What’s a Utility Token Worth Anyway? Using Utility Tokens as Compensation.

Two warnings: First, this is a complicated topic and one that is very challenging to distill into easily digestible concepts. This article is intended to be a cursory summary and not a detailed analysis of everything you need to know.  Make sure to get advice from qualified professionals; Second, tax laws and the tax treatment of tokens are evolving and what might (and I mean might) be the tax outcome today may not be the tax outcome in the future. Finally, the analysis to determine the value of tokens is very fact sensitive.  This article does not constitute tax advice.

Most founders of companies are familiar with the concept of stock options and stock grants as a method of attracting and retaining employees.  Giving employees a “stake in the game” ensures that their interests and goals are aligned with the company’s - it incentivizes and rewards performance by sharing the increasing enterprise value of the company, and engenders loyalty and reduces turnover through “golden handcuffs”.  Stock options and stock grants are subject to tax rules that provide clear direction on valuation and associated tax treatment to both the corporation and the recipient.

Blockchain based technology companies have an additional tool to attract and retain talent –tokens.  Side note: there are plenty of articles on the Internet that use tokens and coins interchangeably, we are referring to the token as a medium of exchange for the products or services of the company issuing the token (aka utility tokens).  By contrast, a coin (or cryptocurrency token) is a token exchangeable for fiat (legal currency) or other cryptocurrency, and a security token is a token that is tied to a physical asset or the equity of the issuer.  This article will focus on utility tokens – tokens that are exchangeable for products or services of the issuer – and all references to tokens are intended to refer to utility tokens only.

Background

Tokens are considered “property” by the IRS, and are generally governed by Section 83 of the Internal Revenue Code.  Tokens can be granted to employees or contractors and are treated the same for tax purposes by the Internal Revenue Service (IRS).  Tokens, unlike incentive stock options or other tax-deferred forms of equity compensation, are not entitled to any deferred tax or other favorable tax treatment.  In short, as of the date of grant, the recipient of a token is deemed to have received ordinary income equal to the fair market value of the token. The question, of course, is how do we figure out the fair market value of the token?

Section 83(a) provides that if a person receives property in exchange for services, the fair market value of the property at the time the recipient has full rights to such property (i.e. they are not subject to a substantial risk of forfeiture), less any amount paid by such recipient for the property, is included in their gross income.  In simple terms, that means that if a token has a fair market value of $1, and the employee received it for services and paid nothing for it, then the employee recognizes income of $1.

Valuation Factors

The process for valuing tokens generally falls into two buckets: objectively determinable value and subjectively determinable value.  For purposes of this article, the valuation analysis assumes that the tokens are not trading on a public exchange. If they are, then a market approach is used - value is based on the pricing established by the trading on the exchange, and the valuation question is simple to answer.

Objective Determination of Value

Objectively determinable value is fairly straightforward, and relies on the following:

  1. the services or products for which the tokens are exchangeable exist at the time the tokens are issued or will exist shortly after tokens are issued;
  2. the services or products have a fair market value, either because they are priced by the issuer or because the market has established a value;
  3. the tokens have a specific exchange rate for the services or products;
  4. at any given point in time the issued and outstanding number of tokens is known;
  5. The company has not established any fixed price at which tokens are sold (pre-ICO).

This becomes a simple math exercise at any given point in time:

X= number of tokens required to be exchanged for the services or products;
Y=fair market value of services or products;
Z= price per token

Y/X = $Z

Note that X is dictated by the issuer and may be changed by the issuer to meet its goals for the products/services; as well, the issuer controls the number of tokens issued and similarly can largely dictate secondary market value.  Since all of the above factors that dictate value are controllable by the issuer, these tokens have a readily ascertainable value.

Subjective Determination of Value

Subjective valuation comes into play when some or all of the factors above are unresolved, as well as others:

  1. The services or products are in development and as such, technology risk, execution risk, financing risk, and a myriad of other risks may exist that could cause the deployment of the services or products to be delayed, more costly, or never happen;
  2. Pricing for the services or products is not yet established, either because of point 1 above, or because they are new offerings for which a market value is not yet known;
  3. No fixed rate of token exchange for the products or services has been established;
  4. No decision has yet been made on the number of tokens that will be issued in any given period of time;
  5. The tokens are not priced;
  6. The tokens are subject to restrictions on transfer;
  7. The issuer does not have a readily defined plan to resolve the above.

As a result, valuation will largely be dictated by management’s assessment taking into account some or all of the above. The net outcome is that the tokens are likely to have a nominal fair market value at the time of grant.

             Risk of Forfeiture

The last component of valuation is determining whether the tokens are subject to a “substantial risk of forfeiture”.  A substantial risk of forfeiture exists when the tokens are subject to vesting criteria, the failure of which results in the recipient losing the tokens.  Typical vesting criteria is time based, performance based, or some combination of the two.

Tokens that are subject to a substantial risk of forfeiture are not deemed by the IRS to be received by the recipient. Thus, on the date of grant, and thereafter until they vest, the recipient does not recognize any income.  However, as the tokens vest, the recipient is deemed to have received income in an amount equal to the fair market value of the tokens at that time, and if the value of the tokens has increased substantially from the date of grant, the recipient can find themselves with a hefty tax bill.

Thus, to mitigate the tax impact of a grant of tokens that have a substantial risk of forfeiture, the IRS permits a recipient to elect to report income as of the date of grant in an amount equal to the discounted fair market value of the tokens at that time. To make the election, the recipient must file a Form 83(b) within thirty (30) days of grant.

The more onerous the vesting criteria, the greater the risk of forfeiture, and the greater the discount.  Discounts can range from 10% to as high as 90%, based on the severity of the vesting criteria (by way of example, if the recipient had to stay employed with the company for 50 years to vest in their tokens, it should be obvious that the risk of forfeiture is very high, and therefore the value of the tokens should be very low). By filing Form 83(b), the recipient will pay (hopefully nominal) taxes on a current basis, but as the vesting criteria is satisfied, the recipient will not recognize any additional income and it will be deferred until the tokens are disposed of (in this case, traded, sold or used to purchase the associated services or goods).

Conclusion

Tokens can serve as a powerful incentive to employees and contractors and a useful tool for companies.  Just make sure that the tax implications are considered and properly addressed.

Kurt D. Olender is the managing partner of the Firm. For more information, contact Kurt at 908-964-2485, or kolender@olenderfeldman.com.