New Coins on the Block: How Should Cryptocurrency Hard Forks be Taxed?

• Author: Elman, William

TABLE OF CONTENTS I. INTRODUCTION 56 II. BACKGROUND 60 A. What is Cryptocurrency? 60 B. The Bitcoin-Bitcoin Cash Fork 62 III. HARD FORK CRYPTOCURRENCY IS NOT GROSS INCOME UNDER GLENSHAW GLASS 64 A. Short-Term Prices Are A Poor Measure of Network Value 66 B. Hash Rate Is a Better Measure of Network Value Than Prices 69 C. Hash Rate Analysis Shows the Bitcoin--Bitcoin Cash Hard Fork Did Not Produce an Undeniable Accession to Wealth 70 1. A Messy Divorce: August 2017-December 2017 70 2. Parting Ways: December 2017-Present 72 IV. HARD FORKS ARE ACTUALLY LIKE CORPORATE SPIN-OFFS 74 V. THE IRS SHOULD TAX FORKED CRYPTOCURRENCY AS A CAPITAL ASSET UPON DISPOSITION 76 A. The IRS Should Tax Cryptocurrency Only Upon Disposition 76 1. Fairness 76 2. Administrability 77 3. Compliance 77 B. The IRS Should Tax Forked Cryptocurrency as a Capital Asset with a Zero Cost Basis 79 VI. CONCLUSION 80 I. INTRODUCTION

Cryptocurrencies are an important innovation in a changing financial landscape. (1) These digital currencies, which consist of cryptographically secured transactions on a publicly distributed ledger, (2) can be used, among other things, to buy and sell goods and services, send remittances, and store wealth. (3) Bitcoin, the first successful cryptocurrency and the most widely recognized, (4) has allowed its owners to store wealth outside the fiat money system, (5) earning it a reputation as "digital gold." (6) Against the backdrop of the COVID-19 global pandemic and unprecedented governmental economic stimulus, one unit of bitcoin (7) soared in value from approximately $8,500 in late February 2020 to over $60,000 one year later. (8) Major corporations and institutions have begun demonstrating serious interest, as exemplified by Tesla's $1.5 billion bitcoin purchase in February 2021. (9)

Though Bitcoin is now the dominant cryptocurrency, (10) its fate was not always clear. (11) On August 1, 2017, in an event called a "hard fork," (12) Bitcoin split into two distinct networks after participants failed to resolve a disagreement over how Bitcoin should function. (13) The conflict related to the appropriate balance between transaction processing speed, the distribution of network control, and network security. (14) The newly forked cryptocurrency was named "Bitcoin Cash." (15)

In a hard fork, the parent or legacy cryptocurrency--here, Bitcoin--survives alongside the new cryptocurrency network. (16) The new network--here, Bitcoin Cash--inherits the attributes or protocols of the parent network except for the changes that inspired the hard fork. (17) When a hard fork occurs, owners of the parent cryptocurrency receive a claim to an equal number of units of the new cryptocurrency, like "free money" that comes "out of almost thin air." (18) For example, if Alice owned ten units of bitcoin before the fork, she would own ten bitcoin and ten Bitcoin Cash after the fork.

The Bitcoin-Bitcoin Cash hard fork was the seminal event in a contentious period from approximately 2015 to 2018 that has been termed "The Fork Wars" or "The Bitcoin Civil Wars." (19) To date, there have been forty-five hard forks of Bitcoin alone and twenty-two of other cryptocurrencies. (20) Hard forks have provided cryptocurrency owners across the world with billions of dollars' worth of newly issued cryptocurrency. (21)

The Bitcoin Cash market alone was valued at an estimated $30 billion soon after inception. (22)

The hard fork phenomenon raises an important question: how should the units of cryptocurrency received from a hard fork be taxed? (23) Other questions follow: How should value received from forks be characterized? (24) When does the taxable event occur? (25) How should the value of forked cryptocurrencies be determined? (26) Though these questions have generated lively debate among academics, tax lawyers, and taxpayers, Congress has failed to answer them directly. (27) Consequently, the Internal Revenue Service (IRS) has tried to fill the legislative void through administrative interpretation and guidance. (28)

In Revenue Ruling 2019-24, the IRS issued its first and most formal guidance on hard fork taxation to date, in which the agency declared that forked cryptocurrency would be taxed twice: first as gross income upon receipt, and subsequently as a capital asset upon disposition. (29) Despite public criticism of the agency's lack of clarity on the finer points of realization timing and valuation, and also of the agency's fundamental misunderstanding of hard forks, (30) no overt challenges have been leveled against the agency's key assumption: that hard forks provide gross income under the legal test established in Commissioner v. Glenshaw Glass. (31) Instead, observers have mostly accepted the deceptively appealing notion that hard forks provide a windfall, or "free money." (32) A few others have indeed questioned the premise. (33) However, they have not evaluated it rigorously, in part for a lack of sufficient data. (34)

