Toku Primer

ABOUT THE AUTHOR

Toku provides token compensation, global employment, and token tax compliance solutions for crypto-native employment in 100+ jurisdictions globally. The growing list of customers includes Protocol Labs, Mina Foundation, Astar Network, dYdX Foundation, Filecoin Foundation, Gitcoin, Gnosis, Hedera Hashgraph, Safe, and many more
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Content Plan

Introduction
Types of Token Compensation
Restricted Token Awards (RTAs)
Token Purchase Agreements (TPAs)
Restricted Token Units (RTUs)
Grant Matrix
Conclusion

This primer is not intended to constitute legal, tax or financial advice and is only providing general information. You are encouraged to consult your own legal, tax and financial advisors with respect to token compensation. For any question regarding this Primer, please contact Benjamin Snipes, Esq. at team@toku.com
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Introduction

This primer provides an overview of token grant compensation alternatives commonly used in the blockchain and digital asset industry. We will cover token grant compensation’s background, various models for token-based compensation, and certain United States legal, regulatory, tax, and operational considerations of the models discussed.¹

Token-based compensation refers to the practice of rewarding individuals with tokens (cryptocurrencies or tokens issued on blockchain platforms). Token-based compensation borrows from well-known models used in equity-based compensation, but its structure is driven by separate regulatory developments, technological advancements, and changes in industry practices.^2
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This primer assumes that readers have a basic understanding of equity-based compensation, the distinction between traditional equity and non-equity tokens, and the associated tax implications, since they are necessary to understand token compensation and choosing a model that works best for your project.³

Interest in token incentive plans and grant agreements for employees and contractors (which we refer to collectively going forward as “employees”) has grown along with the increasing regulatory and compliance maturity of the crypto industry overall. While significant progress has been made in raising awareness and acceptance of token grant agreements among founders, executives, and workers, there remains a critical knowledge gap when it comes to the structure, communication and implementation of token grants.

The goal of this primer is to offer insights into token compensation alternatives and guide further adoption of token compensation models by crypto-native organizations.
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Types of Token Compensation

In our experience, the three main types of token compensation⁴in use today are:
- Restricted Token Awards (RTAs),
- Token Purchase Agreements (TPAs), and
- Restricted Token Units (RTUs)
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Restricted Token Awards (RTAs)

What they are: Restricted Token Awards (RTAs) are immediately granted to the employees with full ownership rights over the tokens and are immediately transferred to the employee’s digital wallet or an intermediary wallet that employees may draw from when restrictions are lifted. RTA tokens are subject to a "lock-up" period during which they cannot be sold or transferred, and “claw back” rights, which provide the grantor with the right to take back the tokens before they have vested.

How they are used: RTAs are often used for United States tax purposes for grants issued after tokens have been minted prior to a token being publicly launched. The United States allows recipients to file a form called an “83(b) election” for a limited period on transferred property that is subject to vesting, which recognizes receipt of the tokens for tax purposes when property is transferred (potentially even if lock-up or claw-back restrictions are still in place). Early recognition of income for tax purposes on the tokens when granted may be a good result for employees because the full value of the tokens for tax purposes is usually minimal pre-launch, but it depends on future growth in value. If recipients were to recognize the tokens as income later when the value of the tokens is higher, their taxes would be higher too, without necessarily being able to liquidate a portion of the tokens to pay the income taxes due to applicable lockups or limited market liquidity.

To transfer tokens while maintaining legal restrictions around them, RTAs are often administered using multi-signature intermediary wallets, which means that the tokens are not fully self-custodied until the vesting period for the tokens ends.

What you should watch out for: RTAs may not be taxable until the lock-up and claw-back period ends, but in the United States, employees may potentially elect to be taxed on the entire token grant value at the time of grant by making an 83(b) election.⁵ Specifically in the United States, a timely 83(b) tax election also starts the clock for capital gains tax purposes.⁶

Token Purchase Agreements (TPAs)

What they are: Token Purchase Agreements (TPAs) are like RTAs, with similar restrictions on the tokens until they vest, except that they establish a purchase price to acquire the initial grant of tokens and cash is paid by the recipient for the tokens.

How they are used: Like RTAs, TPAs would most often be used after the token is minted but before the token launch, to allow workers to pay taxes at grant when the token value is presumably low. However, because workers must pay a price for the tokens at grant, that purchase price may be set at the token value to nullify taxable income and set the tax basis for the tokens at the purchase price.

