IRS Memo Addresses Blockchain Protocol Upgrades

IRS Releases Memorandum on the Tax Consequences of a Blockchain Protocol Upgrade


On April 21, 2023, the Internal Revenue Service (IRS) released a Chief Counsel Advice memorandum (ILM 202316008), concluding that a protocol upgrade to the consensus mechanism of a cryptocurrency blockchain that did not result in the issuance of new tokens (or coins) did not result in gain, loss or other income to a taxpayer who held cryptocurrency native to that blockchain.

In Depth


On September 15, 2022, Ethereum implemented a protocol upgrade known as “The Merge” whereby Ethereum upgraded from the original proof-of-work (PoW) consensus mechanism to proof-of-stake (PoS). The Merge was one step of Ethereum’s roadmap to better scale itself and adapt to the latest technologies that emerge from research and development. This did not result in any change in ownership for holders of Ether (ETH) tokens, unlike a hard fork, another type of protocol update that may involve the issuance of new tokens (or coins) to preexisting token holders. Ethereum has additional upgrades on its roadmap and just recently completed another protocol update known as the “Shanghai Upgrade,” which involved the final step for Ethereum to move from a PoW to a PoS consensus mechanism.

Ethereum is not the only blockchain to undergo a protocol upgrade. In the same month as The Merge, Algorand announced the implementation of a major protocol upgrade as well. As blockchain technology continues to develop, and as new technologies are created and released, additional protocol updates are anticipated with evolving blockchains (such as Ethereum).

The IRS’s memorandum addressed the federal income tax consequences of a blockchain that underwent a protocol upgrade. While no reference is explicitly made to which blockchain is being referred to, based on the facts provided in the memorandum, it can be inferred that such guidance likely relates to The Merge.

The memorandum considered a simple fact pattern in which a specific blockchain (K) used distributed ledger technology to record transactions involving cryptocurrency based on a particular protocol. The protocol included a consensus mechanism for adding new blocks of transactions to the blockchain, including those involving a particular cryptocurrency (C). A taxpayer purchased 10 units of C and stored the private keys for these units. Later, K changed its consensus mechanism used to select who may validate transactions and add blocks of transactions to the K blockchain from PoW to PoS. The memorandum labeled this change as the “protocol upgrade.” After the protocol upgrade, the K blockchain required that transactions be validated and new blocks be added to the K blockchain exclusively through the new PoS consensus mechanism. The protocol upgrade did not affect or otherwise change the existing transaction history on the K blockchain and new blocks were added to the K blockchain pursuant to the new protocol. Units of the cryptocurrency C remain unchanged, including the 10 units held by the taxpayer. The taxpayer did not receive any cash, services or property as a result of the protocol upgrade.


Code Section 1001 provides rules for the computation and recognition of gains and losses related to the sale or other disposition of property. Gains and losses generally arise from the difference between the amount of money (as well as the value of any property) received from selling or otherwise disposing of property and the taxpayer’s tax basis in that property. Treasury Regulations further provide that when property is exchanged for other property differing materially in kind or in extent, gain or loss may be realized and is treated as income or as a loss sustained. However, an exchange of property is only a realization event if the exchange results in the receipt of property that is materially different from the property transferred. Properties must embody legally distinct entitlements to be materially different. Otherwise, the transfer will not result in a realization of gain or loss.

Code Section 61 provides the rules for gross income. Gross income means all income from whatever source derived, including gains from dealings in property. Generally, all gains that are clearly realized by the taxpayer are included in gross income. This includes when a taxpayer receives property or services that have a greater fair market value than what the taxpayer pays for it. Because this calculation is concerned with the value received, income may be realized in many forms, including money, property or services.


The memorandum’s conclusions on gain or loss treatment and income resulting from the protocol upgrade are straightforward. First, the memorandum concluded that the protocol upgrade did not result in a realization event in which the taxpayer realized gain or loss on the existing 10 units of cryptocurrency C. This is because the existing units of cryptocurrency C were not changed by the protocol upgrade and there was no taxable exchange of units.

Second, the memorandum concluded that the protocol upgrade did not result in the inclusion of income to the taxpayer. This is because there was no accession to wealth resulting from the upgrade; the taxpayer’s 10 units of cryptocurrency C remain unchanged and the taxpayer did not otherwise derive any separable economic benefit from the protocol upgrade, such as cash, services or other property (including other cryptocurrencies).


Although the memorandum deals with a fact pattern that involves a protocol upgrade that does not directly result in a hard fork, the memorandum’s guidance is consistent with Situation 1 of Rev. Rul. 2019-24 and Question 22 of the IRS’s FAQs on Virtual Currency Transactions, both of which provide that if a cryptocurrency went through a hard fork but a taxpayer did not receive any new cryptocurrency (whether through an airdrop or some other kind of transfer), the taxpayer does not have any taxable income. Unlike Situation 2 of Rev. Rul. 2019-24 and Question 23 of the IRS’s FAQs where the IRS ruled that a taxpayer does have taxable income if an airdrop was followed by a hard fork, Situation 1 of Rev. Rul. 2019-24 and Question 22 of the IRS’s FAQs haven’t been viewed as controversial guidance that requires further clarification and such guidance can reasonably be extrapolated to a fact pattern that involves a protocol upgrade that is not a hard fork.

Notwithstanding the above, the IRS’s additional guidance regarding a protocol upgrade (without a hard fork) continues to support the fact that absent (1) a change in an existing property, (2) an exchange of property or (3) the receipt of property (or another separable economic benefit) to a taxpayer, a taxpayer may be able to expect that a protocol update (whether in the form of a hard fork without an airdrop, an update to a consensus mechanism or otherwise) does not result in gain, loss or other income to itself.

The memorandum shows the IRS’s view that guidance related to the taxation of cryptocurrency (and related technologies) is important and is being given priority.