Introduction

One question that should be on the minds of every holder of Ethereum is: Will there be any tax liability created as a result of the ‘merge’? However, the problem is that no one can give a definitive answer to the question until the ‘merge’ takes place and plays out.

That’s right folks, there is no way to determine whether or not you will owe taxes on the proceeds of the merge until after it happens. But, we can discuss the possible tax situations that can result from this ‘merge’.

In General, Is the Conversion of Ethereum (PoW) to Ethereum (PoS) a Taxable Event?

In short, the answer to this is: if there is no distribution of tokens beyond the new Ethereum (PoS) token, there will be no taxable event to cause a tax liability.

Basically, if the ‘merge’ proceeds within the team’s basic parameters and results in producing merely an Ethereum token based on Proof of Stake instead of Proof of Work, from a tax standpoint essentially a ‘soft fork’ has occurred. Such a ‘soft fork’ is described in IRS FAQ 30, which provides:

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.

[IRS. Frequently Asked Questions on Virtual Currency Transactions. (Accessed September 3, 2022)].

[Of parenthetical note: “In 2014, the IRS issued Notice 2014-21, 2014-16 I.R.B. 938, explaining that virtual currency is treated as property for Federal income tax purposes and providing examples of how longstanding tax principles applicable to transactions involving property apply to virtual currency. The frequently asked questions (“FAQs”) below expand upon the examples provided in Notice 2014-21 and apply those same longstanding tax principles to additional situations” [Id].

So, “[g]eneral consensus in the crypto community says that Ethereum 2.0 is completely replacing the original Ethereum […] The IRS has acknowledged that this type of “soft fork” does not result in the creation of a new cryptocurrency and thus does not create a taxable event” [Gordon Law Group. Ethereum 2.0 Tax Guide. (Accessed September 3, 2022)].

In the Event of a Hard Fork Get Ready to Pay the Taxman

While there is a waiting period for the Merge, many have expressed concerns over some potential hard forks. In addition, the Ethereum network still has some miners operating on the system, creating more tension within and outside the community. With the completion of the Merge, the miners could move over to Ethereum Classic, which is still operating as a PoW. But if they continue to work on the Ethereum blockchain, they would hard fork the chain. In a recent report, some Ethereum miners have declared a technology for freezing liquidity pools. This came mainly from the ETHPOW group. This group of miners plans to hard fork the Ethereum blockchain after its transition.

[Denis. Ethereum Miners To Freeze Liquidity Pool After Hard Fork. (Accessed September 3, 2022)].

Although the above may sound somewhat ridiculous, it can not be dismissed as beyond the realm of possibility. In any event, this September 15 ‘merge’ is not the completion of the Ethereum ‘grand scheme’. With the waiting periods built into the timeline, a lot could happen, including a hard fork creating a new separate and distinct token of Ethereum based on Proof of Work that would be distributed to token holders 1:1 based on their immediate pre-merge holdings.

Should this scenario play out and in fact a hard fork is realized, the IRS would recognize the dropped coin as income and therefore a taxable event. IRS FAQ 23 is clear:

If a hard fork is followed by an airdrop and you receive new cryptocurrency, you will have taxable income in the taxable year you receive that cryptocurrency. 

[IRS, supra].

NOTE “the airdrop is taxed as income rather than a capital gain” [Gordon Law Group, supra].

Of course the IRS provides you with directions on how you should calculate income derived from a hard fork. IRS FAQ 24 provides:

When you receive cryptocurrency from an airdrop following a hard fork, you will have ordinary income equal to the fair market value of the new cryptocurrency when it is received, which is when the transaction is recorded on the distributed ledger, provided you have dominion and control over the cryptocurrency so that you can transfer, sell, exchange, or otherwise dispose of the cryptocurrency.

[IRS, supra]

Now if you are really following along, IRS FAQ 24 creates quite a bit of confusion. Miles Fuller, head of government solutions from the Tax compliance firm TaxBit told Cointelegraph:

[S]hould a hard fork occur, meaning ETH holders are sent duplicate PoW tokens, then a variety of tax impacts may fall out “depending on how well supported the PoW ETH chain is” and where the ETH is held when the fork occurs. For ETH held in user-owned on-chain wallets, Fuller points to IRS guidance stating that any new PoW ETH tokens would be regarded as income and will be valued at the time the user came in possession of the tokens. Fuller explained the situation may be different for ETH held in custodial wallets, such as exchanges, depending on whether the platform decides to support the forked PoW ETH chain, noting: “How custodians and exchanges handle forks is generally covered in your account agreement, so if you are not sure, you should read up.”

[Huigsloot, L. Ethereum Merge and the hefty tax bill you could be in for. (Accessed September 3, 2022)].

Fuller clarifies this by explaining: “If the custodian or exchange does not support the forked chain, then you likely don’t have any income (and may have missed out on a freebie). You can avoid this by moving your holdings to an unhosted wallet pre-Merge to ensure you get any coins (or tokens) resulting from a possible chain-splitting fork” [Id].

Miles Brooks, Director of Strategy at CoinLedger, in a tweet suggests that the post issue performance of the PoW token may ultimately impact the size of your tax liability and suggests you consider the sale of some tokens so issued to cover the tax owed:

Photo Source

Final Thoughts

“The cryptocurrency exchange Poloniex, which claims it was the first exchange to support both Ethereum and Ethereum Classic, has given its support to a hard fork and has already added trading for ETHW.” [Huigsloot, supra]. Nonetheless,

Cryptocurrency exchange Bybit told Cointelegraph that in the event of forked tokens, Bybit’s risk management and security teams have criteria in place to determine whether a PoW token would be listed on their exchange. Bybit claims that exchanges already listing ETHW tokens are putting profits over user safety, and caution traders against moving their ETH to exchanges that are supporting the PoW tokens due to volatility and security risks: 'We caution traders that the potential Ethereum PoW forks may be extremely volatile and entail increased security risks. Exchanges that are already listing tokens for potential PoW forks are putting profits over user safety.”

[Id].

So please exercise extreme caution with regard to this Ethereum ‘merge’ - your hard earned dollars could be at risk.