Cryptocurrency and Equity Compensation

Cryptocurrency, also known as digital currency or virtual tokens, has been gaining popularity in recent years, and its use is becoming an increasingly mainstream consciousness. With its decentralized nature, fast transaction processing times, and low fees, it's no wonder that businesses are starting to explore the use of cryptocurrency in their compensation packages. 

In this article, we'll explore how cryptocurrency is used as equity compensation, the benefits and considerations for both companies and workers, and the tax implications associated with token based awards.

Understanding Cryptocurrency and Equity Compensation

Before diving into how cryptocurrency is used as equity-based compensation, it's important to understand what cryptocurrency is. 

Cryptocurrency is a digital asset that uses cryptography to secure, verify, and control transaction, as well as the creation of new units. Unlike traditional currency, which is regulated by a central authority, cryptocurrency is decentralized and operates on a blockchain, which is a public ledger that records all transactions.

How is Cryptocurrency Used as Equity-based Compensation?

Cryptocurrency can be used as equity-based compensation in a similar way to traditional equity based awards, such as stock options and restricted stock units. Instead of receiving employer stock, employees receive a predetermined number of virtual tokens. These token based awards are subject to vesting, meaning the employee's ownership of the tokens is contingent on past or future services and/or performance based vesting conditions.

Initial Coin Offerings (ICOs) and Token-based Awards

One popular way for companies to distribute token based compensatory awards is through initial coin offerings (ICOs). An ICO is a fundraising method in which a company issues digital tokens that can be bought and sold on a blockchain platform. In exchange for the tokens, investors provide cryptocurrency payments to the company, which can be used for various purposes, including compensation for employees and other service providers.

Comparison Between Crypto-based and Traditional Equity Awards

Compared to traditional equity based awards, crypto-based compensation has several advantages. For one, digital assets can be transferred quickly and with low fees, making it easier and cheaper for companies to pay employees. Additionally, since the value of the cryptocurrency is determined by market forces, there is no need for a company to determine the fair market value (FMV) of the cryptocurrency, as is required with employer stock.

Restricted Token Units (RTUs)

Restricted token units (RTUs) are a type of token-based compensation that grants employees the right to receive a predetermined number of tokens at a future date, subject to vesting based on certain performance targets or the employee's continued service. RTUs are similar to restricted stock units (RSUs) in that they offer employees the right to receive a certain number of shares or token options at a future date, subject to vesting conditions.

Unlike options or traditional stock awards, RTUs do not grant employees the right to purchase or receive tokens at a pre set price. Instead, RTUs are typically granted as a reward for past or future services, and the value of the token options issued is based on the FMV at the time the RTUs vest. This means the employee's compensation income and tax consequences are not determined until the RTUs vest.

When the RTUs vest, the employee receives a certain number of tokens, subject to any applicable income and payroll taxes. The employee can then sell or exchange the token options, subject to any remaining restrictions on the tokens. Like other token-based remuneration, any gain or loss on the sale or exchange of the tokens is considered a capital gain or loss and subject to applicable tax rules.

Cryptocurrency Compensatory Award and the Securities Act

Companies that offer cryptocurrency as employee equity may be subject to the Securities Act of 1933, which regulates the offer and sale of securities. Under the Securities Act, companies must register their securities with the Securities and Exchange Commission (SEC) unless an exemption applies.

One exemption that companies may use for cryptocurrency-based equity compensation is Rule 701, which allows private companies to offer securities as remuneration to workers and other service providers without registering with the Securities and Exchange Commission (SEC), subject to certain conditions. For example, companies must provide specific information to workers about the securities, such as the risks and investment objectives, and the total amount of securities offered cannot exceed certain thresholds.

Another important consideration for companies is compliance with the Internal Revenue Code (IRC) and Internal Revenue Service (IRS) regulations. For example, companies must report the FMV of the cryptocurrency on the date of grant as ordinary income to the employee, and workers may be subject to income and payroll taxes on the value of the cryptocurrency received.

Furthermore, companies that offer cryptocurrency as equity must ensure that they are not providing investment advice or creating an investment contract, which could trigger additional securities law requirements. Companies may also consider using a platform such as Upstock.io and Fidelity platform to manage their cryptocurrency-based equity programs, which can help ensure compliance with applicable regulations and minimize risk.

Benefits of Cryptocurrency as Equity

There are several benefits to issuing and accepting cryptocurrency as employee equity. For one, it can be a way to attract and retain talent, particularly in the tech industry, where knowledge and understanding of blockchain technology are becoming increasingly important. But here are other benefits to gain from it:

A. Benefits for Business Owners

1. Attract and retain top talent

Offering cryptocurrency as employee compensation can be a unique and attractive benefit for workers, especially for those who are interested in digital assets and blockchain. This can help companies to attract and retain top talent in a competitive job market.

