So, your company has generated some tokens (presumably offshore) and you want to use them to compensate employees. Common ways to do so include:
Restricted Tokens
Tokens can be sold or awarded to employees. Since the employee will generally either need to pay for the tokens or pay tax on the value of the tokens, this alternative is usually only used when the tokens are worth very little.
If the tokens are (i) fully vested, or (ii) unvested, but a tax code Section 83(b) election is filed, then the tax consequences are as follows:
- On the grant date: Taxable income, subject to withholding, equal to the difference between the fair market value of the tokens at such time and the amount paid, if any.
- On the vesting date: No tax.
- On sale: Long-term capital gain if held for more than 1 year after the grant date.
If the tokens are unvested and no tax code Section 83(b) election is filed, then the tax consequences are as follows:
- On the grant date: No tax.
- On the vesting date: Taxable income, subject to withholding, equal to the difference between the fair market value of the tokens on the vesting date and the amount paid, if any.
- On sale: Long-term capital gain if held for more than 1 year after the vesting date.
If the tokens are going to be illiquid during the vesting period, and it is expected that value may increase significantly during such time, it generally does not make sense to accept a restricted token award unless you plan on filing a tax code Section 83(b) election.
Restricted Tokens Units
A restricted token unit, or RTU, is a contractual right to a token grant in the future, that is generally subject to service-based vesting with the tokens issued as it vests.
Assuming the tokens are delivered at vesting this award causes ordinary income tax, subject to withholding, on the value of the tokens at the time of vesting.
As such, it generally makes sense to create a second vesting trigger tied to the liquidity of the tokens, such that the tokens are only delivered at a time when you can sell them to cover your tax hit.
In such case, to prevent employment tax from being due on such RTUs at the time service-based vesting occurs, there needs to be a substantial risk that the tokens may ultimately never be delivered. This risk is generally created by putting an expiration date on the award, and if the token liquidity event doesn’t occur during such term, then the tokens are never delivered.
Token Options
Token options are taxed as nonstatutory stock options. Assuming they are only exercisable after they’ve vested, this means:
- On the grant date: No tax.
- On the vesting date: No tax.
- On the exercise date: Ordinary income, subject to withholding, equal to the difference between the fair market value of the tokens on the exercise date and the exercise price.
- Sale of tokens: Long-term capital gain if held for more than 1 year after the exercise date.
To comply with tax code Section 409A, a token option may only be exercisable on one or more of certain allowable events, including, the employee’s death, disability, separation from service, a change in control of the company, or a fixed date (which can be as broad as a calendar year but which cannot span calendar years).
Token options can be granted with an exercise price lower than the fair market value of the underlying token. However, folks worry that if you discount the exercise price too low, the Internal Revenue Service might try to recharacterize the award as a restricted token grant, taxable on grant if it is vested or a tax code Section 83(b) election is filed, otherwise taxable as it vests.
Conservative practitioners will tell you not to discount below 25% of fair market value. So, for example, if the current fair market value of the token is $1.00, do not set the exercise price below $0.25. This is based off of a Supreme Court case where such an option was respected. However, based on additional case law, I think you can easily go down to 10%, or $0.10 in our example, without a problem. If on the other hand, the exercise price was $0.0001 and the token was worth a $1.00, now I think you may have a restricted token grant.
Securities Issues
My corporate colleagues tell me that it is likely that tokens are considered securities by the Securities Exchange Commission, and thus if unregistered, one would need a securities exemption for each issuance. So, what exemption can we use?
Usually, for compensatory equity issuances, we rely on Rule 701, which allows an issuer to issue stock to its service providers, provided they are natural persons and certain limits are adhered to. However, a typical token structure involves on one side a topco foundation (often Cayman, or Panama) with a British Virgin Islands entity underneath it, with the BVI entity actually minting the tokens and then as a separately owned entity a Delaware operating company.
This potentially makes Rule 701 unavailable, because the employees are not always employees of the BVI entity and the token is not a security of the Delaware company. If Rule 701 is unavailable, you’re left relying on other securities exemptions, like the exemption for accredited investors, sophisticated purchasers (which I’m told should be limited to 6 folks), or those purchasing tokens after receiving a private placement memorandum (which I’m told should be limited to 35 folks).
Company Tax Issues
Tax code Section 1032 allows a company to issue their own stock for services, cash, or other property in a tax-free manner. This exception does not apply to tokens. As such, if a Delaware operating company issues tokens in which it has a $0 basis to employees, that will trigger taxable income to the Delaware company equal to the value of the tokens. There will usually be an offsetting compensation deduction, but keep in mind, this is still not as favorable to the Delaware company as issuing stock, because in that case it can get the compensation deduction and have no tax, so the stock issuance can actually shield other income from tax, whereas at best the token issuance nets to zero.
Tokens not yet Minted
The above assumes that the tokens have been created. If the tokens have not been generated yet, keep an eye out for a future post on future token contracts, which will describe a potentially tax favorable alternative.
Mike Baker frequently advises with respect to the use of tokens as compensation. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.