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The Merge: Will Ether Holders Have a Taxable Event Upon a Successful Merge?

By Jeffrey M. Glassman on September 15, 2022
Today marks a day years in the making in the crypto world. Today, the Ethereum blockchain is scheduled to convert from a Proof of Work system to a Proof of Stake system. This is commonly known as “the Merge.” As background, a Proof of Work system relies on miners expending massive amounts of energy to create—or “mine”—new blocks in a blockchain. A Proof of Stake system, on the other hand, relies on people staking their cryptocurrency—essentially locking it up from trading for a period of time. Those who stake a sufficient amount of cryptocurrency are then able to validate transactions for, and add new blocks to, the blockchain. Both miners and stakers receive rewards in the form of cryptocurrency for their efforts.

If “the Merge” is successful, the Ethereum blockchain should be considered to have undergone a “soft fork,” which is essentially a software update to the blockchain. UPDATE: Preliminary reports are that the Merge has occurred and was successful. Those who hold Ether (the cryptocurrency on the Ethereum blockchain) will still hold Ether after the soft fork. Fortunately, the IRS has said that soft forks are not taxable events.

In the IRS’ cryptocurrency FAQs (link) the IRS states:

Q30. Do I have income when a soft fork of cryptocurrency I own occurs?

A30. No. A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and thus does not result in the creation of a new cryptocurrency. Because soft forks do not result in you receiving new cryptocurrency, you will be in the same position you were in prior to the soft fork, meaning that the soft fork will not result in any income to you.
That is unfortunately where the good news ends for taxpayers, as there are some miners in the Ethereum Proof of Work system who wish to see the Proof of Work system continue—quite possibly because they wish to continue to receive mining rewards. These people have created a new Ethereum Proof of Work blockchain that may launch around the same time as the Merge. If the new Ethereum Proof of Work blockchain successfully splits from the Ethereum blockchain, it should result in what is known as “hard fork.” As background, a hard fork occurs when a blockchain splits into one or more blockchains—i.e., not just a software update to one blockchain. If the hard fork results in new cryptocurrency being sent (commonly known as an “airdrop”) to, and received by, Ether holders, the IRS is likely to believe that those people have taxable income. (The concept of “receipt” has some nuance that is beyond the scope of this article.)

Below is what the IRS says regarding hard forks in its FAQs:

Q22. One of my cryptocurrencies went through a hard fork but I did not receive any new cryptocurrency. Do I have income?

A22. A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger. This may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. If your cryptocurrency went through a hard fork, but you did not receive any new cryptocurrency, whether through an airdrop (a distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses) or some other kind of transfer, you don’t have taxable income.
This is certainly an issue worth monitoring. Whether the IRS’ conclusions regarding the taxation of airdrops are correct is an open question and one I would expect to be challenged by taxpayers. But it bears noting that in pending legislation (i.e., not law) in Congress (link), airdrops would not be taxable until a taxpayer claims the airdrop and disposes of its value.

If you have any questions about this article, digital assets, or any other federal tax matter, please contact me at jglassman@meadowscollier.com or 214-749-2417.