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

The Ethereum Merge went smoothly after much preparation and buildup. Tax season will be the next test. In the past, cryptocurrency forks such as Bitcoin Cash have caused headaches for both investors and accountants.

Despite some progress, the United States Internal Revenue Service rules are still not ready for an upgrade to the Ethereum network. There seems to be a way for tax professionals and taxpayers to simplify IRS rules and avoid paying unexpected tax bills.

How Bitcoin Cash ruined 2017 tax returns

Bitcoin split in 2017 because of disagreements over block sizes. Every Bitcoin owner received the same amount of Bitcoin Cash (BCH) as before. However, they had some problems when they received it.

Bitcoin Cash was issued for the first time in fall, but it didn’t reach Coinbase or any other major exchanges until December. It had risen in value significantly by that point. Free coins are considered income for tax purposes. Many investors suddenly had an abundance of income that they could claim.

Related: Be prepared for an incompetent IRS agent in 2023

Many crypto-savvy accountants recommended that clients claim Bitcoin Cash’s value when it was issued and not when it arrives in their exchange accounts. This is not an IRS guidance that explicitly says it’s OK. It runs counter to the accounting principle dominion, control. However, it seems like the only way to deal with the issue.

Another gray area is irdropped evidence-of-work ETH

Due to the difficulties in reporting income from Bitcoin Cash the IRS issued Revenue Ruling 2019-24. This ruling addresses the issue of blockchain forks. The ruling states that forks that result from the airdroping of a new cryptocurrency to an existing holder can be taxable additions to wealth. Although “airdrop” is not a term most investors use, the IRS uses it to describe the moment a holder of an existing cryptocurrency gets a new currency via a fork.

There is potential confusion in the Ethereum upgrade because it is not clear how to assign the forked currency and the original currency based only on the ruling. It is easy to see how the IRS could claim that the Ether (ETH tokens) held in exchanges around the world are a new coin and that the Ethereum proof-of work (PoW), which continues on the legacy network, is the original.

This argument is logically sound, but it would lead to chaos. Each U.S. taxpayer holding ETH, or assets such nonfungible tokens. (NFTs) based upon Ethereum smart contracts, on Sept. 15 would be required to claim its value for ordinary income. Although it uses the older technology, Ethereum PoW clearly is the “new” currency.

The investor’s assets have not changed, but the underlying consensus mechanism has been upgraded. And unlike Bitcoin Cash, where there was disagreement between two legitimate parties, the Ethereum upgrade received widespread support and was opposed only by self-interested miners.

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EOS also froze Ethereum’s EOS token and moved its holders to the EOS mainnet. As rights were simply teleported from the EOS network to another chain, the continuation of the coin was not considered taxable. (Crypto traders probably didn’t notice.

Is it always the less-adopted coin that is “new”? What is the coin’s technology? This issue will not be addressed by the IRS before April Tax Day. Taxpayers and advisors will have to decide. It seems that the decision is easy.

Additional considerations for developers and investors

Tax-savvy Ethereum owners may wish to wait to see if Ethereum POW is adopted before they attempt access to the coins. Accepting them will ensure taxable income, but it is possible to argue that the fork is a farce/scam like many other derivative Bitcoin forks from 2017-2018, which had very little traded values on remote exchanges.

An investor selling Ethereum PoW may see its value drop before it sells. This can lead to a tax bill greater than the asset’s value. Bitcoin Cash’s value dropped to less than $100 in 2018 from more than $2,500, with a brief spike in 2021). Grayscale Ethereum Trust’s September 16 press release indicated that it would claim, sell, or distribute proceeds from the ETH POW coins, so there might be some value at the end.

Related: Post-Merge Ethereum has become obsolete

To claim Ethereum POW, which is less than 1% of the equivalent amount of Ethereum, it takes some effort. Although early adopters have an advantage in crypto, a fork could be a good example of patience.

Forks can cause tax headaches for crypto developers, depending on how the fork was executed. If the IRS follows the example of the crypto tax community, the Ethereum upgrade is a good example of how it should be done.

Justin Wilcox, a partner in the Connecticut accounting and advisory company Fiondella, Milone & LaSaracina, is a tax specialist. In 2018, he founded the cryptocurrency practice at Fiondella, Milone & LaSaracina. He provides tax and advisory services for Web3 companies and crypto investors. He continues to support the Ethereum Merge, but he mines cryptocurrency like DOGE. He has a variety of cryptocurrencies and NFTs. This article also mentions coins.

This article is intended for informational purposes only and should not be construed as investment or legal advice. These views, thoughts and opinions are solely the author’s and do not necessarily reflect the views or opinions of Cointelegraph.

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