Guide

Understanding How the US Taxes your Token Awards in 2023

October 27, 2023

Understanding How the US Taxes your Token Awards in 2023
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Key Takeaways

In the United States:

  • Tokens are considered as property for US tax purposes
  • The fair market value of tokens can be derived in only a few ways
  • The timing of taxation for token awards varies on the type of token award
  • Employers have withholding obligations for their full-time employees and should have a preferred tax withholding strategy in mind

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Disclaimer:The content of this blog is for informational purposes only and is not intended as legal, tax, or financial advice. Consult a professional advisor or get in touch with Toku for specific advice related to your situation. Toku is not liable for decisions made based on this content.

Today, roughly 29% of the global crypto workforce is based in the United States. This means a lot of people who are paid in crypto will be taxed in the United States by the Internal Revenue Service (IRS).

In this article, we will explore how the United States taxes tokens, the timing of US taxes on tokens, the withholding obligations for token payments and sales, and the valuation of tokens for tax purposes.

Tokens are Property in tax terms

Tokens, ranging from popular coins like Bitcoin to alt coins, are considered property for US tax purposes. This classification means that tokens are subject to taxation as ordinary income at the moment they are transferred to the recipient, less the cost to acquire the tokens. 

For an example of token incentive compensation, a token grant under a Restricted Token Unit scheme that vests on October 25th, 2023 will create a taxable event when the token eventually settles. This vesting token amount will be taxed as property transferred in connection for services rendered. Settlement in the token context means that the token is actually transferred to a digital wallet or custodial account under the grantee recipient’s control without risk of forfeiture.

Valuation of Tokens for Tax Purposes

The fair market value of tokens is often determined through the spot price at the time of transfer across a broad number of exchanges. For liquid tokens with high trading volumes, this value is more easily derived just given the volume of market transactions. Sometimes the weighted average price over a period may be used as well to mitigate any short-term price swings regardless of liquidity.

For less liquid tokens or ones that are “pre-launch,” even where a market price is readily attainable, one option is to let the valuation be determined by independent third-party’s valuation of the token. This is similar to how private company stocks are valued for 409A purposes. The methods of illiquid token valuation are not yet precisely defined or codified, such as for 409A purposes, given how new token compensation is, so token valuation needs to be redone more frequently than for private company stocky regardless of liquidity.

Timing of Taxation

The timing of taxation for token awards varies depending on the type of award and whether the recipient files an 83(b) election with the IRS.

  • Token Grants without vesting or forfeiture conditions: Tokens granted without such conditions are taxed as ordinary income based on their value at the time of the grant.
  • Restricted Token Units (RTUs), Token Purchase Agreements (TPAs) and Restricted Token Awards (RTAs): These token awards generally are not taxable until they vest
  • Token Options: Recipients of options will not be taxed on the value of the options until the recipient exercises them.

The Employer’s Withholding Obligations

Companies issuing token-based awards to their full-time employees are responsible for complying with income and payroll tax withholding obligations. Withheld amounts must be remitted in cash to the relevant taxing authorities. To meet these obligations, companies can determine a preferred tax withholding strategy:

  • Withholding from Cash (Cash-to-cover): Companies may withhold the necessary tax amounts from cash payments due to the vesting employees. This is commonly called a cash-to-cover tax withholding strategy.
  • Token Reduction (Net settlement or sell-to-cover): Alternatively, they can reduce the number of tokens issued to participants by the fair market value equivalent to the aggregate tax withholding obligations. In this case, companies can choose to either use a net settlement or sell-to-cover operation to withhold the cash amount for tax withholding.

Conclusion

Paying the right taxes, and the right amount, is challenging. Much more so in the United States, as it requires a firm grasp of the IRS guidelines on both cryptocurrencies and grant taxation. 

Tokens are treated as property, and their taxation timing depends on their vesting or purchase mechanism. Companies issuing token awards also have withholding obligations, which can be fulfilled either through one of three tax withholding strategies. 

Lastly, valuing tokens accurately for tax purposes is crucial, considering the volatility of cryptocurrencies. 

Although this is a lot to track and calculate, leading companies like Protocol Labs and Gnosis don’t have this problem because they have Toku at their side.

Make crypto taxation simple today with Toku.