Virtual currencies have been growing rapidly in terms of type and frequency of use. They are increasingly becoming an accepted form of payment even by major established companies and financial institutions. Not all taxpayers, however, appear to be familiar with or complying with their tax reporting obligations involving virtual currencies.

The Internal Revenue Service estimates that only a few hundred taxpayers have reported virtual currency transactions, while the agency has collected information on and started sending out letters to around 10,000 taxpayers that it believes have engaged in virtual currency transactions.

Addressing this area of noncompliance is becoming an IRS area of focus, and taxpayers and their tax advisors would be well-advised to review their virtual currency tax requirements before IRS enforcement action heats up further.

Notice 2014-21

The first guidance that the IRS issued in the virtual currency area was in 2014. That guidance stated that virtual currencies would be treated as property and not currency and that transactions involving virtual currencies would generally be taxable. No further guidance was forthcoming from the IRS until this year.

Revenue Ruling 2019-24

Revenue Ruling 2019-24 was issued on Oct. 9, 2019. It reaffirms the guidance under Notice 2014-21 and addresses a couple of particular forms of virtual currency transactions that have emerged since 2014.

The ruling defines a “hard fork” as a change to a distributed ledger underlying a cryptocurrency that results in a split from the original distributed ledger, which may result in a new cryptocurrency on a new ledger. The ruling defines an “air drop” as a means of distributing units of a cryptocurrency following a hard fork to the distributed ledger addresses of multiple taxpayers.

If through a hard fork, or a hard fork followed by an air drop, the taxpayer receives a new cryptocurrency over which the taxpayer has dominion and control, it will be taxable to the taxpayer. A taxpayer is considered to have dominion and control if the taxpayer has the ability to transfer, sell, exchange or otherwise dispose of the cryptocurrency units.

Cryptocurrencies are defined as a type of virtual currency that uses encryption to secure transactions digitally recorded on a distributed ledger. Virtual currencies also include digital currencies and any virtual currency having an equivalent value in, or acting as a substitute for, real currency, defined as the official legal currency of a country.

Revenue Ruling 2019-24 specifies that the income recognized will be ordinary income, and basis will be the fair market value at the time of their receipt.

Along with Revenue Ruling 2019-24, the IRS also released a set of 43 frequently asked questions. These give examples of some of the transactions discussed in the revenue ruling and discuss the calculation of gain or loss, the determination of fair market value, and the calculation of basis. The questions point out that virtual currency transactions involving gifts or charitable contributions and soft forks, when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and does not result in the creation of a new cryptocurrency, will generally not be subject to tax.

The questions also address the ability of the taxpayer to specifically identify the units of cryptocurrency involved in a particular transaction. Absent such specific identification, the default treatment is first-in, first-out.

IRS letters

Starting in July 2019, the IRS began sending letters to taxpayers suspected of having been involved in virtual currency transactions. The information was obtained by the IRS from at least one virtual currency exchange. The IRS has said that it expects to issue around 10,000 letters in three versions. The three versions are addressed to taxpayers who may not have met their U.S. filing and reporting requirements for transactions involving virtual currency, taxpayers who may not know the requirements for reporting transactions involving virtual currency, or taxpayers who may not have properly reported their transactions involving virtual currency.

The IRS has described these “soft letters” as an effort to get taxpayers to voluntarily come into compliance before enforcement actions are initiated. They also indicate that the service already possesses significant information to initiate those enforcement actions. This appears to be a program that is similar to the IRS effort to bring foreign account and asset holders into compliance by offering opportunities to come into compliance as the IRS collected information on foreign account holders from foreign financial institutions.

Question on Form 1040 Schedule 1

Also, similarly to the approach that the IRS took with respect to foreign accounts, the IRS has added a question about virtual currencies to the tax return, in this case to the draft Schedule 1 of Form 1040. The question, requiring a yes or no response, is: “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” This would appear to require all taxpayers to file a Schedule 1, if only to respond to this question.

Summary

Even with the additional guidance from the IRS, there remain a number of unanswered questions about the tax treatment of certain virtual currency transactions. As the types of virtual currencies continue to expand and the transactions in which they are involved become more varied, that is likely to continue to be the case.

The thrust of the IRS guidance so far is fairly consistent — virtual currency is property and any transaction that results in something being exchanged for something new is a taxable transaction unless a specific exception can be found in IRS guidance.

The IRS has already obtained considerable information from at least one virtual currency exchange and is likely to be able to obtain additional information. Certainly, any taxpayer who has received a soft letter from the IRS should work promptly to come into compliance before an enforcement action commences.

Those taxpayers who have not received a letter but have engaged in virtual currency transactions should also consider coming into compliance. As the IRS continues to develop additional information on taxpayers engaged in virtual currency transactions, it is not certain that taxpayers in the future will receive a soft letter before enforcements commence.