Are Tokens the New Equity?
For years, many startup and small-cap companies have used stock options to reward employees and pay them for specified services. As partial ownership shares in the company, stock options have enabled such companies to retain founders, directors, employees, outside consultants and other service providers during the early years without having to outlay large sums of cash for salaries.
Now, in today’s digital age, blockchain “tokens” (also called “virtual tokens” or just “tokens”) are fast emerging as an alternative to stock options. In this context, a token can best be described as a digital unit that a company uses to achieve some end result (e.g., compensation, reward).
Tokens as compensation offer many of the same benefits as stock options. Similarly, they also carry legal and tax implications, so any business that is considering using tokens as compensation should follow related best practices with respect to each area. Below, we’ve highlighted some of the key tax considerations.
- With stock options, it’s necessary to withhold the appropriate taxes (e.g., income and payroll). The same applies to tokens. You may pay people in virtual tokens, but the IRS wants taxes withheld in old-fashioned U.S. dollars. This applies to payroll, federal and state income tax. Specific amounts vary based on jurisdiction, as well as the specific arrangement with employees (e.g., paying a certain amount of tokens versus paying in tokens related to a U.S. dollar value).
- If restricted token units are used (restricted tokens being tokens subject to vesting based on continued service or achievement of performance targets), their fair market value at the time of settlement (i.e., the time at which they vest) is treated as compensation to the employee at ordinary tax rates. The eventual tax consequences of any appreciation or depreciation of those tokens, at ordinary rates or capital gain rates, depends to a large extent on how long the employee holds them.
- With regard to vesting schedules, things get a bit more complex. A typical token award is taxed at the fair market value when the award occurs (i.e., the recipient is fully vested, and there are no stipulations for vesting). If the awards are restricted and vest equally over, say, four years, the recipient is taxed once the token vests, which could be significantly greater than the value at the grant date. That’s where a Section 83(b) could be beneficial.
- A Section 83(b) election may be filed so that a token recipient pays ordinary income tax on the fair market value of the tokens at the date they were granted, instead of over the four-year period that precedes their vesting. A Section 83(b) offers two primary potential advantages:
- It could save the recipient taxes over the lifetime of the vesting;
- It starts the clock sooner on qualifying the tokens under capital gain status of one year.
The downside to a Section 83(b) election is that if the recipient forfeits the awarded restricted tokens, they cannot get that prepaid tax they paid based on the value at grant date.
- Security tokens differ from utility tokens, and restrictions apply, so know the differences and plan accordingly. A virtual token can be one of two things: a security token (i.e., essentially a security), or a utility token (i.e., not subject to SEC regulations and intended for a specific purpose). Today, many companies filing initial coin offerings (ICOs) have been claiming that their token is a utility token; as such, they’ve argued they aren’t subject to compliance with SEC guidelines concerning raising money. The SEC, meanwhile, argues that in most cases, they indeed are security tokens, and consequently, the issuer must comply with SEC regulations. Currently, SEC guidance on the distinction is evolving. Given this, most experts agree that if issuers claim their tokens are utility tokens, they should be absolutely certain of their position.
Through the years, experts have used the Howey Test to gauge whether stocks and other conventional investments fall under the category of securities. Today, tokens are being evaluated using this test. Many industry veterans believe that an agreement to acquire a utility token in the future constitutes an investment contract (as per Howey), and therefore is a security regulated under the Securities Act.
If your company is interested in pursuing token compensation within its compensation framework, your team should evaluate all options with tax-driven advantages. That said, it is imperative to work with qualified legal and financial counsel to ensure agreements are properly written and structured, and all tax considerations are accounted for.