Blockchain is a revolutionary technological tool in the way it tracks and stores data, decentralizes information, establishes trust in electronic files, and dispenses of intermediaries. This technology powers virtual currencies, also known as cryptocurrency or virtual tokens. Companies are raising money using “initial coin offerings” (ICOs) and using tokens to compensate and incentivize founders, directors, employees, and consultants. This raises legal questions as to how the tokens will be viewed and regulated by the Internal Revenue Service (IRS) and the U.S. Securities and Exchange Commission (SEC).
How are employers using tokens in an employment context? They are being used like equity or phantom-equity awards, granted as compensation for past or future services. They may be subject to vesting based on continued service or achievement of performance targets, and acceleration of vesting can be triggered based on designated events, such as the occurrence of a change of control transaction, the termination of an employee without cause, or the achievement of technical milestones. If an employee quits, the employer has the right to repurchase any remaining restricted tokens that have not yet vested.
Token-based awards tend to copy traditional equity-based awards. The standard token award grants tokens outright to the recipient or gives the recipient the right to buy tokens. “Restricted tokens” are not accessible until vested. “Token options” provide the employee the right, but not the obligation, to purchase a pre-determined number of tokens at a pre-set price, which can be subject to vesting. Finally, employers can issue “restricted token units,” which are promises to pay property (typically, tokens) to the employee in the future, usually after time or performance-based vesting conditions are met.
As with any form of innovation, there are challenges. The IRS has released guidance indicating that tokens issued to individuals in exchange for services would generally be treated as compensation subject to income and payroll taxes under the Internal Revenue Code and reported on Form W-2. Therefore, employers issuing tokens to employees and other service providers must determine the fair market value of the tokens in US dollars to properly report it.
However, it is interesting to note that the IRS does not treat tokens as currency; rather, the IRS views tokens and other cryptocurrencies as property. Therefore, depending on the type of award, the recipient may want to file an election with the IRS to tax the award at the time of grant (an “83(b) election”), although this can be risky if the tokens are later forfeited or fall in value.
The IRS has not issued guidance regarding whether token options are subject to Section 409A of the Internal Revenue Code, so issuers should assume that token options are subject to Section 409A, and should comply with Section 409A. Restricted token units should also be designed with Section 409A compliance in mind.
In addition, the SEC broadly categorizes all token offerings issued to raise money as securities. Therefore, employers who issue token-based compensatory awards should follow Rule 701 or other exemptions from registration under the Securities Act, as well as applicable state securities laws.
The takeaway is that the same tax, securities, and other rules that apply to compensatory equity awards may apply to compensatory tokens.