Tax Implications of Digital Asset Consensus Changes

In the ever-evolving landscape of digital assets, investors and cryptocurrency users often find themselves grappling with the intricacies of tax regulations. One particularly complex issue arises when a cryptocurrency experiences a protocol upgrade, particularly a shift in its consensus mechanism. This article delves into the tax implications of such changes, drawing inspiration from the Ethereum Merge in September 2022, when Ethereum transitioned from a proof-of-work (PoW) to a proof-of-stake (PoS) consensus.

Consensus Mechanisms: A Game Changer

Proof of Stake (PoS)

The consensus mechanism of a blockchain network determines how transactions are validated and added to the ledger. PoS has gained prominence due to its energy-efficient nature and potential for scalability. Investors should be aware that the switch from Proof of Work (PoW) to PoS can impact taxation, as it may alter the character of the assets held.

Staking and Taxation

With PoS, staking becomes a prevalent practice where users lock up their assets to support network security and earn rewards. However, staking can trigger tax events, including income tax, when rewards are received. Proper reporting is essential to avoid potential tax liabilities.

Understanding the IRS Guidance (CCA 202316008)

Recently, the IRS issued unofficial guidance, coded as CCA 202316008, which offers general advice concerning the tax consequences for individuals holding cryptocurrency native to a blockchain that undergoes a protocol upgrade. This document addresses two crucial questions:

1. Realization of Gain or Loss: Does an individual incur a gain or loss on their cryptocurrency holdings due to the protocol upgrade?
2. Gross Income: Does the individual possess an item of gross income resulting from the protocol upgrade?

To provide context, we'll present a hypothetical scenario closely resembling the Ethereum Merge, which will help clarify the guidance's implications.

The Hypothetical Scenario

Let's consider Adam, who owns 10 ETH in his wallet. In September 2022, Ethereum underwent a monumental shift in its consensus mechanism from PoW to PoS - an event commonly referred to as the Merge.

According to CCA 202316008, Joe does not realize gain or loss under §1001 of the Internal Revenue Code (Code) on his 10 ETH due to the protocol upgrade. Furthermore, he does not possess an item of gross income under §61(a) of the Code as a result of the upgrade.

The Rationale Behind the Guidance

This conclusion stems from the fact that the protocol upgrade primarily impacts how future transactions are validated and blocks are added to the Ethereum blockchain post-merge. However, it does not retroactively alter past transactions or blocks, including Adam's 10 ETH. Consequently, there is no exchange of these ETH under §1001. Thus, Adam retains ownership of the same 10 ETH both before and after the upgrade, with the protocol upgrade not triggering a realization event leading to gain or loss on his existing holdings.

Similarly, Adam does not acquire any additional wealth from the upgrade. His 10 ETH remains unchanged, and he does not derive any distinct economic benefits, such as cash, services, or other property, from the upgrade. Lacking accession to wealth, the protocol upgrade does not result in Adam having an income inclusion within the meaning of §61(a).

A Clash of Concepts: Protocol Upgrades vs. Airdrops

This guidance introduces an intriguing contrast with the language of Rev. Rul. 2019-24, which deems airdrops of new cryptocurrencies following hard forks as taxable events. In the case of the Merge, and most other hard forks, there was no airdrop of ETH. Instead, the fork gave rise to two resulting chains, ETH and ETHW, each with its claim to being either the old or new chain. While CCA 202316008 references Rev. Rul. 2019-24 for background context, it does not negate the ruling.

The Quest for Clarity

The lack of definitive clarity in these matters poses a considerable challenge for taxpayers aiming to comply with the law. While it's clear that airdropped crypto is considered income upon receipt, the determination of which cryptocurrency the IRS considers as the "new" one remains a question. In the context of the Merge, does the IRS view ETH as the legacy currency, or is it ETHW? Or does the responsibility fall upon the individual, leaving Joe with the pivotal decision?

Conclusion: Seeking Further IRS Guidance

In conclusion, protocol upgrades that alter the consensus mechanism of a blockchain do not trigger gain or loss for individuals holding native cryptocurrency. Additionally, such upgrades do not lead to an item of gross income, as per CCA 202316008.

However, the coexistence of this guidance with Rev. Rul. 2019-24 raises questions about the tax treatment of airdrops and hard forks, emphasizing the need for clearer directives from the IRS. Until further guidance emerges, taxpayers navigating this complex terrain may face considerable uncertainty.