Why Bitcoin Splits Are Both a Cash Windfall and a Tax Nightmare

November 16, 2017, 3:49 PM UTC

Bitcoin owners received a surprise this August when a parallel version of the currency, known as Bitcoin Cash, was distributed to every existing bitcoin owner on a one-to-one basis.

The new currency soon traded for hundreds of dollars, and during a bout of speculative mania this weekend, one unit of Bitcoin Cash was briefly worth as much as $2,500—not as much as the original, but still a tidy chunk of digital change.

Bitcoin Cash arrived quite literally as free money. The windfall, however, poses potential tax headaches for every bitcoin owner at a time when the IRS is getting more aggressive about digital currency.

How do you tax an “air drop”?

Bitcoin is familiar to many people as a decentralized digital currency whose value, in the last year, has soared more than seven-fold to above $7,000. Fewer people understand its offshoot, Bitcoin Cash.

The rival currency came into existence when a group of miners (the people who deploy mass amounts of computer power to extract “coins”) created a different version of the bitcoin software. This led to a “fork” of bitcoin’s blockchain ledger—basically a duplicate set of transaction records, which then diverged following the creation of Bitcoin Cash in August.

The forked version of bitcoin also replicated the original blockchain’s distribution of wealth: Anyone who had five bitcoins on the original chain, for instance, is entitled to five units of the new currency, Bitcoin Cash. People in cryptocurrency circles refer to such events—when a new piece of digital money is distributed out of thin air—as an “air drop.”

The creation of Bitcoin Cash, which has been criticized as a dangerous trick by some longtime bitcoin supporters, also poses tricky tax questions for those who receive it. Is an air drop akin to corporate dividend, which are taxed at lower rates? Or is it more like a share split? If the latter, then no one owes Uncle Sam anything.

It turns out Bitcoin Cash is probably neither of these things. According to Robert Crea and Elizabeth Crouse, who are experts on digital currency at the law firm K&L Gates, the IRS is likely to treat an air drop as ordinary income.

“It’s something new—it doesn’t fit neatly into a dividend or stock split or even mining,” says Crea.

Crouse adds that the IRS’s only guidance comes in the form of a bulletin from 2014, which treats bitcoin and other digital currency as a form of property.

“From the IRS’s perspective, whenever you get something new you didn’t pay for, it’s accretive—it’s income,” she says. “When the Bitcoin Cash shows up in someone’s account, that’s probably a taxable event. The question is what’s it worth.”

The answer to the “what’s it worth” question may also provide an unpleasant surprise. Many bitcoin owners likely think they can pay the taxman based on the value of their Bitcoin Cash when they sell it, but that may not be the case.

According to Crouse, what likely matters for tax purposes is when they receive it. As such, the relevant moment may be the day Bitcoin Cash was created in August. If that’s the case, there is an argument that the value is zero (if you consider the very moment of its inception), but the answer could also be “hundreds of dollars” based on its value in the market that same day.

Crouse is not the only one who thinks bitcoin owners might owe the IRS this spring for Bitcoin Cash. The CEO of Node 40, which makes tax compliance software designed for digital currency, says the company’s in-house accountants think a liability might already exist.

“A lot of people will assume the value is a capital gain and can pay when trade it out,” says Perry Wodin. “But doing that and not paying income tax now could bite you if the IRS treats this as ordinary income. Paying at distribution is the safest route.”

For many ordinary bitcoin investors, this conundrum becomes harder still because Coinbase, the most popular U.S. cryptocurrency exchange, has yet to distribute the Bitcoin Cash to its customers. Instead, Coinbase says it will release the Bitcoin Cash to customer accounts in January—raising the question of whether, for tax purposes, the distribution takes place in 2017 or 2018. (Update: On December 19, Coinbase distributed the Bitcoin Cash to its customers).

A spokesperson for Coinbase said the company could not comment on the tax issues surrounding Bitcoin Cash.

Waiting for word from the IRS

Lawyers and accountants are buzzing about the tax issues springing up around Bitcoin Cash and other new air-dropped currencies. But one entity that’s remained strangely silent about the whole thing is the IRS. In multiple phone calls and emails, Fortune tried to get the agency to comment on the tax treatment of air drops as well as that for newly-mined digital currency, where the rules are likewise ambiguous. When the IRS finally offered a response, it was only to reiterate that the rules are set out in its 2014 bulletin. That bulletin, however, offers little guidance beyond stating that digital currency is considered to be property.

This places bitcoin owners in the unenviable position of paying a tax bill this spring on Bitcoin Cash, which is even more volatile than the original currency, and whose value could one day collapse to nearly nothing at all. Or they could do nothing and risk future trouble with the IRS.

Right now, there is a sliver of hope in the form of a bill, proposed by Rep. Jared Polis (D-CO) and Rep. David Schweikert (R-AZ), which would clear up some of the tax uncertainty. Titled “The CryptoCurrency Tax Fairness Act,” the bill would create an exemption for transactions under $600 and clarify what third party exchanges should do to help with tax reporting.

Unfortunately, a Congressional committee this week denied Polis’s attempt to staple the bill to the larger project of tax reform, which is the only realistic way the cryptocurrency provisions could become law this year. This makes help from Congress a long shot at best.

“Obviously this legislation is not Congress’ highest priority but we’re very optimistic,” says Jerry Brito of Coin Center, a group in Washington, D.C. that lobbies on behalf of cryptocurrency owners.

Brito also echoed others in saying there is for now little tax guidance on how bitcoin owners should deal with situations like Bitcoin Cash.

“We think it’s obvious that the correct policy should be that no tax is due unless and until a taxpayer exercises control and dominion over airdropped or forked new tokens. If a taxpayer decides to take advantage of air-dropped or forked tokens then it may be reasonable to expect that tax will be due when they sell or otherwise dispose of those tokens,” he says.

Meanwhile, the IRS remains embroiled in a closely-watched court fight with Coinbase over its demand for the agency to turn over its customer records. The dispute arose after the agency found that only 802 people had declared gains or losses related to bitcoin on their 2015 tax returns. While the agency has scaled back its demands, the case remains before a federal judge.

Bitcoin Cash was trading for around $1,000 on Thursday while the original bitcoin was trading for about $7,500, according to CoinMarketCap.

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This story was updated at 12:45pm ET to clarify comments made by Elizabeth Crouse.