Compensating employees with cryptocurrency raises many of the same tax issues as compensating employees with employer stock and, therefore, requires thoughtful planning on the part of both the employer and the employee, says Blank Rome LLP’s Dan Morgan.
To say that cryptocurrency is in the headlines is a bit of an understatement. In late April, Fidelity announced that it would allow the 23,000 employers who operate their 401(k) plans on the Fidelity platform to include bitcoin as a permissible investment alternative—in the face of a recent Department of Labor pronouncement that doing so is a glaringly bad idea from the perspective of the fiduciary obligations that inform how 401(k) plan investments are to be selected.
The inclusion of cryptocurrency as a retirement plan investment is not the only way that crypto has entered the workplace. There is anecdotal evidence that employers seeking 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 the ramifications to employers if the SEC concludes that cryptocurrency is to be characterized as a “security” under the securities laws, plus the interaction between cryptocurrency payments and the federal and state wage and hour laws—raise important legal issues in their own right.
The Tax Basics
In a 2014 notice, the IRS stated that cryptocurrency is to be treated for tax purposes as property rather than money. The IRS also said that an employee who receives cryptocurrency as compensation for services has been paid income tax withholding wages—which means that cryptocurrency is includable in wages at its value on the date that the employee receives, or if later, vests, in the cryptocurrency.
The IRS does not accept tax deposits in the form of cryptocurrency. The practical upshot is that some arrangement must be made either to withhold the income taxes attributable to the cryptocurrency from other wages payable to the employee or have the employee write a check to the employer to cover the taxes. Under the tax law, although it is the employee who is taxable on the receipt of the cryptocurrency, the failure to pay income withholding taxes is a liability of the employer.
The price volatility of cryptocurrency can produce a potentially painful tax result to an employee paid in cryptocurrency. If on day one, an employee receives a bonus of 100 digital tokens with a value of $10,000, but the tokens decline in value to $2,000 at 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 limit on the deduction of capital losses.
Cryptocurrency Subject to a Vesting Schedule
It is common for employers who compensate their employees with employer stock to have ownership of that stock vest over a period of time such that a termination of employment prior to the completion of the vesting period results in a full or partial forfeiture of the employee’s right to keep the stock.
Employer stock that is subject to vesting requirements is taxable when it vests at the stock’s value on the vesting date. An employee, however, can elect to have the stock taxed 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 the most sense if the election is made at a time when the stock has little value, as would be the case if the employer is a brand-new start-up. Under other circumstances, the election can prove to be a remarkably bad idea, because if the stock is forfeited, the employee may only receive a capital loss because of the forfeiture—and then only to the extent that the amount the employee paid for the stock, if any, exceeds any payment that the employee receives from the employer in connection with the forfeiture.
This same dynamic would be at play if an employee’s ownership of employer-transferred cryptocurrency must satisfy vesting requirements.
Consider an employee who receives 100 digital tokens with a value of $10,000, doesn’t pay for the tokens, and must work for the employer for four years to vest in the tokens. If the employee makes an 83(b) election and then forfeits 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 an 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 attendant obligation to make an income withholding tax deposit with the IRS based on the $100,000 value.
Deferred Payments and Options to Purchase Cryptocurrency
Instead of transferring cryptocurrency that an employee must vest in, an employer can transfer the cryptocurrency when it vests. Under this approach, the taxation of the cryptocurrency coincides with the employee’s receipt of the currency.
An employer who would like its employees to pay for cryptocurrency, which is subject to a vesting schedule, creates the same tax quandary described in the example above—except that a forfeiture following an 83(b) election 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. Also, even if there is no forfeiture, a decline in the value of the cryptocurrency results in a capital loss, as compared to the ordinary income treatment of the value of the cryptocurrency when it was treated as wages.
To avoid this harsh result, an employer might consider granting its 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 exercise price and the value of the cryptocurrency on the date of exercise. Again, the taxation of the cryptocurrency would happen at the same time as the receipt of the currency.
There is one especially important caveat that applies to both an employer’s deferred transfer of cryptocurrency and an employer’s grant of an option to purchase cryptocurrency. Under the tax code, the transfer and the exercise of the option can only occur on dates that are pre-specified in a written document. Those dates can include a specific date (for example, the date of vesting); a change of control of the employer; or the death, disability, or termination of employment of the employee. Those dates can only be changed in very limited circumstances. Failing to comply with this timing requirement can result in the employee having to pay a 20% additional tax on the value of the cryptocurrency at vesting.
Compensating employees with cryptocurrency raises many of the same tax issues as compensating employees with employer stock and therefore requires thoughtful planning on the part of both the employer and the employee.
The volatility in the value of cryptocurrency that is traded on an exchange can create tax surprises that receipt of stock in a private employer doesn’t; private employer stock is generally only valued once per year. On the other hand, the existence of an exchange allows an employee to readily sell cryptocurrency, at least to the extent it is vested, which enables the employee to sell the cryptocurrency to cover their tax liabilities. The same is not true of stock of a private employer for which there may be no easily accessed market other than the employer, and most private employers are reluctant to commit to purchasing stock transferred by the employer to employees.
“Cryptocurrency as Compensation: A Tax Primer,” by Daniel L. Morgan was published in Bloomberg Law on June 2, 2022. Reprinted with permission.