What you should watch out for: TPAs require those receiving token grants to pay a purchase price, which might not be well received by employees. Also, the cash component of the consideration for tokens could impact how the tokens are treated under U.S. securities laws.⁷

Restricted Token Units (RTUs)

What they are: A holder of Restricted Token Units (RTUs), similar to Restricted Stock Units (RSUs), is granted a right to receive a fixed number of tokens that are subject to a vesting schedule. Like RSUs, the vesting schedule for RTUs can be flexible, but tends to follow the standard precedent of a four-year vest with a one-year cliff, with the tokens vesting monthly or quarterly afterwards. Upon vesting, tokens are delivered to the participant (this delivery is commonly called “settlement”); provided, however, that in the case of monthly vesting, most companies provide for settlement of vested awards on a quarterly basis for ease of administration.

How they are used: RTUs are most often used once a token is launched. RTUs, like RSUs, are taxed at delivery at the then-current fair market value. RTUs are also usually easier to administer than RTAs because the tokens are not transferred to the employee until vesting and settlement.

What you should watch out for: Once the vesting period for an RTU lapses according to schedule, RTUs deliver tokens, and the tokens are then sent by the company to the employee’s digital wallet. Initiation of settlement is typically the time that RTUs become taxable for United States ordinary income tax purposes at their then-current fair market value to the employee.⁸

For employees, the value will be subject to withholding, which may be made by withholding tokens that would otherwise be delivered upon vesting. However, any withholding must be paid in cash. Therefore, if a company elects to satisfy tax withholding by withholding tokens that would otherwise be issued upon vesting, the company should consider whether it either will have cash reserves available or if it can sell tokens, i.e., if lockup restrictions have expired, to generate cash.

Grant Matrix

This grant matrix⁹ outlines the three main types of token grant agreements. It highlights the key considerations across personal tax, corporate tax and other considerations
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Grant Matrix
	Restricted Token Awards (RTAs)	Token Purchase Agreements (TPAs)	Restricted Token Units (RTUs)
Description	- In exchange for start of employment, generation and transfer of Tokens to employee, subject to transfer, vesting and forfeiture restrictions - Tokens that do not vest are forfeited/returned to the Company for no consideration	- In exchange for purchase price and start of employment, generation and transfer of Tokens to employee, subject to transfer, vesting and forfeiture restrictions - Tokens that do not vest are forfeited/returned to the Company for no consideration	- In exchange for purchase price and start of employment, generation and transfer of Tokens to employee, subject to transfer, vesting and forfeiture restrictions - Tokens that do not vest are forfeited/returned to the Company for no consideration
Lock-Up/ Transfer Restrictions	- Tokens may be subject to lock-up for a period of time post issuance	- Tokens may be subject to lock-up for a period of time post issuance	- RTUs are not transferable - Tokens may be subject to lock-up for a period of time post-issuance

Grant Matrix - Personal Income Tax (United States)
	Restricted Token Awards (RTAs)	Token Purchase Agreements (TPAs)	Restricted Token Units (RTUs)
Grant	- If 83(b) election is timely filed, ordinary income tax on FMV at time of transfer	- If 83(b) election is timely filed, ordinary income tax on the excess (if any) of the FMV at time of transfer over the price paid for the tokens	- No tax at time of grant
Vesting	- None, if 83(b) election is timely filed - If no 83(b) election, ordinary income tax on the FMV at time of vesting	- None, if 83(b) election is timely filed - If no 83(b) election, ordinary income tax on the excess of the FMV at time of vesting over the price paid for the tokens	- Ordinary income tax on the FMV when Tokens are settled immediately following vesting
Exercise	N/A	N/A	N/A
Settlement	Depends on election	Depends on election	Taxed at vesting and settlement
Subsequent Sale of Tokens	- If 83(b) election timely filed, capital gain on difference between sale price and FMV on date of issuance if held for investment purposes - If 83(b) election timely filed, long-term capital gain if Tokens held for more than one year from transfer - If no 83(b) election, capital gains is measured from date of vesting and value is based on difference between sale price and FMV on date of vesting	- If 83(b) election timely filed, capital gain on difference between sale price and FMV on date of issuance if held for investment purposes - If 83(b) election timely filed, long-term capital gain if Tokens held for more than one year from transfer - If no 83(b) election, capital gains is measured from date of vesting and value is based on difference between sale price and FMV on date of vesting	- Capital gain on difference between sale price and FMV on date of settlement - Long-term capital gain if Tokens held for more than one year from settlement

Grant Matrix - Company Tax (United States)
	Restricted Token Awards (RTAs)	Token Purchase Agreements (TPAs)	Restricted Token Units (RTUs)
Grant	- The Company recognizes gain on FMV in excess of the Company's basis - Company is entitled to a compensation tax deduction on the transfer (or, if no 83(b) election, at the time of vesting) equal to FMV - Company has an obligation to withhold on the FMV of the Tokens at transfer (or, if no 83(b) election, at vesting)	- The Company recognizes gain on FMV in excess of the Company's basis - Company is entitled to a compensation tax deduction on the transfer (or if no 83(b) election, at the time of vesting) equal to excess (if any) of FMV over the price paid - Company has an obligation to withhold on the excess of FMV of the Tokens over the price paid at transfer (or, if no 83(b) election, at vesting)	None
Vesting / Exercise	None, if 83(b) election is timely filed	None, if 83(b) election is timely filed	- The Company recognizes gain on FMV in excess of the Company's basis - Company is entitled to a compensation tax deduction on the FMV of the tokens transferred at vesting - Company has an obligation to withhold on the FMV of the Tokens when transferred following vesting
Subsequent Sale of Tokens	None	None	None
83(b) Election	Yes, an 83(b) election may generally be filed within 30 days of transfer	Yes, an 83(b) election may generally be filed within 30 days of transfer	N/A
409A	Exempt	Exempt	Could be subject to 409A, consider impacts

