Hello everyone and thank you for reading! This article includes various sections regarding crypto-currency with an emphasis on Bitcoin. Feel free to scroll through and stop on the heading that interests you most if you don't feel up to reading the article in it's entirety, though the overview section will help with some of the terminology used in the latter sections. The sections included are as follows: Overview of Bitcoin and how it is mined, walk-through of a Transaction, Current Tax Treatment, Development/patching of the Bitcoin blockchain, Forks (specifically Bitcoin Cash), Taxation of Forks, and Airdrops

Overview

Before we get into the specifics of a hard fork or an airdrop I would like to start with an overview of just what a crypto-currency like bitcoin is, why it is important, and why huge financial institutions are devoting immense amounts of resources to mine some crypto of their own.

Most money in the world today exists merely as transaction histories and balances – bitcoin is no exception. The “Blockchain” is the ledger of these transaction and your “wallet” is where you compartmentalize and valuate your holdings.

Back in 2009 an anonymous man named Satoshi set up a web hosted, decentralized network where by devoting the processing power of your computer to solving a certain algorithm named “Sha-256” you could create a "link in the chain" that is distinctly your own. The name Sha-256 comes from the hash value size of 256 bits. These links that are being created through solving the puzzle that is the Sha-256 algorithm are known as Satoshi's, named after the developer of this blockchain. One Satoshi represents .00000001 (one hundred millionth) of a bitcoin. The process of using your computer to tap into the Bitcoin blockchain and solve the SHA-256 algorithm is known as “mining”

When the SHA-256 algorithm is solved a "verified transaction" has occurred between the bitcoin blockchain and your personal identity (denominated in a string of text known as your "address"). A Satoshi is the user side of this transaction that proves "It was I, 13qiTUnQncsKdksryCPyufjkhYyeUpU1gT, who did the work to solve this puzzle and have earned this coin (Satoshi/Bitcoin) as a result".

Bitcoin needs to be physically saved on a hard drive, cloud, or any other file depository. We call these depositories wallets. Each wallet consists of a private key and a public key. A public key is how other users find your wallet, a private key allows the recipient in a transaction to decrypt sent bitcoins.

Transactions





Here I have a visual representation of a possible transaction between Kevin and my friend Hugh. The green block would be filled with code representing my "witness". The "witness" is Kevin's private key and the Hugh's public key. Hugh wont be able to actually see my private key, it is encrypted, however the fact that it is there will allow him to decrypt the say 50 million Satoshis (or .5 bitcoins) worth of verified transactions that I am trying to send him.

Within the transactions’ code is a very data heavy section called the script and a lighter section that includes the public keys associated with the transactions' verification. The bundle of these verified transactions, my signature, and Hugh’s public key are known as a "block".

Shown in the graphic are some notable bitcoin addresses. The US marshals service obtained roughly 495 Million dollars (by today's markets) in bitcoin by shutting down and seizing transactions from the “Silk Road.” This Deep web e-commerce site for predominately illegal wares operated with Bitcoin as it's main median of exchange from 2009 to November 6, 2014. During the time of the fed’s investigation, bitcoin prices went from 13$ a coin to as high as 945$ a coin, a %7269 increase.

Another noteworthy public address is that of the WikiLeaks donation page which was Julian Assange’s project to leak sensitive government information.

Current Tax Treatment

From the IRS’ perspective, crypto-currency in general is considered a personal use asset – similar to a car or your father’s stamp collection. Gain/losses are capital in nature. Similar to personal use assets, if bitcoins are used as currency to buy or sell goods/services you must realize capital gains taking into consideration market value and your relinquished basis; you cannot deduct any losses if the market has fluctuated so that the fair market value is less than your cost.

Wash sale rules do not apply as the IRS does not consider bitcoin securities

Because bitcoin are not considered an “appreciated financial position,” bitcoin’s unrealized gains can be hedged without constructive sales rules as spelled out in IRC section 1259 applying.

Now due to the nature of Bitcoin, being decentralized and transactions occurring anonymously, basis tracking by the IRS is incredibly difficult. All they will know is that a transaction occurred however it will be incredibly difficult to trace your basis relinquished especially if the coins were mined. If bought on an exchange and the exchange cooperates with the IRS; giving records of buy/sell orders, then yes they’ll be able to see when you bought and at what price.

