Tax on income you never earned? It’s possible after Ethereum’s Merge

After much build-up and preparation, the Ethereum merger went smoothly this month. The next test will be during tax season. Cryptocurrency forks, such as Bitcoin Cash, have created headaches for investors and accountants alike in the past.

While there has been progress, the rules of the United States Internal Revenue Service were not yet ready for something like the Ethereum network upgrade. However, there appears to be an interpretation of the IRS rules that tax professionals and taxpayers can adopt to achieve simplicity and avoid unexpected tax bills.

How Bitcoin Cash Cracked 2017 Tax Returns

Due to a block size disagreement, Bitcoin was forked in 2017. Everyone who held Bitcoin received an equal amount of the new forked currency, Bitcoin Cash (BCH). But when they received it caused some problems.

Bitcoin Cash was first issued in the fall, but didn’t hit Coinbase or other major exchanges until December. At that time, it had increased significantly in value. For tax purposes, receiving free coins is income. Suddenly, many investors had a lot of income to claim they hadn’t anticipated.

Related: Prepare for a swarm of incompetent IRS agents in 2023

Many crypto expert accountants advised clients to claim the value of Bitcoin Cash when it was issued, not when it finally arrived in their exchange accounts. No IRS guidance explicitly said this was OK, in fact it is contrary to the accounting principle of dominance and control, but it seemed like the only reasonable way to handle the problem.

Airdropped proof-of-work ETH is another gray area

As a result of issues with Bitcoin Cash’s income tax return, the IRS issued Revenue Ruling 2019-24 to address the treatment of blockchain forks. According to the ruling, forks that result in the airdrop of a new currency to an existing holder are taxable additions to wealth. While not the usage of “airdrop” that most investors are used to, the IRS uses the term to describe when a holder of an existing cryptocurrency receives a new coin from a fork.

The potential confusion with the Ethereum update is that the allocation of the forked and original coin based on the decision is not clear. One can easily see how the IRS could take the position that, post-upgrade, the Ether (ETH) tokens held in wallets and exchanges around the world are a new currency and that Proof of Work (PoW ) of Ethereum, which continues. on the legacy network: it’s the original.

Cryptocurrencies, IRS, Taxes, Tax Cuts, United States, Law, Ethereum 2.0

While the argument makes logical sense, this position would also lead to chaos. All US taxpayers who held ETH, or assets such as non-fungible tokens (NFTs) based on Ethereum smart contracts, on September 15 would have to claim their value as ordinary income. Although it uses old technology, Ethereum PoW is clearly the “new” currency.

The investor’s assets have not changed, but the underlying consensus mechanism was improved. Also, unlike Bitcoin Cash, which resulted from a disagreement with two legitimate parties, Ethereum’s upgrade was widely supported and opposed only by interested miners.

Related: Biden is hiring 87,000 new IRS agents, and they’re coming for you

Another example would be when EOS froze the Ethereum-based EOS token and moved holders to the EOS mainnet. The continuation of the coin on the EOS network was not considered taxable, as the rights were simply teleported to another chain with the same ticker symbol. (Crypto exchange traders probably haven’t even noticed.)

Is the “new currency” always the least adopted currency? Is a currency your technology or your community? The IRS likely won’t rule on this before tax day in April, so taxpayers and preparers will just have to make the call. But it seems the choice is clear.

Additional considerations for investors and developers

Tax-savvy Ethereum holders may want to wait and see if Ethereum PoW is adopted before attempting to access the coins. Accepting them will guarantee taxable income without leaving room for the argument that the fork is a fork/sham/scam, like many of the Bitcoin spin-off forks in 2017-2018, which had under-traded values ​​on remote exchanges.

If the value of Ethereum PoW falls before an investor sells, it can mean a tax bill that exceeds the value of the asset. (Bitcoin Cash fell from over $2,500 in value to under $100 in 2018, except for a short-lived spike in 2021). On the other hand, Grayscale Ethereum Trust’s September 16 press release indicates 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.

Related: Post-Merge ETH Has Been Obsolete

Something needs to be done to claim an Ethereum POW that is worth less than 1% of the corresponding amount of Ethereum. Early adopters often have an advantage in crypto, but a fork is a case where patience might be wise.

Any crypto developer considering a fork should be aware that forks always create tax headaches, the severity of which varies depending on the reason for and execution of the fork. Assuming the IRS once again follows the crypto tax community’s lead, Ethereum’s update provides an example of how to get it right.

Justin Wilcox is a partner in the Connecticut accounting and advisory firm of Fiondella, Milone & LaSaracina. He founded the firm’s cryptocurrency practice in 2018, providing tax and advisory services to Web3 organizations and crypto investors. It mines cryptocurrencies like DOGE (although it still supported Ethereum Merge). It has several cryptocurrencies and NFTs, including the coins mentioned in this article.

This article is for general information purposes and is not intended and should not be taken as legal or investment advice. The views, thoughts and opinions expressed herein are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.

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