myself question its sustainability in the long run, there is no doubt in my mind that cryptocurrency is "real" money. Money solves the central problem of barter, known as the "coincidence of wants." (17) That is, in order to undertake commerce in a simple barter system, two parties must each "want" what the other one possesses. The earliest money consisted of an intermediate good that all participants in a market agreed was valuable and would accept as payment for the goods they possess. Gold is the most storied and prominent example of this type of money: I will accept gold from you as payment for my goods because I have the expectation that someone else will accept that gold as payment for goods that I want.

   While gold has intrinsic value due largely to its beauty and usefulness as jewelry, it is not necessary for a "token" to have intrinsic value in order to be used as money. Paper currency is an obvious example. For example, a $100 bill is worth much more than the paper it is printed on. Livio Stracca, Head of International Policy Analysis at the European Central Bank, offers an excellent explanation:

   How can something without intrinsic value (with a relative price of zero against any other commodity) arise as a credible means of payment? It can only do as a result of a social convention based on collective imagination. A society can pretend that something intrinsically worthless has positive worth if used as an intermediate element in transactions. (18) In short, cryptocurrency is money precisely because enough people--in their collective imagination--believe that it is money. It is possible to quantify this belief. A cryptocurrency coin has a value in dollars at the price that it trades. The measure of belief in a particular cryptocurrency is its so-called market capitalization--i.e., the trading price for a coin multiplied by the number of coins outstanding. The combined market capitalization of all cryptocurrencies is a good measure of people's collective belief in cryptocurrency as money.

   Cryptocurrency has the three textbook characteristics of money. It is a medium of exchange, a store of value, and a unit of account. (19) To function as a medium of exchange, a token typically must be portable, durable, divisible, and hard to forge. (20) Cryptocurrency coins can be used and verified by anyone who has a computer with the right software. Furthermore, coins can readily be broken into fractional units. (21) While cryptocurrency's usefulness as a store of value is somewhat diminished by its extreme volatility, many holders invest in Bit-coin precisely for this reason. (22) Another requirement for a token to function as a store of value is scarcity. All cryptocurrencies are designed in one way or another to limit the number of coins that can be minted and circulated at any time. (23)

   In the cryptocurrency world, there are...