Bitcoin image
Photo by @pixabay

The IRS’s clueless taxation of cryptocurrency hard forks needs a lawsuit challenge now

This IRS FAQ publication dictates: “If a hard fork is followed by an airdrop and you receive new cryptocurrency, you will have taxable income in the taxable year you receive that cryptocurrency.”

Imagine if you downloaded a game, let’s say Call of Duty: World War II Again. You spend some time playing and then save your progress. Now imagine we’re in a universe where there’s no intellectual property law and another game developer grabs the Call of Duty source code and decides they want to replace all Nazi soldiers with mustachioed cats. They make the appropriate changes, release Call of Duty: WWII Cats Attack as their own, and announce all save games are compatible, so any progress made in the original can be carried over to their version.

Yes, this is an analogy of a cryptocurrency hard fork (except most crypto is open-source so IP infringement wouldn’t apply). You may be a diehard Call of Duty player with no interest in amateur efforts. The fact that this philosophically silly fan-made copy exists does not mean you have an interest in consuming it or acknowledging its existence. The fact that your save game file may allow you to pick up from the same point in the cats-only variation does not mean you intend to load it. You may not even trust the Cats Attack release, through concern that the author has little programming skills and their version may include malware or vulnerabilities.

Understand custody in crypto

Let’s say I owned 50 BTC in 2015. In 2017, the Bitcoin Cash hard fork occurred and since it utilized the blockchain history of the original Bitcoin, whatever BTC units existed, there is now a replica BCH unit. As an owner of 50 BTC, I took absolutely no action for these replica units to come into existence or to supposedly come into my custody.

“Custody” in cryptocurrency is a minefield of a topic. In traditional physical goods, custody is obvious — there is only one version of the good, and whoever physically holds it has custody, whether legally owned by them or not. But a crypto unit is not only purely digital, its very existence is nothing more than a distributed group of computers agreeing it exists. There is no unforgeable digital file you can store and say you have custody of.

Crypto ownership is literally the capability to spend specific units of the currency. If two or more people have knowledge of the unit’s private key, then ALL of those people have “custody.” It just so happens that only the first person to spend it will be able to truly say they once held it.

I have absolutely zero faith in Bitcoin Cash or any of the subsequent Bitcoin derivative hard forks. I don’t agree with their philosophy, I hold no confidence in their development team. As a custodian of my own private keys, the only way to access the hard forked currency units would be to download their wallet software, something that incorporates considerable risk and I am neither compelled or interested in doing.

Taxing knowledge but not action

How has the IRS decision to tax inaction not been legally challenged? Under their guidance, the instant some scam artist decides to hard fork Bitcoin at no cost, all current holders must immediately pay tax on the new holdings magicked into existence. The cost basis is 0, and the market value is whatever an exchange showed the unit traded at on that day. Never mind that the only way the holders could sell that unit would require they download potentially dangerous software onto their machine — it certainly will not have undergone the same scrutiny and consensus review as the original bitcoin software on day one of its release, if it ever will.

One needs only a basic understanding of crypto technology to realize how moronic a ruling this was by the IRS. Bravo.