Ethereum Merge – Soft Fork for Now?

Cadwalader, Wickersham & Taft LLP
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Cadwalader, Wickersham & Taft LLP

Without an apparent hitch, Ethereum effected its Merge on Thursday, September 15, 2022 whereby the blockchain platform switched its validation from proof-of-work (“POW”) to proof-of-stake (“POS”). The switch will reduce the high environmental impact of POW by removing the need for massive computer power to solve the mathematical problems associated with POW validation. Whether other benefits result (such as reducing transaction costs and increasing capacity) remains to be seen. 

The tax question is whether the Merge gives rise to a taxable event for owners of ETH. For many, the answer, for now, is apparently not. In the Internal Revenue Service’s parlance, is the Merge a “hard fork” (and potentially a taxable event) or “soft fork” (generally not a taxable event) as defined in IRS FAQs (reproduced here)? The IRS has generally defined “forks” as protocol changes with the distinguishing feature that “hard forks” are protocol changes that give rise to a new “ledger” while the legacy ledger continues in existence (i.e., generally continuation of the old cryptocurrency and receipt of a new cryptocurrency tracked on a new ledger). In the FAQs and rulings, the IRS has issued guidance that “soft forks” do not give rise to taxable income, while “hard forks” may give rise to taxable income when the taxpayer has dominion and control over the “new” cryptocurrency, as discussed here and here

While the Merge clearly involves protocol changes, it appears that, for many, Ethereum continues to utilize the existing ledger, and no new ledger or distinct new form of ETH has been created (at least for now). On its face, the Merge appears to be “soft fork” that may not give rise to a taxable event for owners of ETH (producing either deemed gain or deemed loss). However, there appear to be some exchanges that are maintaining a POW platform, and users holding on these exchanges may be receiving POW-ETH. In this case, a “hard fork” and airdrop may have occurred, and taxes may need to be accounted for.

Moreover, the IRS has not provided guidance directly on point, and its broad baseline of “protocol change” as the starting point for whether a “fork” has occurred could lead to the argument that the post-Merge ETH could be a new cryptocurrency distinct from pre-Merge ETH. Given the centrality of validation and decentralization to cryptocurrency, it might be argued that a ledger based on POS is different from a ledger based on POW, and the post-Merge ETH is different from the pre-Merge ETH. The IRS would be stretching if it pursued this line of argument.

Even if the IRS were to pursue a strategy of treating the Merge as giving rise to a taxable event, it may be a pyrrhic victory. With the current market capitalization of ETH at approximately $166 billion and prior lows and highs ranging between $120 billion and $456 billion during 2022, treating the Merge as a taxable event could give rise to a mix of outcomes that may not benefit the IRS. Given the large market correction during 2022, owners of depreciated ETH may have an aggregate tax loss that dwarfs the amount of phantom gain that owners of appreciated ETH may be forced to recognize upon the Merge.  

For now, unless the IRS attempts to redefine a “hard fork,” the Merge, for many, appears to be a nonevent for tax purposes. This conclusion could be tested, however, if market reactions (including those of certain exchanges and miners) to the Merge give rise to new ledgers and “hard forks.”

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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