Cryptocurrency as Compensation: An Introduction to Taxation
To say that cryptocurrency is making headlines is an understatement. At the end of April, Fidelity announcement that it would allow the 23,000 employers who run their 401(k) plans on the Fidelity platform to include bitcoin as a permitted investment alternative – in the face of a recent statement by the Department of Labor that this is a blatantly bad idea from the perspective of fiduciary obligations that dictate how 401(k) plan investments should be selected.
The inclusion of cryptocurrency as a retirement plan investment isn’t the only way crypto has entered the workplace. There is anecdotal evidence that employers looking to differentiate themselves in a competitive hiring environment are offering to pay their workers with cryptocurrency.
Which brings us to the topic at hand: the tax implications of cryptocurrency as compensation. Other considerations related to paying employees with cryptocurrency – including ramifications for employers if the SEC concludes that cryptocurrency should qualify as “safe” under securities laws, as well as the interaction between cryptocurrency payments and federal and state wage and hour laws – raise important legal issues in their own right.
The basics of taxation
In a review 2014, the IRS has said that cryptocurrency should be treated for tax purposes as property rather than cash. The IRS also said that an employee who receives cryptocurrency as compensation for services has received income tax withholding wages, which means the cryptocurrency is included in wages at its current value. the date the employee receives, or if later acquires, in the cryptocurrency. .
The IRS does not accept tax filings in the form of cryptocurrency. The practical result is that arrangements must be made either to withhold income taxes attributable to the cryptocurrency from other wages payable to the employee, or for the employee to write a check to the employer to cover the taxes. . Under tax law, although it is the employee who is taxable upon receipt of the cryptocurrency, non-payment of withholding taxes is an employer liability.
Cryptocurrency price volatility can produce a potentially painful tax outcome for an employee paid in cryptocurrency. If on the first day an employee receives a bonus of 100 digital tokens worth $10,000, but the value of the tokens decreases to $2,000 by the time the employee sells them, the employee will have ordinary income of $10,000 and a capital loss of $8,000, which would be subject to the annual capital loss deduction limit.
Cryptocurrency subject to an acquisition schedule
It is common for employers who compensate their employees with employer shares that ownership of those shares vests over a period of time such that termination of employment before the end of the vesting period results in a loss. full or partial of the employee’s right to keep the stock.
Vesting-required employer shares are taxable when vested at the value of the share at the date of vesting. An employee, however, can elect to tax the action at the time the employee receives it by making an “83(b) election.” By making the election, the employee avoids being taxed on the value of the stock at the time of vesting. This generally makes more sense if the choice is made at a time when the stock is of little value, as would be the case if the employer is a brand new start-up. In other circumstances, the election may turn out to be a very bad idea, because if the stock is forfeited, the employee can only receive a capital loss as a result of the forfeiture, and only to the extent that the amount the employee paid for the action, if any, exceeds any payment the employee receives from the employer in connection with the forfeiture.
This same dynamic would be at play if employee ownership of employer-transferred cryptocurrency were to meet vesting requirements.
Consider an employee who receives 100 digital tokens worth $10,000, does not pay for the tokens, and must work for the employer for four years to acquire the tokens. If the employee makes an 83(b) election and then loses the tokens, the employee would have $10,000 of ordinary income at the time of receipt, but no offsetting deduction at the time of forfeiture. On the other hand, if the employee does not make the 83(b) election and the tokens are worth $100,000 at the time of vesting, the employee would have $100,000 of ordinary income and the employer would have the obligation to make an income tax withholding deposit with the IRS based on the value of $100,000.
Deferred payments and cryptocurrency purchase options
Instead of transferring the cryptocurrency that an employee needs to acquire, an employer can transfer the cryptocurrency when it is acquired. According to this approach, the taxation of cryptocurrency coincides with the receipt of the currency by the employee.
An employer who wants their employees to pay for cryptocurrency, which is subject to a vesting schedule, creates the same tax dilemma described in the example above, except that a forfeiture following an election 83(b) produces a capital loss equal to the amount by which the employee paid for the cryptocurrency in excess of the amount payable by the employer to the employee in connection with the forfeiture. Moreover, even if there is no forfeiture, a decline in the value of the cryptocurrency results in a capital loss, compared to the ordinary income treatment of the value of the cryptocurrency when it was treated as wages.
To avoid this difficult outcome, an employer might consider granting their employees options, which vest over time, to purchase cryptocurrency at its value when the option is granted. The option would be taxable upon exercise, with the employee having wage income equal to the difference between the strike price and the value of the cryptocurrency on the date of exercise. Again, the taxation of cryptocurrency would occur at the same time as the receipt of currency.
There is a particularly important caveat that applies to both the deferred transfer of cryptocurrency by an employer and the granting by an employer of an option to purchase cryptocurrency. Under the tax code, the transfer and exercise of the option can only take place on dates previously specified in a written document. These dates may include a specific date (for example, the date of acquisition); a change in control of the employer; or the death, disability or termination of employment of the employee. These dates can only be changed in very limited circumstances. Failure to meet this time requirement may result in the employee paying an additional 20% tax on the value of the cryptocurrency at the time of acquisition.
Paying employees with cryptocurrency raises many of the same tax issues as paying employees with employer stock and therefore requires thoughtful planning on the part of both employer and employee.
Volatility in the value of exchange-traded cryptocurrency can create tax surprises that receiving stock from a private employer does not; the stock of private employers is generally assessed only once a year. On the other hand, the existence of an exchange makes it easy for an employee to sell cryptocurrency, at least to the extent that it is acquired, which allows the employee to sell the cryptocurrency to hedge his tax debts. The same is not true for private employer shares for which there may be no readily available market other than the employer, and most private employers are reluctant to commit to buying shares. transferred by the employer to the employees.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
Dan Morgan is a partner in the benefits and executive compensation division at Blank Rome LLP. He has spent his career representing a wide range of public and private companies and not-for-profit organizations, as well as senior executives of these companies and organizations.
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