Why Token Option Agreements Are Risky in the U.S.

As the global Web3 ecosystem continues to mature, token-based compensation has emerged as a powerful tool for crypto companies to reward contributors and align incentives. But as innovative as token grants and options may be, they also bring unique legal and tax challenges — especially under U.S. law. One of the most misunderstood and complex areas involves token option agreements, which, while seemingly similar to traditional stock options, carry significant compliance risks that can have serious tax consequences for workers and employers alike.

At Toku, we’ve seen first-hand how token compensation structures can unintentionally expose companies and their teams to U.S. tax penalties. Many organizations assume that issuing token options provides flexibility — allowing workers to decide when to exercise and receive their tokens, much like they would with stock options. In theory, this structure could help manage when taxes are triggered. In practice, however, token options often fail to qualify for key exemptions available to traditional equity, placing them squarely under the scope of Section 409A of the Internal Revenue Code — a section designed to regulate deferred compensation.

Why does that matter? Because once Section 409A applies, the consequences of non-compliance can be severe. Workers could face immediate taxation on unexercised options, 20% penalty taxes, and interest on unpaid amounts, even before they’ve received any liquid tokens they can sell to cover their tax bills. For companies, non-compliance can lead to legal exposure, reputational risk, and significant administrative burdens as they attempt to correct improper grant structures retroactively.

The heart of the issue lies in classification. Under 409A, certain types of deferred compensation — including traditional stock options like Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs) — can qualify for exemptions because they are tied to what’s known as “Service Recipient Stock.” Tokens, however, do not meet that definition. They aren’t stock, they don’t represent ownership in the issuing company, and they exist in a legal gray zone without explicit regulatory recognition as a qualified security. As a result, token options fail to meet the criteria for exemption, making them inherently risky from a compliance perspective.

This creates a challenging paradox for crypto companies: how do you reward contributors with tokens — one of the industry’s defining features — without triggering unintended tax liabilities or violating federal law? The answer lies in understanding the nuances of Section 409A, designing token grant programs that meet its requirements, and working with experienced administrators and legal experts who specialize in token compensation compliance.

At Toku, we help organizations navigate this complexity every day. From structuring token grants and agreements to maintaining ongoing compliance and reporting, our mission is to simplify global payroll and token compensation — so teams can innovate confidently without facing avoidable legal or tax setbacks.

What Happens to Token Options if 409A Applies

Once a token option agreement falls under the scope of Section 409A, it is treated as a form of deferred compensation — and that designation changes everything. Section 409A sets strict requirements for how and when compensation can be deferred, exercised, and paid. When a token option plan doesn’t comply, the results can be financially devastating for workers and reputationally damaging for companies.

Immediate Taxation — Even Without Liquidity

If a token option plan fails to comply with Section 409A, the worker must recognize income immediately on all previously deferred compensation — even if the options haven’t been exercised or converted into tokens yet. This means that as soon as the tokens vest, the IRS treats their fair market value as taxable income.

The issue is particularly painful in crypto because tokens are often illiquid at the time of vesting or exercise. Workers may owe taxes in fiat currency before they’ve had any opportunity to sell or exchange their tokens. In some cases, this results in significant out-of-pocket tax liabilities — a situation no worker or contributor wants to face.

Penalties and Interest

In addition to early taxation, Section 409A imposes a 20% penalty tax on all income that becomes taxable due to non-compliance. On top of that, interest accrues at the IRS underpayment rate plus 1%, calculated from the date the compensation should have originally been included in income. These penalties compound the financial burden, often leading to tax bills that far exceed the value of the initial grant.

State-Level Penalties

Some states — including California — enforce their own versions of Section 409A penalties. That means a worker could face additional state income taxes and penalties on top of federal ones. For contributors in high-tax jurisdictions, this can turn an otherwise promising compensation package into a financial liability.

Implications for Employers

While the tax burden primarily falls on the worker, crypto employers aren’t immune to the consequences. Companies that issue non-compliant token options risk lawsuits, indemnification claims, or strained relationships with former workers who discover unexpected tax bills years later.

The administrative cost of correcting non-compliant plans can also be significant. Employers may need to amend grant agreements, restate option terms, or coordinate retroactive reporting corrections — all while maintaining transparency with their workforce and investors. For early-stage crypto companies, this can divert critical resources away from growth and innovation.

