Income tax for services provided
Bitcoins, or any cryptocurrency, received as a payment from providing some service or product are treated as ordinary income. The federal tax on this income can range anywhere between 10% to 37% depending on the taxpayer’s income slab. Additional state taxes depend on the taxpayer’s local state laws.
For instance, if 2 bitcoins are received in an exchange for certain services, then the following points would help in understanding how they would be taxed:
Price on Coinbase on the day of incoming payment:
2 X US $10,000=US $20,000
Taxes Levied→ Income Tax, Self Employment Tax
The IRS clarified that income received in exchange for a product or service is taxable- regardless of whether they are provided as an employee of a company or as an independent contractor.
There may be cases where the cryptocurrency received in exchange for a product or service does not have a published value. In such a scenario, the fair market value of the service or property exchanged for the cryptocurrency would be considered as the cryptocurrency’s fair market value. This is to be recorded at the time when the transaction occurs.
Hard forks and the IRS’s perspective
A hard fork is related to blockchain technology in general, and not just bitcoins. It refers to a major change in the network protocol, which renders all earlier invalid transactions and blocks valid or vice versa. In the case of a hard fork, all users/nodes in the blockchain must upgrade to the protocol software’s latest version.
A few reasons why forks happen are:
- To rectify security risks and vulnerabilities. Updating blockchain software ensures that no hacker takes advantage of them and the larger ecosystem is protected
- To introduce new functionalities. The Byzantium hard fork in Ethereum was a compulsory upgrade for improving scalability and privacy.
- For rolling back previous transactions. For instance, a hard fork on the Ethereum blockchain was done for reversing the hack on the decentralized autonomous organization (DAO).
How does IRS tax cryptocurrency hard forks?
Cryptocurrency forks are part of the IRS’s 2019-24 ruling and guidance. If a cryptocurrency held by the taxpayer has a hard fork, then any new forked currency received would be taxed as income. The cost basis of this new cryptocurrency is the recognized income for calculating tax.
For instance, consider a holding of 2.5 bitcoin in June 2017. As a result of the hard fork, the holder of 2.5 bitcoins would have acquired an additional 2.5 Bitcoin Cash. This new 2.5 Bitcoin Cash would have to be recognized as income based on the Fair Market Value on the day it was received. If the Bitcoin Cash price was $500 on that day, the total ordinary income to recognize would be 2.5 * $500= $1,250.
Another similar term is a cryptocurrency soft fork. In a soft fork, a change in the protocol renders only previously valid transactions/blocks as valid. No new cryptocurrency is created as part of a soft fork, so no tax liabilities are there.
Airdrops and the IRS’s perspective
An Airdrop refers to the distribution of a cryptocurrency coin or token. This is generally done for free and involves credit to many wallet addresses. A cryptocurrency airdrop aims to gain new followers and attention. The large-scale disbursement of coins helps to attract a large user base. Airdrops distribute cryptocurrencies either by selecting the recipient wallets at random or by publishing about the event in a related newsletter or bulletin boards.
When is a cryptocurrency received via airdrop, taxed?
As per the IRS guidelines, an airdropped cryptocurrency will produce a receipt when it gets recorded on the new ledger. For tax purposes, the receipt may take place earlier or later, depending on when the taxpayer can exercise control of the new cryptocurrency.
For instance, the airdropped cryptocurrency may not credit the holder’s account at the crypto exchange immediately. This may be because the exchange does not support that specific cryptocurrency yet. In such a case, the IRS will consider the date of receiving the cryptocurrency later- once it gets credited into the taxpayer’s account and they can sell, transfer, exchange or dispose of it otherwise.
Hard Fork and Airdropped Cryptocurrencies: A few examples
There can be multiple scenarios of airdropped and hard forked cryptocurrencies. With the IRS still formulating rules around the same, not every scenario may have a defined rule for it. Two of the most common scenarios on how the tax would be calculated are discussed ahead.
If a cryptocurrency goes through a hard fork, it creates new cryptocurrency. However- the units/coins of this new cryptocurrency are not transferred into an account that the taxpayer can control. Since no units/coins yet are credited, there is no gross income at that time on which federal tax is to be paid.
Similar to the above example, suppose that units of this new cryptocurrency are airdropped in the taxpayer’s ledger address and are immediately available for disposal. In such a scenario, the recipient has what IRS terms as ‘accession to wealth’ and ordinary income in the ongoing tax year. This ordinary income equals the fair market value of the new units at the date-time when the airdrop transaction gets recorded on the blockchain ledger.