Grant Matrix - Other Notes
	Restricted Token Awards (RTAs)	Token Purchase Agreements (TPAs)	Restricted Token Units (RTUs)
Advantages	- Issuances prior to, at or around public Token launch may benefit from lower FMV - 83(b) election provides potential for favorable tax treatment for employee - Vesting may provide retention value for Company - Exempt from Section 409A	- Issuances prior to, at or around public Token launch may benefit from lower FMV - 83(b) election provides potential for favorable tax treatment for employee - Vesting may provide retention value for Company - Exempt from Section 409A	- Vesting may provide retention value for Company - Vesting is easier to enforce because Tokens are not actually transferred until vesting - No upfront tax liability for employee on Tokens subject to forfeiture
Disadvantages	- Withholding obligation must be satisfied in cash - Vesting may be difficult to enforce, unless embedded into smart contract or handled manually by Company - May require generation and issuance of Tokens in advance of public issuance and/or network launch	- Withholding obligation must be satisfied in cash - Vesting may be difficult to enforce, unless embedded into smart contract or handled manually by Company - May require generation and issuance of Tokens in advance of public issuance and/or network launch	- Potentially greater ordinary income tax obligation and withholding obligation because FMV of Tokens may increase over time - Withholding obligation must be satisfied in cash - Multiple withholding events can be administratively complex - Need to consider impact of Section 409A

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. As digital assets continue to gain popularity, token compensation offers employees a chance to participate in the potential growth of the value of these assets and enjoy the features and benefits the tokens were designed to provide. Nevertheless, both employers and employees should carefully consider the implications and risks associated with token compensation before incorporating tokens into their compensation packages.

Selecting a type of token-based compensation requires considering a wide variety of factors, including business goals, compensation preferences, the nature of your business, and the location of your business and employees. Once you decide on the best token compensation structure for your business and employees, implementing your token compensation plan should incorporate following best practices learned from leading lawyers, compensation consultants, and plan administrators using best-in-class software and workflows.
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FootNotes

¹ Please consult local counsel for best practices in non-United States jurisdictions.
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²   While the determination of whether or not a token is considered to be a security under United States law is outside the scope of this Primer, if a token was considered an unregistered security, issuance of that token to employees could possibly still qualify for exemption from registration under 17 CFR Part 230.701 (“Rule 701”) as equity-based compensation. Projects contemplating issuing a token should consult with competent legal counsel with respect to the potential security status of a token under US law.
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³   See SEC v. LBRY, No. 21-CV-260-PB, 2022 WL 16744741 (D.N.H. Nov. 7, 2022).
⁴   Token options and token warrants are not recommended in the United States for token compensation, though they may be used in an investment context. Due to restrictions under United States tax law (IRC Section 409A), the structure of a typical stock option does not easily translate into token options or token warrants for compensation purposes.
⁵   An 83(b) type election is generally recommended if the token holder believes the token will appreciate in value since the value of tokens are often far less when a token is initially granted than they would be later on; IRS Rev. Proc. 2012-29.
⁶ See ASC 718-10-55-8 as discussed in PwC, 2.4 Reloads and clawback features of stock compensation awards, US Stock-based compensation guide (Sep 30, 2021). In the US, short-term capital gains rates are the ordinary income rates, and long-term capital gains rates are 0 percent, 15 percent and 20 percent, depending on income. The United Kingdom, among other jurisdictions, provides a similar election referred to as a “Section 431 Election.”
⁷ I.e. under the "investment of money" prong for Howey as discussed in, Sec. & Exch. Comm'n v. Ripple Labs., 20 Civ. 10832 (AT) (S.D.N.Y. Oct. 3, 2023).
⁸   IRS Notice Notice 2014-21; IRS, Frequently Asked Questions on Virtual Currency Transactions, found at https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions; C.f. U.S. Internal Revenue Service, Equity (Stock) - Based Compensation Audit Techniques Guide (August 2015).
⁹ Contributions included by permission from Mary M. Lewis, Cooley LLP.
¹⁰ A relatively open legal question remains whether token minting and distribution is required before recognizing transfer of property for IRC §83(b) purposes.
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