An example of the tax ramifications in using bitcoin as a currency to buy a product are displayed in the graphic. Each time a bitcoin is used, the basis and fair market value of your transaction must be calculated. In the above example, a $1,046 short term capital gain (based on the holding period of under a year) would be recognized and taxes due would be calculated based off the current short term capital gains tax rate rate of 35% . Tax Liability = $1,046*.35= $366

Bitcoin is a work in progress and while the original developer of Bitcoin is largely unknown though nowadays the development is crowd sourced, and almost anyone can develop a patch.

Development/Patching

GitHub is a website where you can do just that – offer up a Bitcoin improvement proposal (or BIP) to amend or improve the way bitcoin functions. The first ever BIP was created by Amir Taaki on 8/19/2011 and it spelled out the structure of what a BIP should look like.

“A bitcoin improvement proposal (BIP) is a design document for introduction features or information to Bitcoin. The BIP should provide a concise technical specification or the feature and a rationale for the feature. This is the standard way of communicating ideas since bitcoin has no formal structure.” –BIP0001

Miners (nodes) vote on these proposals and if they pass they are implemented into the Bitcoin network. Bitcoin Cash was BIP-0143 that spelled out the first “fork” in the bitcoin blockchain which occurred on August 1st, 2017. There were many reasons why the fork needed to happen – most notably the scalability issue with Bitcoin. The “Block Size”(mining cap) is set at 1 MB and any miner pushing more than 1MB of data to the blockchain is immediately kicked back and the transaction is deemed invalid. Bitcoin cash’s Block size is set at 8MB, with the capability further increases built into it's structure.

Forks

The above graphic can help visualize what the fork looks like for the bitcoin blockchain. “All current Bitcoin holders will automatically own Bitcoin Cash. The existing ledger at the time of the split is preserved, thus users retain any balances they had before the split.” So basically, all “verified transactions” that we talked about earlier that would get you Bitcoin in your wallet will now also serve as “verified transactions” for this new currency Bitcoin Cash. There were a few changes to the structure of bitcoin with the Bitcoin Cash fork, most notably they increased the maximum block size and also the “Segregated Witness” protocol. Segwit was an accepted proposal that removes the signature from the “header” of the 1MB block and makes it a separate block – basically it separated a portion of the code to a separate block thus freeing up more space for transaction information – making the blockchain lighter.

An additional fork occurred in November after the accepted proposal for Segwit2x which created the second break in the Bitcoin blockchain creating a currency known as "Bitcoin Gold".

Awesome, we held bitcoin on these fork dates and effectively tripled our number of coins, but what does that mean from a valuation perspective and how do we report it on our taxes?

Taxation of Forks





There are two prevailing tax theories. One is that this fork will be treated as a property division and will not create a taxable event. Another is that the market value of the property received will be treated as ordinary income.

The property division theory is that the fork should be treated similarly to a stock split where the only tax implications would be to make sure the basis is being tracked correctly.

The issue with this, though, is that in a traditional stock split the shares divide into 2 or 5 or 10 identical securities. The market values of BTC vs BCC will show that they certainly are not identical. BTC is trading currently at around $16,000, BCC at $1,500, and BTG at $260. They also show distinct differences in nature (10 mb mining cap for BCC vs 1 mb for BTC). The WSJ wrote an article entitled “No One knows how much to pay in Bitcoin Cash taxes” where it consulted top tax professionals and some said that Bitcoin Cash income could be taxable in the current year.

"Because the original bitcoin ownership [remains] unchanged, it is possible that the Bitcoin cash could be viewed as ordinary income. The amount of income recognized could either be based on the value of bitcoin cash when issued, or when investors could trade it, which wasn’t immediately."

The price on August 1st (Date of fork) ranged from 200-500$. There were also large discrepancies in market value based on which exchange you were trading on. Without a clear market value - it is difficult to discern just how much income is to be recognized.

Some additional consideration is many investors hold their bitcoin on the exchange Coinbase. Coinbase has not distributed bitcoin cash to their clients who held bitcoin before the fork and are instead waiting until 1/1/2018. With the above insight in mind, what do you think? Should I report their market value as ordinary income for the 2017 tax year? I would think not because they’re not in my “wallet” and I don’t have custody of them to trade however the IRS could argue that I could’ve taken the BCC at any time from Coinbase. We will have to wait for guidance on this one.

A possible third option involving a theory I came up with is that the IRS could treat crypto forks as a tax free spin - off distribution as written in IRC section 355. Let's look at the requirements and allow me to prove to you that although section 355 involves distributions from companies in the event of a consolidation, Bitcoin cash could potentially meet these requirements and the distribution could be treated as tax free.

