DISCLOSURE: This publication contains general information only and LiquiFi, Inc. (“Liquifi”) is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer, or solicitation for the purchase or sale of any security. Liquifi does not assume any liability for reliance on the information provided herein.
Withholding tax accurately is the legal responsibility of the issuing company. Liquifi provides tools and support to help you navigate compliance, but consult your legal and tax advisor if you have tax-related questions.
Tax withholding for tokens
Employers are legally required to withhold taxes for tokens used for compensation. Since tokens hold financial value, they’re considered taxable income.
Dealing with taxes on token compensation gets complicated quickly. Different factors like the type of token grant you use (restricted tokens, restricted token units, or token options), your place(s) of employment, and certain tax elections (Section 83b) can significantly affect the end tax calculation.
The stage of your project, the value of your tokens, and the desired timing of your tax liability decide the token grant you use. Operators must understand these nuances. Otherwise, they incur costly expenses and take on significant risks.
Solutions like Liquifi reduce your administrative overhead, staffing needs, and compliance risks from calculating and tracking token payroll taxes on your own.
Our previous article covered implementing and structuring tokens as a part of your overall compensation. This article will focus on the payroll tax and legal implications of token compensation. Before you read further, check with your legal and tax advisor to see if payroll taxes on token-based compensation apply to you.
Why are payroll taxes for tokens required?
In the US and certain countries, employers are required by law to withhold their employees' income tax, also known as payroll tax.
The amount of payroll tax an employer withholds from an employee's paycheck depends on two things:
- The amount the employee earns.
- Adjustments from Form W–4, filled out by the employee. (US-specific)
These payroll taxes include various taxes such as the federal income tax, Social Security tax, Medicare taxes, and state income tax.
While there is no formal guidance on payroll taxes for tokens, we've seen operators take the conservative route and apply existing frameworks and interpretations of income taxes for other types of non-cash income (equity, property, employee benefits, etc.).
Once again, we want to emphasize that any opinion or observations of token-related regulation are not legal, financial, or tax advice.
The four main types of token compensation
Crypto companies use these four types of compensation structures:
- Future token awards
- Restricted tokens
- Restricted token units
- Token options (or warrants)
Future token awards are given to employees before a token is minted. It provides employees the conditional rights to receive a token if and when a protocol launches a token.
Restricted tokens generally work best for early-stage protocols after the token is minted, the token valuation is low, and beneficiaries can leverage the 83(b) election to decrease the future tax burden.
Restricted token units are more commonly used for developed protocols with a higher price or valuation for their live token.
Token options (or warrants) can be used in certain circumstances, even before the token is minted, with the 83(b) election. It offers optionality for employees to decide if they want to exercise their options and the timing of the tax liability.
Token options/warrants are the least frequently used for employees of the four types. It’s more commonly seen with investors and is becoming less used.
As always, consult your counsel to see which token compensation type is best for you and how to navigate this compliantly.
Future token awards
TLDR: Seen most commonly at early-stage companies before the protocol has a token.
What is it?
Future token awards are the rights to receive future tokens if and when the protocol launches a token. It's useful because it assures employees that they'll receive tokens as a part of their employment agreement.
However, companies do not always use future token awards as the team may not know if and when they want to launch a token until a much later after an employee's hiring. In addition, launching a token is operationally tricky and carries regulatory risks, so we often advise holding off on token awards until there is a clear path and plan to launch a token.
How is it taxed?
Generally, there is no tax liability because the tokens do not yet exist and have no financial value. However, you may be taxed when a price or valuation for future token awards is set in certain situations, such as a priced token fundraising round. These scenarios have significant tax implications that require careful planning and structuring with your tax and legal counsel.
TLDR: Seen most commonly at early-stage companies with a live token for founders and early employees when the valuation of the tokens is low.
What is it?
Restricted tokens are the token equivalent of restricted shares or restricted stock awards. Tokens are sold or awarded to employees with certain vesting or milestone terms. Companies use restricted tokens when the token is live, usually when the tokens are minted or shortly after that when the value is low.
How is it taxed?
Restricted tokens are most commonly used as a tax-favorable strategy with the 83(b) election for founders and early-stage employees when the value of the tokens is comparatively low. When you file an 83(b) election, you pay taxes on the initial value of the grant. There is no additional tax liability upon vesting, which avoids the overhead of tax compliance when tokens are delivered.
If you do not file the 83(b) election, then tokens are taxed at vesting instead of at the time of grant. The taxable income is based on the difference in fair market value of the tokens at the time of vesting and the amount paid for the tokens.
Section 83(b) tax election
The Section 83(b) election is an IRS provision used to shift forward tax liability so that future gains are treated as capital gains instead of traditional (higher) income tax. Electing to file an 83(b) means the timing of tax liability of the asset is at the time of grant. As a result, there is no additional tax liability upon vesting and only capital gains upon sale.
83(b) elections could be favorable when the asset price or valuation is low during the grant period and expected to rise in value over time. For founders and early employees at high-growth startups, there are significant tax savings from accelerating tax liability when the value of the tokens is comparatively low. However, there are downsides and risks, mainly that they may be paying a tax liability on an asset not guaranteed ever to have a material gain or increase in value.
83(b) elections only explicitly apply to restricted stock awards and early exercisable stock options. We're still in a gray area on whether the 83(b) election applies to tokens. Please consult legal counsel and tax advisor for specific guidance.
Restricted Token Units
TLDR: Seen most commonly at later-stage companies with a live token or with high fair market valuations.
