Questions surrounding the use of virtual currencies and other digital tokens ("tokens") as compensation came to the forefront last month following formal guidance from the U.S. Securities and Exchange Commission ("SEC") on token offerings.
Our previous client alert discussed the SEC's guidance on token offerings, also known as initial token offerings, token launches, token sales, or initial coin offerings ("ICOs"). Tokens represent a new method being explored by emerging companies, funds and corporations to raise capital, both quickly and from a broad investor base.
This alert discusses the U.S. federal income tax consequences to employees (and other service providers, including directors, consultants and other advisers) who receive compensation in the form of tokens. This alert does not address whether the tokens constitute "securities" under U.S. federal securities laws. Please see our previous client alert on the SEC's guidance regarding whether tokens constitute securities under U.S. federal and state securities laws.
In March 2014, under Notice 2014-21 ("Notice"), the U.S. Internal Revenue Service ("IRS") issued formal guidance on the taxation of "convertible virtual currencies," which the IRS defined as virtual currencies that have an equivalent value in real currency, or that act as a substitute for real currency. The guidance is brief, providing 16 questions and answers including several important questions and answers on the taxation of convertible virtual currencies paid as compensation. To date, the Notice remains the only official guidance on convertible virtual currency—or any other digital token—tax issues released by the IRS; no further guidance has followed. Since the Notice's publication, virtual currencies and other kinds of tokens have proliferated (the market capitalization of virtual issuers has been reported to exceed $100 billion), and we believe the guidance provided by the Notice may also apply to digital tokens that do not fall within the definition of a "convertible virtual currency."
The Notice provides that convertible virtual currencies will be treated as "property" (and not foreign currency) for federal tax purposes, and that general tax principles related to property transactions will govern transactions involving convertible virtual currencies. In doing so, the United States joined other jurisdictions (at the time, Australia, Canada and Japan) in treating convertible virtual currencies as property for tax purposes.
Consequently, until the IRS issues further guidance, the U.S. federal income taxation of tokens paid as compensation will typically be governed by Section 83 of the U.S. Internal Revenue Code ("Code"). Section 83 generally governs the compensatory taxation of property paid for services rendered to an employer, such as restricted stock and nonstatutory stock options. Certain related sections of the Code, which among other things govern the compensatory taxation of restricted stock units, will also be implicated. Employers thus have the general flexibility to design compensatory schemes involving tokens that are similar to compensatory equity awards (such as restricted stock or restricted stock units), both in terms of economics and U.S. federal income tax consequences to the employee.
As just one example, an employer may grant an employee (or other service provider) restricted tokens. Similar to restricted stock, absent an election under Section 83(b) of the Code, the "fair market value" of the restricted tokens (minus any amount paid for the restricted tokens) generally would be treated as compensation income to the employee on the relevant vesting date(s). Alternatively, the employee could make an election under Section 83(b) of the Code, in which case the fair market value of the restricted tokens (minus any amount paid for the restricted tokens) would generally be treated as compensation income to the employee on the date of grant, and any subsequent appreciation in the fair market value of the token would generally be treated as capital gains when the token is disposed.
The Notice made clear that convertible virtual currencies paid by an employer as compensation will constitute "wages" for tax purposes, highlighting the general rule that the medium used for compensation is immaterial to whether that compensation constitutes wages. Consequently, tokens paid as compensation will be subject to federal tax withholding, the FICA tax, the FUTA tax and, if paid to an employee, will be reportable on the Form W-2. The Notice also made clear that convertible virtual currencies received by an independent contractor as compensation for services constitute self-employment income, subject to the self-employment tax.
While the classification of tokens as property provided some certainty to employers from the world's largest tax jurisdiction, the Notice is far from comprehensive, leaves many important questions unanswered and entails innumerable pitfalls. The IRS received 36 public comment letters relating to the Notice following its release, but has not responded or taken any action to clarify the ambiguities raised by the comments.
One significant ambiguity relates to the determination of fair market value. To determine fair market value, the Notice refers to exchange rates established by market supply and demand, and recommends that taxpayers use a "reasonable manner that is consistently applied" to calculate the fair market value of tokens. However, the Notice does not address the fact that tokens are typically traded on multiple published exchanges, with no formal "closing" of the exchange, and the value reported on each such exchange is typically not the same. Pending clarity on this point, employers may, for example, consider applying a volume-weighted average price over principal published exchanges for their token.
As to pitfalls, one area employers should take into consideration is the fair market value regime under Section 409A of the Code, which will apply to options on tokens in addition to Section 83 of the Code. Although a convertible virtual currency constitutes property under the Notice, it is not clear that convertible virtual currencies or any other digital tokens could constitute employer stock under Section 409A of the Code, which could create significant tax issues for optionees and their employers. Finally, employees should remember that issuing tokens to service recipients, even if not intended as compensation, will presumptively be treated as compensation.
In sum, although the IRS has been silent on tokens since early 2014, employers should be aware that compensating employees with tokens constitutes taxable income to the recipients, and generally requires employers to withhold related taxes (for which employers are secondarily liable) and issue information statements (e.g., the Form W-2) to both the IRS and the recipients.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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