Ethereum (ETH) hodlers that don’t play their cards right following the Ethereum Merge may be in for a hefty bill come tax time, according to tax experts.
Around Sept.15, the Ethereum blockchain is set to transition from its current proof-of-work (PoW) consensus mechanism to proof-of-stake (PoS), aimed at improving the network’s impact on the environment.
There is a chance that The Merge will result in a contentious hard fork, which will cause ETH holders to receive duplicate units of hard-forked Ethereum tokens, similar to what happened when the Ethereum and Ethereum Classic hard fork occurred in 2016.
Tax compliance firm TaxBit Head of Government Solutions, Miles Fuller told Cointelegraph the Merge raises some interesting tax implications in the case that a hard fork occurs, stating:
The biggest question for tax purposes is whether the Merge will result in a chain-splitting hard fork.
“If it doesn’t, then there are really no tax implications,” explained Fuller, noting that the current PoW ETH will just become the new PoS ETH “and everyone goes on their merry way.”
However, should 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.”
“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,” he explained.
The performance of the PoW token can also impact the potential tax bill, according to an Aug. 31 Twitter post from CoinLedger Director of Strategy Miles Brooks.
“If the value of the tokens goes down severely subsequent to the PoW fork (and after you have control over them) — which could be likely — you may have a tax bill to pay but potentially not enough assets to pay it.”
Brooks suggested it may be in an investor’s best interests to sell some of the tokens upon receiving the forked coin, which can ensure that at least the tax bill is covered.
7/ What can you do to prepare? If a ETH PoW fork does happen, you’re going to want to know if you’re eligible for the fork, because it may be in your best interest to sell some of these tokens when received to make sure you have enough for the associated tax bill!
— CoinLedger (@CoinLedger) August 30, 2022
There has been a growing push by Ethereum miners and some exchanges for a PoW hard fork to occur, as without a hard fork these miners will be forced to move to another PoW cryptocurrency.
Vitalik Buterin suggested at the 5th Ethereum Community Conference held in July that these miners could instead go back to Ethereum Classic.
Contrary to what is suggested in the associated CoinLedger article, the post-merge Ethereum will not be called ETH 2.0, but simply ETH or ETHS, with any potential forked token referred to as ETHW.
Crypto investors should be wary of any tokens that claim to be ETH 2.0 post-Merge.
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.
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.”