What is it?
Restricted token units (RTU) are the token equivalent of restricted stock units. Tokens are distributed per a vesting schedule and are only considered taxable after distribution.
RTU is a contractual right to a token grant in the future. The employer maintains ownership of the tokens until distribution. As a result, RTUs are not applicable for an 83(b) election.
How is it taxed?
RTUs are taxed at the time of vesting and delivery, and not at the time of grant. The value of the tokens at vesting is considered taxable income and is subject to withholding rules.
As mentioned above, the withholding rate depends on the employee's earnings and any personal adjustments from Form W-4. Because of the nuances of calculating tax withholding, it's imperative to keep track of historical cost basis and token value at the time of grant, vest, and distribution. Failure to track your token tax liabilities can result in costly penalties.
Why should you go with the RTU?
The advantage of the RTU is the ability to delay and manage the timing of tax liability. For example, it can be cost-prohibitive for employees to accelerate the tax liability for tokens with a high fair market valuation or price. With the RTU, employees can offset the tax liability with token sales upon delivery (i.e., sell tokens when you receive them to cover any tax liabilities).
Given the day-to-day volatility of crypto token prices, it's common to see tax liabilities being much higher than the value of the tokens when the price goes down after the vesting date. As a solution, the tax liability can also be deferred on additional milestones like sufficient trading value or liquidity. The deferral tactic is also known as double-trigger vesting. Structuring vesting around the trading value or sufficient liquidity helps mitigate some of the risks and impact of price volatility.
Definition of delivery and time of delivery for RTUs
A critical factor for RTUs and the associated tax liability timing is the definition of 'delivery'. Some consider the delivery date to be the date of vesting since that’s when you “earned” the tokens. Other companies and jurisdictions define it as the date of receipt (the tokens delivered to the end-user’s wallet). The implications are significant and will materially shape your processes for tracking the appropriate date and price of the tokens. Again, consult your legal and tax advisor for guidance.
Token Options or Warrants
TLDR: Seen most commonly with companies without a live token and want to accelerate tax liability.
What is it?
Token options or warrants are the token equivalents of stock options. They give employees the right to buy tokens at a specified price within a certain period. This specified purchase price is also known as the exercise, grant, or strike price. The period for purchasing tokens is known as the exercise window.
How is it taxed?
Token options are not taxed upon grant or vest. Instead, token options are taxed when exercising the options based on the fair market value of the tokens on the exercise date and the strike price.
If an early exercise clause exists and 83(b) election is filed, then token options are taxable based on the difference in the fair market value of the tokens at the time of grant and the amount paid for the tokens, if any.
Token options are less common but may offer particular advantages that restricted tokens or restricted token units do not - namely, the flexibility of exercising options and the tax considerations for doing so.
Token options may also have additional compliance requirements, like obtaining an independent valuation, similar to Section 409a. Consult a token valuation or legal expert to see if getting a token valuation is applicable.
US-based vs. International Token-based Compensation
Beyond the structure of your token compensation, another consideration is US-based vs. International compliance for tokens. Each jurisdiction is different, and there may be rules on whether tokens are a valid form of compensation and tax rules for token compensation. Employers must take this into account and ensure they comply with all employment rules.
Most commonly, we’ve seen companies opt to avoid tax compliance challenges for international employees by only including token-based compensation for independent contractors. Because independent contractors are usually responsible for managing their tax liabilities and calculations, it makes it much easier for companies to provide token compensation without incurring administrative overhead and compliance burdens.
DAO structures that operate with independent contractors rather than having a formal entity with full-time employees offer the benefit of reducing tax compliance overhead.
Compliance with local tax regulations can be challenging for crypto companies using token-based compensation. Contact Liquifi to see how we can help you navigate this process.
Valuation of tokens for calculating taxable income
Because calculating taxable income and tax liabilities depend on the tokens' FMV (fair market value), valuations may be required as a part of your token-compensation process.
However, getting a third-party valuation and assigning a market value for tokens can have significant consequences and considerations. Our advice here is to note this as something to keep in mind and involve experts for guidance on whether you should or should not move forward with a valuation process.
While Liquifi cannot give formal tax/valuation advice, please consider reaching out to a valuation expert like Redwood Valuation and Teknos Associates and a tax advisor of your own.
There are three scenarios where you may need to obtain a token valuation:
- Pre-launch of tokens
- Launched but low trading liquidity
- Launched and highly liquid
Consider a valuation when your token is pre-launch, and you're using future token rights and need to set a strike price for token options based on a fair market value.
Launched but low trading liquidity
Another case where token valuations are essential is when your token is public but has low trading liquidity and is highly volatile. For example, if your token swings from 5 cents to 50 dollars in a given day, what is the appropriate price to calculate taxable income? A third-party valuation expert can provide a set methodology or price for a fair market value and cost basis.
Launched and highly liquid
For highly liquid tokens, we see companies using publicly aggregated price feeds from Chainlink, Coinmarketcap, Coingecko, and market-makers. These prices are used to calculate the taxable income and tax withholding. In this case, the value is set by publicly available market data.
Liquifi can help you implement secure and compliant token-based compensation
When properly implemented, token compensation can help you better hire, retain, and align your team. However, it’s crucial to exercise careful risk management and use trusted processes to navigate tokens’ tax and legal compliance.
Liquifi is the leading provider of token vesting and token cap table solutions. We help you quickly pay your employees with tokens while navigating the complexities of tax compliance.
Get started with Liquifi today.