As discussed in a prior blog post by my colleague, Anthony Daddino, here, the IRS began sending “educational” letters (i.e., warning letters) to taxpayers regarding their potential failure to report or pay tax on cryptocurrency transactions. The identity of the recipients of such educational letters allegedly arose from the information obtained by the IRS from the “John Doe” summons served on Coinbase, Inc., a cryptocurrency exchange that primarily dealt in Bitcoin transactions during the time period covered by the summons. The primary focus of the letters was to “educate” taxpayers who purportedly engaged in sales or exchanges of virtual currency; however, such letters also identified an additional source of taxable income and reporting requirements that could arise from cryptocurrency payments made to employees or independent contractors for their services (i.e., compensation).
FAQ on Virtual Currency Transactions. Shortly after the IRS began sending educational letters, the agency released new guidance to taxpayers on virtual currency transactions in the form of a FAQ. The FAQ, published on October 9, 2019, can be found here. The FAQ addressed not only the receipt of cryptocurrency as payment received in exchange for services, but also sales and exchanges, gift transfers, determination of basis and reporting requirements for transactions triggering income or gain. The FAQ expands on previous IRS guidance provided in IRS Notice 2014-21, 2014-16 I.R.B. 938, which you can find here and Revenue Ruling 2019-24, 2019-44 I.R.B. 1004, which was issued contemporaneously with the FAQ. Revenue Ruling 2019-24 can be found here.
With regards to the IRS’ recent FAQ, Q&A #8 through 14 address the payment and receipt of virtual currency with regards to services. Generally, a U.S. service provider that receives virtual currency as remuneration for services must report the fair market value (in U.S. dollars) of the virtual currency on the date of receipt as ordinary income, which is subject to self-employment taxes. The U.S. service recipient may deduct such amount as wages or other compensation paid that would also be equivalent to the fair market value (in U.S. dollars) of the virtual currency on the date of payment and has a duty to withhold federal income tax and federal employment taxes if the service provider is an employee, as well as the typical duties to report and deposit such taxes. Further guidance was also provided with respect to capital gain or loss to be recognized by the service recipient (or payor) if the virtual currency was a capital asset to such person.
Compensating Employees with Cryptocurrency. The foregoing IRS FAQs are an important step in providing much needed taxpayer guidance as more businesses are entering the digital space. As is the case for many start-up businesses that award equity such as stock options and restricted stock units (“RSUs”), start-ups in the digital space are using virtual currency as a way to compensate and incentivize directors, executives, consultants and other service providers by granting virtual currency, such as coins or tokens, and often contemporaneous with an “initial coin offering” or “ICO.” More often than not the compensatory coins or tokens are awarded with attendant transfer restrictions in a manner similar to traditional equity-based awards, such as restricted stock, RSUs or options, and most often subject to vesting over a certain period of time based on either a continuation of services being provided or performance targets and can also be subject to accelerated vesting upon pre-determined events that trigger such acceleration, such as a change of control transaction by the issuer, termination of the service provider or the achievement of particular milestones for the issuer’s business objectives or platform. Although the recent IRS FAQs do not address awards of restricted compensatory virtual currency, such awards should be treated by the IRS in the same manner as other restricted compensation.
A service provider’s receipt of restricted compensatory virtual currency should therefore be evaluated similarly, with the recipient becoming subject to U.S. income tax on the difference between the fair market value of such award at the time it vests and the amount paid for such award, if any, unless the recipient files an election under § 83(b) (an “§ 83(b) Election”) of the Internal Revenue Code of 1986, as amended (the “Code”), within 30 days after such award is granted. As with all § 83(b) Elections, recipients of restricted virtual currency awards should carefully consider whether such election should be made, which subject was generally discussed in my prior blog post discussing qualified equity grants here.
Based on the facts and circumstances, a recipient of traditional restricted equity in a privately held start-up business that files a timely § 83(b) Election will oftentimes incur minimal or no income tax in the tax year in which the award is granted since such equity typically has little to no value. Thereafter, the § 83(b) Election prevents the recipient’s incurrence of income tax liability as the equity vests while the business is still privately held and lacks a secondary market on which the recipient could sell the equity to provide cash available to pay such tax liability. With restricted compensatory virtual currency, however, the fair market value of the awarded coins or tokens will be tied to the respective ICO or token generation event (“TGE”) if issued in connection with either, or trading values on a secondary trading market for the particular virtual currency awarded. In this situation, the recipient may in fact incur income tax liability in connection with a § 83(b) Election in the year of grant on the difference between the fair market value and the amount paid for the virtual currency, if any. Therefore, the recipient may be less concerned about the ability to obtain capital gain treatment in the future with the § 83(b) Election if incurring an accompanying income tax liability with such election, especially in light of the ability to easily sell the vested virtual currency on the many cryptocurrency exchanges currently available. Recipients of coin or token-based option awards should also be aware that it is unclear if such awards will be subject to or exempt from Code § 409A, which was also discussed in my above-noted blog post and in a prior blog post by my colleague, Steve Beck here.
Securities Laws and Cryptocurrency. Although the U.S. tax ramifications of compensatory virtual currency are becoming clearer with the recent IRS guidance, there is still much uncertainty surrounding the securities law implications of virtual currency in general, much less in the compensation arena. The Securities and Exchange Commission (the “SEC”) issued guidance in July 2017 and instructed securities law practitioners to apply the tests enunciated in the U.S. Supreme Court case of SEC v. W.J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100, 90 L. Ed. 1244 (1946), in determining whether an issuer’s virtual currencies would be considered securities under the Securities Act of 1933, as amended (the “Securities Act”), which is the foundation of the application of securities laws in the U.S. In practical terms, however, the SEC’s increasing enforcement in the virtual currency arena should provide practitioners with sufficient evidence, as well as a warning, that the SEC considers ICOs as offerings of securities that should either be registered under the Securities Act or fall within one of the exemptions from registration.
Issuers of compensatory virtual currency awards have often relied on Rule 701 for such exemption from registration, which allows for securities to be issued to “covered service providers.” Rule 701 imposes several limitations on, and conditions for, such issuances, which may be made to the employees, officers, consultants and advisors of the issuer (or certain of the issuer’s affiliates). Importantly, the issuances cannot be in connection with an ICO or Simple Agreement for Future Tokens (“SAFT”) and may only be made to natural persons, with the exceptions of a single-member limited liability company or personal corporation wholly owned by such qualifying natural person. Should Rule 701 be unavailable for an issuance, other exemptions from registration may be available, such as Regulation D or Regulation S, if the service provider is either an “accredited investor” or not a U.S. person, respectively, assuming that the other requirements for such exemptions are met. In any issuance, however, it is always advised (and often required, depending upon the governing law of the jurisdiction of issuance) that the awards are granted pursuant to a written plan or agreement. It should be noted that in conjunction with the Securities Act, state securities laws must also be followed, and issuer’s counsel should take into consideration the jurisdiction of issuance if such written plan or agreement is proposed to be drafted in the form of an electronic or “smart” contract as not all jurisdictions consider the foregoing to satisfy such requirement.
Although the IRS recently provided additional guidance on the U.S. federal income tax ramifications on the receipt and payment of virtual currency as compensation, there still remain questions since such guidance was very general and did not specifically address issuances of virtual currency as deferred compensation. With regards to the securities laws aspects of virtual currency, practitioners would be wise to follow a conservative approach and assume that issuances will be viewed as securities by the SEC and state securities regulators and rely on either registration or falling within an exemption from registration until such time as more definitive guidance is provided.