Protecting Against Non-Compliance

The only reliable way to avoid these consequences is proactive compliance. Token option plans must be drafted and operated in a way that satisfies Section 409A’s strict requirements. This means setting exercise prices at fair market value, defining clear payment schedules, and ensuring there are no impermissible deferrals or accelerations of income.

Given how complex and evolving the regulatory environment is, crypto organizations should work closely with legal and tax professionals who understand both U.S. tax law and the unique characteristics of token-based compensation. Even small drafting errors or operational oversights can trigger 409A issues — so prevention is far more cost-effective than correction.

At Toku, we specialize in this very challenge. Our team of global payroll and tax experts helps crypto companies design, administer, and maintain compliant token compensation programs. From valuation and grant administration to ongoing operational oversight, Toku ensures that organizations can reward their contributors confidently — without exposing them to hidden tax risks.

Understanding IRC Section 409A and Why It Exists

Section 409A wasn’t written with crypto in mind. It originated in 2004 as part of the American Jobs Creation Act — legislation passed in the wake of corporate scandals like Enron. Those scandals revealed how executives manipulated deferred-compensation arrangements to delay income taxes indefinitely.

409A’s purpose is simple:

“To prevent individuals from deferring income recognition while still controlling when they get paid.”

It does this by enforcing strict rules around:

• Timing of deferrals (when compensation is earned vs. received)
• Valuation of underlying assets (must reflect fair market value at grant)
• Payment schedules and accelerations (cannot be changed arbitrarily)

Any compensation that allows a person to decide later when to receive payment — and thus when to be taxed — is subject to 409A unless it qualifies for an exemption.

Traditional equity like Non-qualified Stock Options (NSOs) and Incentive Stock Options (ISOs) are exempt because they represent ownership in the employer company’s stock. They meet the definition of “Service Recipient Stock.”

Tokens, however, do not. They are not company stock. They don’t carry shareholder rights or voting privileges. They may represent network utility, governance, or value — but legally, they’re not equity, and therefore cannot qualify for the same exemptions.

That’s why even well-structured token options end up being treated as deferred compensation under 409A. The law simply wasn’t designed for assets that live on a blockchain.

The Structural Problem: Why Tokens Fail the “Service Recipient Stock” Test

The Service Recipient Stock exemption is the cornerstone of how U.S. companies issue compliant stock options. To qualify, the option must:

1. Be issued for actual company stock, not derivatives or substitutes.
2. Have an exercise price at or above fair market value on the grant date.
3. Relate to equity of the service recipient — the same entity that employs or engages the worker.

Tokens generally fail all three tests:

• Not Equity: Tokens are typically not shares in the legal entity; they represent utility or governance rights in a protocol or foundation.
• Valuation Challenges: Establishing a “fair market value” for a token before it launches or trades publicly is nearly impossible.
• Entity Mismatch: Tokens are often issued by a foundation or DAO, not the legal employer, creating a disconnect between who grants and who pays.

Because of these gaps, token options cannot satisfy the 409A exemption and automatically fall under its deferred-compensation rules.

For a simple comparison:

Until U.S. tax authorities establish new frameworks for digital assets, token options will remain legally ambiguous — and therefore risky.

Safer Alternatives to Token Options

The good news: there are compliant alternatives that still allow companies to reward contributors with tokens while avoiding 409A pitfalls.

1. Token Grants (Non-Deferred)

Companies can issue tokens outright upon vesting, triggering taxation at the time of receipt. This avoids deferral issues altogether. Workers pay tax based on the fair market value at vesting, and if tokens appreciate later, future gains are taxed as capital gains.

2. Restricted Token Units (RTUs)

RTUs mirror Restricted Stock Units (RSUs) — tokens are granted but only delivered when specific conditions are met (like network launch or liquidity event). Because there’s no worker election to defer income, RTUs generally avoid 409A issues if properly drafted.

3. Phantom Token Plans

These are cash-settled plans that track the value of a token without actually transferring it. Payments are made in fiat or stablecoin equivalents. This structure keeps compensation compliant and simplifies tax reporting.

4. Stablecoin or Fiat-Based Bonuses

For some companies, the simplest approach is to pay variable bonuses in stablecoins or fiat tied to token value. This delivers crypto-aligned incentives without introducing deferred-compensation risk.

