Polygon Advisory Group LLC

As the world of digital assets continues to evolve, many investors and users of cryptocurrencies find themselves navigating the complexities of the tax landscape. One such complexity involves the tax implications of holding a cryptocurrency that undergoes a protocol upgrade, specifically a change in the consensus mechanism. This scenario describes the ETH merge (the Merge) in September 2022, when Ethereum changed from a proof-of-work (PoW) to a proof-of-stake (PoS) consensus.

Earlier today, the IRS published unofficial guidance (CCA 202316008), which provides non-taxpayer-specific advice regarding the tax implications for an individual holding a cryptocurrency native to a blockchain that undergoes a protocol upgrade. The document answers two main questions:

1. Does an individual realize gain or loss on their units of cryptocurrency because of the protocol upgrade?

2. Does the individual have an item of gross income due to the protocol upgrade?

To provide some context, let's look at a hypothetical scenario. While the document doesn’t directly reference the Merge, the scenario described relates closely to what happened, so we will use it in our example:

Joe previously purchased and now holds 10 ETH in a wallet. In September 2022, the Ethereum blockchain changes its consensus mechanism from PoW to PoS - this is the protocol upgrade in question, also referred to by many simply as the Merge.

The document concludes that Joe does not realize gain or loss under §1001 of the Internal Revenue Code (Code) on their 10 ETH due to the protocol upgrade. Additionally, he does not have an item of gross income under §61(a) of the Code due to the protocol upgrade.

Here's why: the protocol upgrade affects the consensus mechanism by which future transactions are validated and blocks are added to the Ethereum blockchain after the date of the Merge. However, it does not alter past transactions or blocks, including Joe’s 10 ETH. The existing ETH remain unchanged by the protocol change, and there isn't an exchange of those ETH under §1001. Therefore, Joe continues to own the same 10 ETH before and after the upgrade, and the protocol upgrade does not result in a realization event from which he realizes gain or loss on their existing 10 ETH.

Similarly, Joe does not derive any accession to wealth from the upgrade. His 10 ETH remain unchanged, and he does not derive any separable economic benefits, such as cash, services, or other property (including other cryptocurrencies) from the upgrade. Without an accession to wealth, the protocol upgrade does not result in Joe having an income inclusion within the meaning of §61(a).

In conclusion, when it comes to protocol upgrades that change the consensus mechanism of a blockchain, individuals holding cryptocurrency native to that blockchain do not realize gain or loss and do not have an item of gross income due to the protocol upgrade, according to the CCA.

This is an interesting and important concept to consider against the language of Rev. Rul. 2019-24, which provides that airdrops of new cryptocurrencies following hard forks are taxable. In the case of the Merge (and most other hard forks), there wasn’t an airdrop of ETH. Rather, due to the fork, there were two resulting chains (ETH and ETHW), each of which could possibly be considered the old chain (or the new chain). The CCA references Rev. Rul. 2019-24 in a few places, but only for background purposes – the CCA does not revoke the Ruling.

So, this new guidance may bring more questions than answers. We know, for example, that airdropped crypto is considered income when received, but how do we know what the IRS considers the “new” cryptocurrency? When analyzing the Merge, is ETH considered the legacy currency, or is it ETHW? Or is it up to Joe to decide?

The lack of clarity makes it difficult for many taxpayers to comply with the law. It’s clear that we will need better guidance from the IRS on this issue. Otherwise, poor Joe has his work cut out for him.