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).
Regulations can be a real thorn for organizations that want to be agile and move fast while creating a compliant token compensation plan. The act of transferring tokens to your employees can incur tax liabilities or other consequences. In certain jurisdictions, this gets to a point where either you or your employee could even decide it’s not worth the headache to receive these tokens.
In these cases, many crypto organizations will choose to administer phantom token grants, which offer a way to incentivize and reward workers without granting them actual ownership of any tokens.
In this article, we'll delve into what phantom tokens are, how they work, and why they are used.
Defining Phantom Tokens
Phantom tokens are a financial instrument designed to mimic the value and benefits of tokens they are pegged to. Instead of receiving actual tokens, employees are given virtual “phantom” token units that track the performance of the underlying tokens in some way.
Phantom tokens are essentially a contractual agreement between a company and an employee - nothing more and nothing less. Under this agreement, employees receive hypothetical or "phantom" units that track the value of the real tokens.
Why Use Phantom Token Grants?
Phantom tokens are a powerful incentive alignment tool to get key employees vested into your project’s success. Since the value of phantom tokens is tied to the value of the project’s tokens, employees are incentivized to work toward its growth and success.
A key advantage of phantom tokens is that projects will have less complexity in designing and administering them:
- Projects have flexibility in designing the terms of phantom token agreements, such as vesting periods, performance targets, and other conditions to align with their specific goals and needs.
- Phantom token grants are relatively easy to administer compared to token grants and token options. There is no need for tokens to move between wallets or for anyone to deal with accounting of the tokens.
- Unlike RTUs, RTAs and Token Options, phantom tokens do not take out any tokens away from the existing number of tokens held in treasury if the goal is to retain control of the tokens and rights awarded to token holders.
- There are some circumstances for regulatory and compliance purposes, that companies would not want to grant, and workers would not want to receive the tokens. Phantom tokens allow workers in such places to benefit financially from participating in token projects without the regulatory risk.
The Mechanics of Phantom Tokens
- Granting of Units: Companies grant phantom token units to selected employees, typically based on their position, performance, or other criteria. Each unit represents a financial relationship to the value of the related tokens. There may in some circumstances be a one-to-many or many-to-one relationship between tokens and phantom token units, and the value ratios between the tokens and the token units may vary from a one-to-one correspondence.
- Vesting Period: Phantom tokens often come with a vesting period during which employees must remain with the company to earn the full value of the units. This encourages employee retention.
- Value Tracking: The value of phantom tokens is tied to the performance of the tokens. As the token price increases, so does the value of the phantom tokens in some way.
- Airdrops: In some cases, phantom token holders may also receive simulated airdrops based on the value of the airdrops given to actual token holders.
- Payout: When certain conditions are met, such as the completion of the vesting period, employees are entitled to receive a payout equivalent to the value of their phantom token units. This payout is often in fiat, but it can also be in tokens or a combination of both.
It is important to note that phantom tokens do not give any ownership of any tokens at any time. This means that your employees will not be true ‘users’ of the project they are working on unless they go out and buy tokens in the market by themselves.
If your tokens also function as governance tokens or act as gateways to services like DeFi, your employees will not automatically be able to access such services and thus may impact their alignment.
Considerations and Tax Implications
While phantom tokens can be an effective incentive, it is crucial for both employees and companies to understand the tax implications associated with this form of compensation. The tax treatment of phantom tokens can vary by jurisdiction, so it's essential for both companies and employees to understand the tax implications of these instruments.
Phantom token units are usually settled in some form of currency, and so the benefits are then taxable as ordinary income. The downside of receiving phantom tokens is they are not capital assets like the tokens themselves that could receive long-term capital gains treatment upon their subsequent sale.
Understanding how phantom tokens are treated in each jurisdiction is a massive challenge. Most organizations would need to consult with the top law firms in each jurisdiction to determine the appropriate tax liabilities and compliant agreement contracts.
Toku partners with top global law firms like Orrick and Goodwin to provide a truly compliant solution to all token compensation plans, including shadow tokens.
Make all of your token compensation plans simple today with Toku.