Taxes on Each Type of Income

Income For Providing Services 
  • Bitcoins, or any cryptocurrencies, received as a payment for providing a 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. Additional state taxes may apply depending 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 of bitcoins on the day of incoming payment: $10,000
  • Taxable income: 2 * $10,000 = $20,000
  • Taxes levied: Income tax (and maybe self employment tax)
  • The IRS clarified that income received in exchange for a product or service is taxable, regardless of whether the taxpayer was paid as an employee of a company or as an independent contractor.
  • Sometimes, the cryptocurrency received in exchange for a product or service may 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 the cryptocurrency's fair market value. This should be recorded at the time when the transaction occurs.
Hard Forks
  • A hard fork is related to blockchain technology in general, 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 a hard fork, all users or nodes in the blockchain must upgrade to the protocol software's latest version .
  • Forks may occur in order to: a) rectify security risks and vulnerabilities, b) update blockchain software to ensure that no hacker takes advantage of it and to protect the larger ecosystem, c) introduce new functionalities, d) improve scalability and privacy, or e) roll back previous transactions. For instance, a hard fork may be performed on the Ethereum blockchain to reverse a hack on the decentralized autonomous organization (DAO).
  • How does the IRS tax hard forks? According to the IRS's 2019-24 ruling and guidance, if a cryptocurrency held by the taxpayer undergoes a hard fork, then any new currency received as a result would be taxed as income. When calculating taxes, the cost basis of this new cryptocurrency is the recognized income. 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 acquire 2.5 Bitcoin Cash. These new 2.5 Bitcoin Cash would be considered income, worth the Fair Market Value on the day it was received. If the Bitcoin Cash price was $500 on that day, the total ordinary income recognized would be 2.5 * $500 = $1,250.
  • A similar term is a cryptocurrency soft fork. In a soft fork, a change in the protocol renders only previously valid transactions or blocks as valid. No new cryptocurrency is created as part of a soft fork, so there are no tax liabilities.
Airdrops
  • An airdrop refers to the distribution of a cryptocurrency coin or token. This is generally done for free and is credited to many wallet addresses. A cryptocurrency airdrop aims to gain new followers and attention with a large-scale disbursement of coins to attract a large user base. Airdrops distribute cryptocurrencies either by selecting the recipient wallets randomly or by publicizing the event in a related newsletter or on forums.
  • When is airdropped cryptocurrency taxed? According to IRS guidelines, an airdropped cryptocurrency may or may not be considered received for tax purposes when it gets recorded on the new ledger, depending on whether the taxpayer can exercise control of the new cryptocurrency. For instance, the airdropped cryptocurrency may not be credited to one's account at the crypto exchange immediately upon being recorded in the ledger. This may be because the exchange does not support that specific cryptocurrency yet. In this case, the IRS will consider the cryptocurrency received later, when the taxpayer can sell, transfer, exchange, or dispose of it after it gets credited into his or her account.
Examples of Hard Fork and Airdrops
  • There can be multiple scenarios of airdropped and hard forked cryptocurrencies. With the IRS still formulating rules around them, 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 below:
  • A new cryptocurrency is created after a network goes through a hard fork, but the units or coins have not yet been transferred into an account that the taxpayer can control. Since no units or coins are credited yet to the taxpayer, there is no taxable gross income at the time of the new cryptocurrency’s creation.
  • Similar to the above example, suppose that units of this new cryptocurrency are airdropped into the taxpayer's wallet address and are immediately available for disposal. In such a scenario, the recipient has what the IRS calls “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 and time when the airdrop gets recorded on the blockchain ledger.