Cryptocurrency: A new frontier (and trap) for employee incentives
With the rise in the prevalence of initial coin offerings (ICOs) and token generation events (TGEs), many companies have turned to paying employees and other service providers with cryptocurrency (e.g., Bitcoin, Ethereum, Litecoin, etc.). While the use of cryptocurrency can assist a company in conserving cash, companies must understand certain limitations and risks associated with using cryptocurrency, particularly from a tax perspective.
As an initial matter, the IRS has clarified that it will treat virtual currency as property for federal tax purposes (Notice 2014-21). As property, virtual currency received in exchange for services must be included in a taxpayer’s gross income at its fair market value, even if the virtual currency is not exchangeable for cash (i.e., it is illiquid). In other words, an employee will be subject to income tax on the value of the cryptocurrency granted to the employee from his or her employer.
Example: Gideon works for Employer that has undergone a token generation event (TGE) to create a Token. Upon completion of the TGE, Gideon is granted 100 Tokens with a fair market value at the time of grant equal to $100. Even though Gideon may not be able to sell or exchange the Tokens for cash, he is subject to ordinary income tax on $100 (the value of the Tokens granted).
As illustrated in the Example above, Gideon will have a cash outlay with respect to his taxes upon grant, meaning that he will have to come out-of-pocket cash currently to pay his taxes, without necessarily having a corresponding cash inflow. In practice, as a condition to the issuance of the Tokens, Employer will require Gideon to make arrangements to satisfy Employer’s tax withholding obligation with respect to the Token issuance (i.e., Gideon will have to pay Employer in respect of Employer’s requirement to remit withholding taxes to the IRS).
The foregoing can be particularly problematic to the extent an employee is entitled to a set number of tokens (by contrast to a number of tokens with a set value) because virtual currencies often have high levels of volatility that could lead to an unexpected large income inclusion for the employee. For example, assuming Gideon in the Example above had a contractual right to receive the 100 Tokens upon the completion of the TGE, at the time of entering into the contract neither Employer nor Gideon know, with certainty, what the value of the 100 Tokens will be at the time of grant. As a result, the amount of taxable income on which Gideon will have to pay taxes is unknown, potentially causing material cash flow issues for Gideon if the Tokens have a greater than expected value (e.g., if the 100 Tokens in the Example had a $100,000 value instead of $100, Gideon would have to pay tens of thousands of dollars in taxes with respect to the grant, but may not be able to sell or exchange the 100 Tokens for cash to use for such purpose).
From an executive compensation standpoint, the use of virtual currency to compensate employees has become an increasing popular mechanism, particularly as employers seek to differentiate themselves to attract talented employees. The use of virtual currency as part of an incentive compensation program, however, must be structured in an appropriate manner to mitigate employee tax exposure and ensure that employees are motivated to drive value. By way of example, companies may consider tying the timing of grants to a liquidity event (i.e., an event when the virtual currency can be converted to cash) or even using an employee loan program as part of an employee incentive program involving virtual currency (although such programs carry their own tax risks that must be navigated).
In short, there are significant risks associated with compensating employees with cryptocurrency, and both companies and employees must, in particular, understand the tax issues arising with respect to the issuance of virtual currency as compensation for services. Nevertheless, if structured properly, virtual currency may represent a new frontier for employee incentive programs.