To start – we have to understand that the bitcoin network is not a “Company”, but a web hosted protocol with millions of users . However, with a market cap of $74 Billion and the ability to trade instantaneously on the various exchanges that exist in the market, a bitcoin certainly shows more similarities to shares of a company than it does to your father's stamp collection. The operations/voting rights are 100% held with the “shareholders” or those who hold bitcoin as we discussed earlier with the GitHub voting procedure. Top developers of Bitcoin could be considered a sort of board of directors as they hold a lot of clout when they come up with a proposal.

Traditionally, spinoffs distributions occur when a publicly traded company’s subsidiary becomes it’s own legal entity, a publicly traded company separate from the parent company. There are taxable and non-taxable spinoff distributions

For the purposes of this discussion I will be considering Bitcoin the “Distributing company” and Bitcoin Cash the “Controlled Company”

There are four statutory requirements for a qualified 355 non taxable spinoff distribution.





Control:

Distributing entity (bitcoin) must be in control of controlled (bitcoin cash) immediately before the distribution.

Bitcoin cash will be utilizing the original Satoshi whitepaper, Bitcoin classic holders have all the voting rights before the fork, will hold all the voting rights of BCC after the fork.

Device:

The distribution cannot be principally a device for the distribution of earnings and profits from the distributing to the controlled.

There were various reasons for the fork, including the increase of block size to 10MB. It was not solely to distribute E&P

Active trade or business:

Distributing and controlled must each satisfy the active trade or business requirements immediately after the distribution:

Corporation must be currently engaged in the active conduct of trade or business

If we consider the “active business” of bitcoin to be mining/transacting then it is and will continue to be engaged.

Trade or business must have been actively conducted throughout the five-year period ending on the date of distribution; trade or business must not have been acquired within the five-year period

Bitcoin, the “distributing company” has been conducting activities since 2009. Because the ledger is essentially copied when bitcoin cash is created, it could be argued that blocks of Bitcoin Cash also contain activity from 2009.

Distribution:

The stock of controlled must be distributed to shareholders of the distributing company with respect to their ownership in the distributing company

Bitcoin cash was distributed to bitcoin holders on a 1:1 ratio

It appears to me that while Bitcoin is not a "corporation" in the traditional sense of the word, it certainly shares similarities and this code section very well could apply to the various underlying coins that are separating from the original blockchain.





Airdrops

Now, there are a lot of other players in the crypto-currency space besides Bitcoin. In the past year, blockchain technologies have become mainstream and a multitude of companies are opening up: Secure messaging platforms, Esports betting platforms such as Unikrn, social media platforms like OmiseGo, and ripple, a blockchain used to transact high volume trades between banks.

Byteball is a virtual currency wallet and to incentivize users to download their service they are issuing a distribution that have been coined “airdrops”.

This is an issuance of their own currency to users who can prove bitcoin ownership. So basically you download their software, transfer your bitcoin balance to their wallet service and on the Airdrop dates you're issued “free” currency based on your holdings.

Again this is less of a spinoff/property division because the GBYTE blockchain is completely separate from that of Bitcoin. Because of this, I believe this would be considered 'other income’ on your tax return, taxed at OI rates.

Footnote

I hope you enjoyed the article and I really do appreciate you taking the time to read. We live in an exciting time and I see incredible potential in blockchain technologies. Now that (hopefully) you understand them a little more you too can see how this tech truly can change our world!









Works Consulted

"Bips/bip-0001.mediawiki at Master · Bitcoin/bips · GitHub." GitHub, github.com/bitcoin/bips/blob/master/bip-0001.mediawiki. Accessed 9 Oct. 2017.

“Bitcoin and Cryptocurrency Algorithms and Implementation Tutorial. | Toptal." Toptal Engineering Blog, www.toptal.com/bitcoin/cryptocurrency- for-dummies-bitcoin-and-beyond .

"Fidelity CEO Abigail Johnson Says the Company is Mining Cryptocurrencies | TechCrunch." TechCrunch, techcrunch.com/2017/09/28/fidelity- ceo-abigail-johnson-says-the-company-is-mining-cryptocurrencies/.

"Mining." Bitcoin Wiki, en.bitcoin.it/wiki/mining. Accessed 9 Oct. 2017.

"Visual Guide to Bitcoin Forks : Btc." Reddit, www.reddit.com/r/btc/comments/71j6wo/visual_guide_to_bitcoin_forks/.

"No One Knows How Much to Pay in Bitcoin Cash Taxes." WSJ, www.wsj.com/articles/no-one-knows-how-much-to-pay-in-bitcoin-cash-taxes-1503658800.

Byteball Wiki, byteroll.com/. Accessed 9 Oct. 2017.