Each alternative has trade-offs in terms of liquidity, tax timing, and accounting complexity. The right choice depends on the company’s jurisdiction, token maturity, and contributor profile.

Toku’s Token Grant Administration (TGA) platform helps organizations evaluate these structures and stay compliant — from issuance to tax reporting.

Real-World Risks: When Non-Compliance Hits

To illustrate why this matters, let’s look at a few anonymized examples based on real situations in the crypto space.

Scenario 1: The Illiquid Tax Trap

A DeFi startup granted token options to early contributors at a notional price of $0.10 per token. Two years later, the token listed publicly at $5.00, but contributors hadn’t exercised yet. Because the plan wasn’t 409A-compliant, the IRS treated the appreciation as deferred compensation. Workers owed income tax on the $4.90 spread per token — even though they couldn’t sell due to lock-ups.

Scenario 2: The California Double Hit

A U.S.-based DAO-related entity issued token options to employees in California. When audited, the state applied both federal 409A penalties and its own additional 5 % penalty. Several employees received combined tax bills exceeding their annual salaries. The company spent months negotiating settlements and reissuing compliant grants through Toku’s platform.

Scenario 3: The Cleanup Cost

A protocol foundation discovered that its token option plan had been misclassified after a law-firm review. Correcting it required amending dozens of agreements, issuing retroactive valuations, and notifying contributors — a process that cost over $250,000 in legal and administrative fees.

These examples underscore a single truth: non-compliance isn’t theoretical — it’s expensive.

The Path to Compliance — How Toku Solves It

Token compensation is complex. Compliance doesn’t have to be.

At Toku, we specialize in helping organizations design, administer, and maintain compliant token-based compensation programs that meet the requirements of Section 409A and other global tax regimes.

Here’s how we help:

1. Token Grant Administration (TGA)

Toku’s TGA solution manages the full lifecycle of token grants — from plan design and documentation to vesting, taxation, and reporting. Our system ensures every grant is drafted to align with 409A requirements or structured to qualify for exemptions.

2. Valuation and Tax Guidance

Working with experienced valuation partners, Toku provides fair-market-value assessments for both equity and tokens, supporting defensible pricing and audit readiness.

3. Compliance Monitoring

Toku continuously monitors global tax and employment-law developments, ensuring your compensation programs remain compliant as regulations evolve.

4. Global Payroll Integration

Through Toku’s integrated Global Payroll Platform, companies can issue fiat, stablecoin, or hybrid payments — compliantly and instantly — across 100 + countries.

5. Expert Advisory Support

Our in-house experts have worked with top crypto organizations such as Protocol Labs and Gnosis to design scalable, compliant compensation systems. We don’t just manage grants — we help companies future-proof them.

The result: peace of mind, knowing that your contributors are rewarded legally and sustainably, and your company remains fully compliant across every jurisdiction.

Token Compensation FAQ

Are token option agreements legal in the U.S.?

Yes, but they are risky. Without 409A compliance, they trigger immediate taxation and penalties.

Do token grants trigger income tax?

Yes. Tokens are typically taxed as ordinary income when received, based on fair market value.

How can I avoid 409A penalties?

Ensure that any deferred-compensation arrangement either qualifies for an exemption (like Service Recipient Stock) or fully complies with 409A’s timing and valuation rules.

Can stablecoins be used for compliant payroll?

Yes. Stablecoins can be treated as cash equivalents if properly reported and valued at fair market rate on the date of payment.

Why partner with Toku?

Because compliance in token compensation isn’t optional — it’s foundational. Toku brings global payroll infrastructure, token-specific expertise, and real-time compliance monitoring under one unified platform.

Hire Toku to Ensure Compliance

Token option agreements might appear to offer flexibility and control, but under U.S. law, they carry significant hidden risks. Section 409A treats most token options as deferred compensation — subjecting them to early taxation, penalties, and interest.

The safest path forward is proactive compliance: structuring compensation in ways that align with existing tax frameworks while preserving the benefits of token-based incentives.

At Toku, our mission is to make global employment and token compensation compliant, effortless, and scalable. We help companies bridge innovation with regulation — empowering them to reward contributors confidently, compliantly, and globally.

Chat with Toku today to learn how our Token Grant Administration and Global Payroll solutions can help your organization stay compliant while embracing the future of work.

‍