Tax on income you never earned? It is possible after the Ethereum merger

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

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

How Bitcoin Cash Cracked the 2017 Tax Returns

Due to a block size disagreement, Bitcoin forked in 2017. Everyone who owned Bitcoin received an equal amount of the new forked currency, Bitcoin Cash (BCH). But when they received this 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, its price had risen significantly. For tax purposes, receiving free coins is income. Suddenly, many investors received a lot of income to claim that they did not expect.

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Many crypto-savvy accountants advise clients to claim the value of Bitcoin Cash when it is issued, not when it finally arrives in their exchange accounts. No IRS guidance specifically says this is OK — in fact, it goes against the accounting principle of dominance and control — but it seemed like the only reasonable way to handle the problem.

Airdropd proof-of-work ETH is another gray area

As a result of Bitcoin Cash revenue reporting issues, the IRS issued Revenue Ruling 2019-24 to address the treatment of blockchain forks. According to the ruling, forks that result in the release of 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 currency from a fork.

The potential confusion with the Ethereum upgrade is that the assignment of the forked and original currency based on the decision alone is unclear. One can easily see how the IRS could take the position that post-upgrade 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.

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

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

The investor assets have not changed—rather, the underlying consensus mechanism has been improved. Plus, unlike Bitcoin Cash, which arose out of a disagreement with two legitimate parties, Ethereum’s upgrade had broad support and was opposed only by self-interested miners.

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Another example would be when EOS freezes the Ethereum-based EOS token and moves holders to the EOS mainnet. The continuation of the coin on the EOS network is not considered taxable, as the rights are simply teleported to another chain with the same ticker symbol. (Crypto exchange traders probably didn’t even notice.)

Is the “new coin” always the less accepted coin? Is a coin a technology or a community? The IRS probably won’t rule on this before tax day in April, so taxpayers and advisors will just have to make the call. But it seems the choice is clear.

Additional considerations for investors and entrepreneurs

Ethereum tax holders may want to wait and see if the Ethereum PoW is accepted before trying to access the coins. Accepting them will ensure taxable income, leaving no room for argument that the fork is a half-hearted fork/farce/scam, like many of the derivative bitcoin forks of 2017-2018 that had thinly traded values ​​on remote exchanges.

If the Ethereum PoW value drops before an investor sells, it could mean a tax bill that exceeds the value of the asset. (The value of Bitcoin Cash fell from over $2,500 to under $100 in 2018, except for a short-lived spike in 2021). On the other hand, Grayscale Ethereum Trust’s September 16th press release indicates that it will claim, sell or distribute the proceeds associated with the ETH POW coin, so there may be some value to report at the end of the day.

Related: Post-Merge ETH Obsolete

Some action is required to claim 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 one instance where patience can be wise.

All crypto developers considering a fork should keep in mind that forks always create tax headaches, the severity of which varies depending on the rationale and implementation of the fork. Assuming the IRS once again follows the lead of the crypto tax community, the Ethereum upgrade sets an example of how to do it right.

Justin Wilcox is a partner in the Connecticut accounting and consulting 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 supports Ethereum Merge). It holds various cryptocurrencies and NFTs including coins mentioned in this article.

This article is for general information purposes and is not intended to be 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 the views and opinions of Cointelegraph.

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