So, your company has generated 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 directly to employees. Because the employee will either need to pay for the tokens or recognize taxable income based on their value, this approach is most attractive when the tokens have relatively little value.
If the tokens are either (i) fully vested when granted or (ii) unvested but the employee timely files a Section 83(b) election, the tax consequences are generally as follows:
- On the grant date: The employee recognizes taxable compensation income, subject to withholding, equal to the fair market value of the tokens less the amount paid for them, if any.
- On the vesting date: No additional tax.
- On sale: Any subsequent appreciation is generally eligible for long-term capital gain treatment if the tokens have been held for more than one year after the grant date.
If the tokens are unvested and no Section 83(b) election is filed, the tax consequences are generally:
- On the grant date: No tax.
- On the vesting date: The employee recognizes taxable compensation income, subject to withholding, equal to the fair market value of the tokens on the vesting date less the amount paid, if any.
- On sale: Any subsequent appreciation is generally eligible for long-term capital gain treatment if the tokens have been held for more than one year after the vesting date.
If the tokens are expected to remain illiquid during the vesting period and could increase substantially in value, accepting a restricted token award without filing a Section 83(b) election can create a significant tax problem. The employee could owe tax as the tokens vest even though there is no market in which to sell the tokens to cover the tax.
For that reason, a Section 83(b) election is worth serious consideration when restricted tokens have a low value at the time of grant.
Restricted Token Units
A restricted token unit, or RTU, is a contractual right to receive tokens in the future. RTUs are typically subject to service-based vesting, with the underlying tokens delivered when the award vests.
If the tokens are delivered at vesting, the employee generally recognizes ordinary compensation income, subject to withholding, based on the value of the tokens at that time.
That can create a liquidity problem. The employee may owe tax before there is a practical way to sell the tokens.
One potential solution is to use a second vesting or settlement condition tied to a liquidity event, so that the tokens are not delivered until there is an opportunity to sell at least some of them to cover the resulting tax liability.
Care is required in structuring this arrangement. In particular, to prevent employment taxes from becoming due when the service-based vesting condition is satisfied, there generally needs to remain a substantial risk that the employee may never receive the tokens.
One way to create that risk is to include an expiration date. If the required token liquidity event does not occur before the award expires, the employee forfeits the right to receive the tokens.
Token Options
Token options are generally taxed in a manner similar to nonstatutory stock options. Assuming the options may be exercised only after they vest, the basic tax treatment is:
- On the grant date: No tax.
- On the vesting date: No tax.
- On the exercise date: The employee recognizes ordinary compensation income, subject to withholding, equal to the fair market value of the tokens on the exercise date less the exercise price.
- On sale: Any subsequent appreciation is generally eligible for long-term capital gain treatment if the tokens have been held for more than one year after exercise.
Token options also present an important Section 409A issue.
Unlike a conventional stock option that qualifies for the Section 409A stock-right exception, a token option needs to comply with Section 409A’s rules governing deferred compensation. That generally means the option may be exercisable only upon one or more permitted payment events, such as the employee’s death, disability, separation from service, a qualifying change in control, or a specified date or fixed payment schedule.
Token options can potentially be granted with an exercise price below the fair market value of the underlying token. But there is a limit to how aggressive the discount should be.
If the exercise price is too low, the IRS could argue that the employee effectively received the token itself rather than a genuine option. In that case, the award could potentially be recharacterized as a restricted token grant, with taxation occurring at grant if the token is vested, or as the token vests absent a Section 83(b) election.
Conservative practitioners may advise against setting the exercise price below 25% of the token’s fair market value. For example, if a token is worth $1.00, they may recommend an exercise price of at least $0.25. That position has support in Supreme Court precedent involving a deeply discounted option that was nevertheless respected as an option.
Based on additional case law, however, I think there is room to go lower. An exercise price equal to 10% of fair market value, or $0.10 for a token worth $1.00, may still be supportable.
At some point, though, the economics stop looking like an option. If the token is worth $1.00 and the exercise price is $0.0001, I think there is a meaningful risk that the IRS could characterize the arrangement as a restricted token grant instead.
Securities Issues
Then there are the securities law issues.
My corporate colleagues tell me that tokens may be treated as securities by the Securities and Exchange Commission. If the tokens are securities and have not been registered, the issuer will generally need an exemption from registration for each issuance.
So, what exemption is available?
For conventional compensatory equity awards, companies frequently rely on Rule 701. Rule 701 generally allows an issuer to issue securities to certain service providers, subject to various eligibility requirements, limitations, and disclosure obligations.
Token structures, however, are often more complicated.
A typical structure might include a top-level offshore foundation, frequently in the Cayman Islands or Panama, with a British Virgin Islands entity underneath it that actually mints the tokens. A separately owned Delaware corporation may employ the U.S. workforce and operate the business.
That structure can create problems for Rule 701. The employees may work for the Delaware company rather than the BVI token issuer, and the token itself is not a security issued by the Delaware employer.
If Rule 701 is unavailable, the issuer may need to rely on another private offering exemption. Depending on the circumstances, those alternatives may include exemptions involving accredited investors, sophisticated purchasers, or offerings accompanied by more extensive private placement disclosure.
The securities analysis should therefore be considered early in the process, particularly if tokens will be issued to a significant number of employees or service providers.
Company Tax Issues
There is also an important corporate tax distinction between issuing stock and issuing tokens.
Section 1032 generally allows a corporation to issue its own stock in exchange for money, services, or other property without recognizing gain or loss. That protection does not generally apply to tokens.
Suppose a Delaware operating company owns tokens with a zero tax basis and transfers those tokens to employees as compensation. The transfer may cause the company to recognize taxable gain based on the value of the tokens.
The company will often have an offsetting compensation deduction, assuming the normal requirements for deductibility are satisfied. But that is still less favorable than issuing the company’s own stock.
When a corporation issues its own stock as compensation, Section 1032 generally prevents the corporation from recognizing gain on the issuance while the corporation may still receive a compensation deduction. The deduction can therefore offset other taxable income.
With tokens, by contrast, the gain recognized on the transfer may consume the compensation deduction. At best, the two amounts may substantially offset one another.
That difference can make token compensation considerably less tax-efficient for the employer than conventional equity compensation.
Tokens Not Yet Minted
Everything above assumes the tokens have already been created.
If the tokens have not yet been generated, see this post.
About the Author
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.