With the dust of The Fork Wars having settled and a larger body of data now available, (35) this Note challenges the IRS' decision to classify the receipt of hard fork cryptocurrency as gross income. Cryptocurrency received from a hard fork is not free money, (36) but a mere byproduct of network reorganization. Much like a corporate spin--off, (37) where a company is divided into smaller parts and shareholders receive shares in the new corporation, a hard fork divides the network into smaller parts and users receive new cryptocurrency. However, like a corporate spin--off, the hard fork does not necessarily create new value. This conceptual understanding of hard forks, plus price volatility around the fork, acquisition timing problems, and the high likelihood of forked cryptocurrency becoming worthless, suggest that hard fork cryptocurrency should not be taxed as gross income upon receipt, but strictly as a capital asset upon disposition through sale or exchange.

Japan has employed this general approach since 2017. (38) Law professor Eric Chason, a leading thinker on hard fork taxation, has also recommended that forked cryptocurrency be taxed upon disposition. (39) However, he justifies this approach strictly for the sake of administrative ease; he nonetheless views hard forks as "windfalls" for recipients. (40) Whereas Japan taxes cryptocurrency gains at its "miscellaneous income" rate of fifty-five percent, (41) and Chason recommends the IRS tax gains at ordinary income rates, (42) this Note recommends that the IRS tax such gains at the preferred capital gains rates. This recommendation coheres with the understanding that forked cryptocurrency is the fruit of a prior investment rather than an "economic windfall." (43) The American Bar Association has also discussed this approach. (44)

This Note focuses on the hard fork between Bitcoin and Bitcoin Cash for three reasons. First, it is the most prominent example of a hard fork. (45) Second, because Bitcoin Cash remains a viable cryptocurrency, it provides more meaningful data than forks that quickly became obsolete--as most have. (46) Finally, the prices of Bitcoin and Bitcoin Cash have diverged widely, (47) which provides an opportunity to consider how owners might strategize paying their taxes.

Part II of this Note provides a historical and technical background of cryptocurrency, Bitcoin, and the Bitcoin-Bitcoin Cash hard fork. Part III argues that forked cryptocurrency fails as gross income under Glenshaw Glass because it does not produce an "undeniable accession to wealth." It is argued that cryptocurrency prices are poor measures of a hard fork's value and that hash rate--a measure of network computing power--is superior. Then, hash rate analysis shows that the Bitcoin--Bitcoin Cash hard fork did not necessarily create new value. Part IV argues that the analogy between hard forks and corporate spin-offs has been prematurely dismissed and is actually helpful in considering how to tax hard forks. Finally, Part V considers fairness, administrability, and compliance in recommending that the IRS tax hard fork cryptocurrency as a capital asset, strictly upon disposition, and with a cost basis of zero.

2. BACKGROUND

   1. What is Cryptocurrency?

      Parties to financial transactions, and their agents, invariably record those transactions on one or more ledgers. (48) If Alice sends Bob ten dollars from her bank, their banks will each record the transaction within Alice and Bob's respective accounts. Alice's bank assures Bob that Alice indeed has ten dollars to spend from her account. Financial and law enforcement institutions also build trust in the integrity of the financial system by fighting fraud and illicit activity. (49) However, despite these efforts, fraudulent transactions occur to some extent. (50)

      In contrast, cryptocurrency transactions are validated through the collective efforts of network participants, eliminating the need for the trust-building validation efforts of financial institutions and governments. (51) Cryptocurrency accomplishes this feat with blockchain technology. (52) The blockchain is a shared, or distributed, digital ledger that includes all validated transactions. (53) This comprehensive public record prevents users from counterfeiting cryptocurrency, thus solving what is called "the double-spend problem": when a user attempts to spend the same unit of cryptocurrency twice (or more). (54) For example, if Alice sends Bob ten units of cryptocurrency, the network deems the transaction valid only after reviewing the ledger (the blockchain) to confirm that Alice indeed possesses ten units of cryptocurrency, and that she has not already spent those units. (55)

      Network participants called "miners" are responsible for building the blockchain by digitally writing new transactions onto the ledger. (56) Miners connect their computers to the network and take note of any new, unvalidated transactions. (57) For each new batch of unvalidated transactions, miners...