Why can token option agreements be problematic under US law?

March 7, 2024

Why can token option agreements be problematic under US law?
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Token option agreements, especially those involving digital tokens or cryptocurrencies, are often considered by crypto companies because if used for token compensation, they would provide a degree of control for when tokens will be received by workers, and thus when workers will be taxed on the receipt the tokens. Being taxed on the receipt of the tokens is problematic because the tokens being received are not able to be sold or traded (are “not liquid”) because either the markets are thin for the tokens or vesting is subject to lockup periods in the grant agreements. So the worker could easily end up in a situation where they have taxes due and payable to the government in fiat, but the worker grantee can’t get any fiat from the sale or trade of tokens to pay the taxes. The worker will need to come up with the cash to pay the taxes from somewhere else.

Because all options, including token options, allow workers to defer compensation by deciding when to make an exercise election on the options, IRC Section 409A applies to them and deals with all forms of deferred compensation. The application of 409A to token options makes them unattractive in the United States because of the difficulty with qualifying the token options for and maintaining compliance under 409A. At this point you might be asking why deferred stock compensation like Non-qualified Stock Options (NSOs) and Incentive Stock Options (ISOs) don’t seem to have this problem that token options do. The reason is that NSOs and ISOs are exempt from 409A because they qualify as “Service Recipient Stock,” but token options do not. 

Service Recipient Stock under 409A of the U.S. tax code refers to the common stock of the company that is provided to employees or consultants (“employees”) as part of their compensation. Since tokens are not common stock, and there is no other classification they fit into for the Service Recipient Stock designation or other exemption, token options fail to qualify for any exemption from 409A like NSOs and ISOs do.

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What happens to token options if 409A applies

When a deferred compensation plan fails to comply with Section 409A, either in form or in operation, significant adverse tax consequences can arise for the worker to whom the deferred compensation is promised. Here are the main consequences of non-compliance:

  • Immediate Taxation: The worker must include in their gross income all compensation deferred under the non-compliant plan for the current tax year and all previous tax years in which their grants have vested, even if the options have not been exercised. This means the option income is taxed earlier than it would be under compliant deferred compensation arrangements, and yet if the tokens aren’t liquid, the fiat must still be paid to the government.
  • Interest and Penalties: In addition to the immediate inclusion of the deferred compensation in income, the worker is also subject to interest at the IRS underpayment rate plus 1% on the underpaid taxes, calculated from the date the compensation should have been included in income. Additionally, there is a 20% penalty tax on the deferred compensation that is required to be included in gross income due to the failure to comply with Section 409A.
  • State Taxes and Penalties: Depending on the state, there may be additional state taxes and penalties for failing to comply with Section 409A.
  • Legal and Financial Implications for Employers: While the primary tax consequences of Section 409A violations fall on the worker, crypto employers can also face legal and financial repercussions. Crypto employers may face challenges from disgruntled former workers and contributors facing surprise tax bills, including lawsuits or demands for indemnification. Additionally, the failure to comply with Section 409A can lead to reputational damage, difficulties in attracting and retaining talent, and the administrative burden and cost of correcting the non-compliance.

To avoid these consequences, it is crucial for crypto employers to ensure that any arrangements that could be considered deferred compensation comply with the requirements of Section 409A from both a plan document perspective and in operation. This often involves careful drafting of token compensation agreements, ongoing token grant administration to ensure operational compliance, and possibly restructuring existing arrangements to bring them into compliance. Given the complexity of the law and the severe penalties for non-compliance, consulting with legal and tax professionals and token grant administrators who specialize in token compensation and Section 409A is highly advisable.

At Toku, we understand the complexity of managing token grants and compensation agreements. We work with the top companies in this space such as Protocol Labs and Gnosis

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