Guide

How To Setup Token Compensation Distribution and Tracking

October 10, 2023

How To Setup Token Compensation Distribution and Tracking
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Key Takeaways

How you distribute and track token compensation matters:

  • For your employees: Employees need to understand how and why tax deductions were made - if it was done by sell-to-cover or other mechanisms or what marginal rate was being used to calculate the withholding
  • For tax authorities: You are required to track the right data to derive information that the tax authorities in different jurisdictions will require. The data requirement depends on the regulator.
  • For yourself: At the end of the day, visibility on your finances is extremely important. Knowing that your employees are always paid fairly and optimally also helps.

In this article, we'll cover the overall aspects of token compensation distribution and tracking that crypto organizations need to be aware of.

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Once you have ironed out the details of your token compensation plan from the establishment of your token grant pool all the way to the finalized form of your token grant agreements, it will be time to actually distribute and execute on these agreements.

From our experiences distributing token grants for some of the largest crypto organizations in the world, we have broadly seen three steps that organizations usually follow.

Step 1: Communicate the Offer and Execute the Agreement

Once you draft and localize token grant agreements, you will need to communicate the token grant offer to eligible employees.

  1. The process comprises numerous sub-steps:
  2. Clearly communicate the token grant offer to eligible employees, providing a comprehensive overview of the key details.
  3. Ensure recipients have access to the full agreement for review and encourage them to read and comprehend the terms or have it reviewed by their counsel.
  4. Obtain formal acceptance from recipients to acknowledge their understanding and secure electronic or physical signatures on token grant agreement. 
  5. Keep organized records for compliance and tracking.

Effectively managing token grant agreements necessitates a clear and comprehensive communication plan to your eligible employees. This comprehensive process ensures a smooth and legally sound execution of token grant agreements.

Step 2: Tracking and Token Distribution

Managing token distributions and tax withholding obligations can be a complex and time-consuming task, but it is the most critical part of the process. Distributing tokens to employees triggers various obligations, including but not limited to recording tokens in payroll, withholding taxes, adhering to reporting procedures, and following legal settlement schedules. 

Much of this distribution process requires complex tax calculations and cannot be automated via smart contracts. Some organizations have in-house teams handling these processes via spreadsheets or they work with a dedicated token grant administrator. Those that have done this work in-house have had to learn over the course of a year or longer how to make the initial grants, and then continuously adapt the token compensation program as the business, workers, technology and regulations change.

If you choose to do it fully in-house, typically you will need to consider the following sub-steps:

  1. Establish a reliable tracking system to monitor grant dates, cliffs, and vesting progress for each grant recipient.
  2. Establish a preferred tax withholding strategy. Several options are available for managing tax withholdings and include but are not limited to:

    2.1 Sell-to-cover
    : A portion of the vested tokens is sold immediately upon vesting to cover the applicable taxes. The proceeds from the token sale are then converted to the local currency and used to fulfill the tax withholding obligation. It is the most common strategy as it avoids the need for cash reserves for tax withholdings; however, it requires careful market execution to sell tokens at the right time and price, and sufficient liquidity to avoid negative market impact.

    2.2 Net settlement
    : Cash from the balance sheet is used to cover the applicable taxes. It is a less common strategy because while it eliminates reliance on the market to sell tokens, it requires substantial cash reserves.

    2.3 Cash-to-cover: Employees use their own funds to cover the taxes on vested tokens. Cash-to-cover is not common, and it may not be legally compliant in all jurisdictions, as it is generally the employer's responsibility to handle tax withholding on behalf of employees. It may also pose financial challenges for some grant recipients who may not have sufficient cash or liquid assets to cover the tax liability.
  3. After tokens vest and lockup periods are lifted if applicable, calculate a breakdown of tax withholding obligations for each individual employee in every jurisdiction. You will need to repeat this process every time tokens are about to be distributed and this may vary significantly depending on the individual’s tax profile, compensation structure (including base salary and bonuses on top of any vested tokens) and specific jurisdictions. Note that if your employees are digital nomads or are very mobile, your withholding obligations and tax calculations are exponentially more challenging for every location added because you must determine how to distribute the taxes between locations. Work with a dedicated token grant administrator and seek tax advice as needed to ensure that you comply with all relevant laws and tax regulations.
  4. Based on the tax calculations, execute sell-to-cover or another tax withholding strategy, and convert withheld fiat into the local currency of the worker. 
  5. Securely initiate the token distribution process to worker wallets and transfer the appropriate amount of fiat to the local tax authority in the jurisdiction where the worker is based. 
  6. Ensure compliance with regulatory reporting and maintain secure record-keeping. Also, issue appropriate payslips to the worker.
  7. Provide post-vesting support and education for grant recipients.

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Step 3: Monitor and Evaluate

Continuously monitor the token grant program's impact on employees, contractors, and the organization.

Compared to equity compensation, taxes on token compensation is not a well-understood topic yet. Many of your employees will have questions about how their tokens are taxed at what rates and why. As crypto provides big upside opportunities, it also creates big taxable events. You should always be prepared to communicate to your employees on why and how their taxes are calculated.

Additionally, regulations change every year and will affect you if your employees reside in many jurisdictions. With a global push for more regulation around digital assets, it will only be a matter of time before multiple countries announce new guidance that your token compensation plan must adhere to.

Be ready to adjust the token grant program if needed to align with dynamically evolving business, technological, regulatory and tax changes to ensure ongoing compliance and to avoid potential legal and financial issues.

Conclusion

Token compensation is an innovative approach to employee incentivization, where companies promise to issue tokens in lieu of or in addition to other compensation or fringe benefits. However, both employers and employees should carefully consider the implications and risks associated with token compensation before incorporating tokens into their compensation packages.

Running a compliant token grant administration program is hard, and can often require many full-time staff to execute compliantly and correctly. The amount of work required to design, implement, administer and monitor the plan in an ever-changing regulatory environment is enough to overwhelm any organization.

Leading crypto organizations such as Protocol Labs and Gnosis choose Toku to administer their token grants.

Make your Token Grant administration simple. Skip out on those sleepless nights by working with Toku today.