The Ethereum Merge went off without a hitch this month, after much anticipation and planning. The next challenge will be during tax season. In the past, cryptocurrency forks such as Bitcoin Cash have caused headaches for both investors and accountants.
While there has been progress, the Internal Revenue Service (IRS) rules in the United States are still not ready for something like the Ethereum network upgrade. Nonetheless, it appears that there is a way to interpret IRS rules that tax professionals and taxpayers can use to achieve simplicity and avoid unexpected tax bills.
Back in 2017, when Bitcoin forked because of a disagreement over block size, everyone who held Bitcoin received an equal amount of the new forked currency, Bitcoin Cash (BCH).
Bitcoin Cash was released in the fall, but it wasn’t available on Coinbase or other major exchanges until December. It had significantly increased in value by that point. Receiving free coins is considered income for tax purposes. Many investors found themselves with unexpectedly large sums of money to claim.
Many crypto-savvy accountants advised clients to claim the value of Bitcoin Cash at the time it was issued, rather than when it arrived in their exchange accounts. No IRS guidance explicitly stated that this was acceptable — in fact, it violates the accounting principle of dominion and control — but it appeared to be the only reasonable way to handle the situation.
Because of issues with reporting Bitcoin Cash income, the IRS issued Revenue Ruling 2019-24 to address the treatment of blockchain forks. Forks that result in the airdrop of a new currency to an existing holder, according to the ruling, are taxable wealth accessions. While not the term most investors are familiar with, the IRS uses “airdrop” to describe when a holder of an existing cryptocurrency receives a new currency as a result of a fork.
The Ethereum upgrade may cause confusion because assigning the forked and original currency based solely on the ruling is unclear. The IRS could easily argue that, following the upgrade, the Ether (ETH) tokens held in wallets and exchanges around the world are a new coin, and that Ethereum proof-of-work (PoW) — which continues on the legacy network — is the original.
While the argument makes logical sense, taking this stance would result in chaos. Every US taxpayer who held ETH — or assets such as nonfungible tokens (NFTs) based on Ethereum smart contracts — on September 15 would be required to claim the value as ordinary income. Despite the fact that it is based on old technology, Ethereum PoW is clearly the “new” coin.
The investor’s assets have not changed; rather, the underlying consensus mechanism has been upgraded. Furthermore, unlike Bitcoin Cash, which arose from a disagreement between two legitimate parties, the Ethereum upgrade was widely supported and was only opposed by self-interested miners.
Tax-savvy Ethereum holders may want to wait until Ethereum PoW is adopted before attempting to access the coins. Accepting them entails taxable income while removing the possibility of an argument that the fork is a half-hearted fork/farce/scam, as were many of the derivative Bitcoin forks in 2017-2018, which had thinly traded values on remote exchanges.
If the value of Ethereum PoW falls before an investor sells, it may result in a tax bill that exceeds the asset’s value. (With the exception of a brief spike in 2021, the value of Bitcoin Cash fell from over $2,500 to under $100 in 2018.) Grayscale Ethereum Trust, on the other hand, stated in a press release on September 16 that it will claim, sell, or distribute proceeds related to the ETH PoW coin, so there may be some value to report at the end of the day.
Any crypto developers thinking about a fork should keep in mind that forks always result in tax headaches, the severity of which varies depending on the rationale for and execution of the fork. Assuming the IRS follows the crypto tax community’s lead once more, the Ethereum upgrade demonstrates how to do it correctly.