2. Cost savings

Using cryptocurrency for employee equity can reduce costs for employers compared to traditional equity based awards. This is because there are no physical certificates or securities to issue and maintain, reducing administrative and legal costs.

3. Global reach

Cryptocurrency is a borderless currency, which can make it easier for companies to offer equity to employees in different countries. This can help companies to expand their workforce globally without the logistical challenges of offering traditional equity awards.

4. Faster settlement

Transactions involving cryptocurrency can settle almost instantly, reducing the time and cost associated with traditional settlement methods. This can help companies to reduce administrative costs and streamline their processes.

5. Improved liquidity

Offering cryptocurrency can provide workers with more flexibility and options for selling or exchanging their tokens, improving liquidity and potentially increasing the value of the tokens.

B. Benefits for Employees

1. Potential for higher returns

Cryptocurrency can be highly volatile, but it also has the potential for significant returns compared to traditional equity awards. This can provide workers with the opportunity for higher remuneration and greater financial freedom.

2. Flexibility

Cryptocurrency can be traded or exchanged for other digital assets or fiat currency, giving employees greater flexibility in managing their incentives. They can also use cryptocurrency for other purposes, such as making purchases or investments.

3. Easy access

Workers can access their cryptocurrency awards through a digital wallet or other online platforms, providing them with unlimited access to their tokens without the need for physical certificates or other documentation.

4. Increased ownership and control

Cryptocurrency compensation provides workers with direct ownership and control over their tokens. This can give them greater flexibility and control over their remuneration and can also provide a sense of ownership in the company.

5. Transparency

Transactions involving cryptocurrency are recorded on a public ledger, providing employees with transparency and a clear record of their incentives. This can increase trust and transparency between employers and workers.

Fair Market Value and the Process of Vesting for Token-based Awards

While the lack of fair market value (FMV) determination can be an advantage for companies, it can also make the process of determining the value of token based awards more difficult for workers. The fair market value of the cryptocurrency is the price at which it would be sold between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the relevant facts. Since the cryptocurrency market is volatile and the value of the tokens can fluctuate greatly, it can be difficult for workers to determine the FMV of their awards.

Considerations for Employers

When considering using cryptocurrency as employee equity, there are several things that employers should keep in mind. For one, employers need to be aware of the tax consequences associated with token based awards. These awards are subject to income and payroll taxes, and employers are responsible for paying the income withholding taxes and payroll taxes associated with the awards. 

Additionally, employers must be aware of the minimum wage requirements and other rules associated with paying employees in virtual currency.

Considerations for Employees

Workers also need to be aware of the tax consequences associated with token based awards. The value of the cryptocurrency is subject to capital gains and losses for tax purposes, and any gains or losses are realized when the employee sells or exchanges the cryptocurrency. If the employee sells the cryptocurrency within a year of receiving it, any gains are considered ordinary income and subject to income taxes. If the employee sells the cryptocurrency after holding it for more than a year, any gains are considered long-term capital gains and subject to lower tax rates.

It's also important for workers to understand the vesting schedule for their token based awards. The vesting date is the date on which the employee's ownership of the tokens becomes unrestricted, and they can sell or exchange them. Until the vesting date, the tokens are considered restricted, and the employee may not have full control over them. Workers need to carefully review the terms of their token based awards to understand when they will receive their remaining restricted tokens.

Tax Implications for Token-based Awards

Income Withholding Taxes

Token based awards are subject to the same tax rules as other compensatory tokens. For tax purposes, the fair market value of the tokens issued is considered income, and the employee's tax liability is based on this value. Employers must report the income on the employee's W-2 form and withhold income and payroll tax accordingly.

Capital Gains

If the employee pays the exercise price for the tokens, any gain or loss on the sale or exchange of the tokens is considered a capital gain or a capital loss. If the employee sells or exchanges the tokens within a year of receiving them, any gain or loss is considered short-term and subject to ordinary income tax rates. If the employee sells or exchanges the tokens after holding them for more than a year, any gain or loss is considered long-term and subject to lower tax rates.

Employers should consult with a tax professional to ensure that they are complying with all applicable state securities laws and tax laws when issuing token based awards to workers.

Upstock’s Game-Changing Solutions for Your RTUs

Indeed, cryptocurrency is becoming an increasingly popular form of equity-based compensation, and its use is likely to continue to grow as blockchain becomes more mainstream consciousness. 

While there are several benefits to using cryptocurrency such as RTUs as employee equity, there are also several considerations and tax liabilities that employers and workers need to be aware of. 

By understanding the tax basics and consulting with a tax advisor, companies can successfully implement token based compensatory awards as part of their employee remuneration packages.

At Upstock, we always seek new ways to integrate equity into a company’s compensation program to ensure seamless, worry-free management of employees’ incentive awards. If you want to learn more about token-based compensation and how it can be used to better incentivize workers and workers, let’s talk!