Compensating employees with cryptocurrency raises many of the same tax issues as compensating employees with employer shares, and therefore requires well-thought-out planning on the part of both employer and employee, says Dan Morgan from Blank Rome LLP.
To say that cryptocurrency makes headlines is an understatement. In late April, Fidelity announced that it would allow the 23,000 employers running their 401 (k) plans on the Fidelity platform to include bitcoin as a permitted investment alternative – in light of a recent statement from the Ministry of Labor that said : This is a grossly bad idea in terms of the trusted duties that explain how 401 (k) plan investments should be chosen.
The inclusion of cryptocurrency as a pension investment is not the only way in which crypto has entered the workplace. There is anecdotal evidence that employers who want to differentiate themselves in a competitive hiring environment offer to pay their employees with cryptocurrency.
Which brings us to the current topic: the tax implications of cryptocurrency as compensation. Other considerations related to paying employees with cryptocurrency – including consequences for employers if the SEC finds that cryptocurrency should be classified as “secure” under securities law, as well as the interplay between payments with cryptocurrency and federal and state payroll and hourly laws – raise important legal issues in their own right.
Basics of taxation
In a 2014 statement, the IRS said that for tax purposes, cryptocurrency should be treated as property rather than cash. The IRS also said that an employee who receives cryptocurrency as compensation for services has received wage withholding in income tax, which means that the cryptocurrency is included in the salary at its current value, the date the employee receives, or if later acquires, in the cryptocurrency. .
The IRS does not accept tax returns in the form of cryptocurrency. The practical result is that either measures must be taken to withhold income tax attributable to the cryptocurrency from other wages to be paid to the employee, or the employee must write a check to the employer to cover the taxes. . Under tax law, even if it is the employee who is liable to tax upon receipt of the cryptocurrency, failure to pay withholding tax is an employer’s liability.
Price volatility in cryptocurrency can result in a potentially painful tax outcome for an employee paid in cryptocurrency. If an employee on the first day receives a bonus of 100 digital tokens worth $ 10,000, but the value of the tokens drops to $ 2,000 when the employee sells them, the employee will have a regular income of $ 10,000 and a capital loss of $ 8,000, which would be subject to the annual capital loss deduction limit.
Cryptocurrency is subject to an acquisition plan
It is common for employers who compensate their employees with employer shares that the ownership of these shares is earned over a period, so that termination of employment before the end of the earning period entails a loss. All or part of the employee’s right to keep stock.
Earned employer shares are taxable when they are earned at the value of the share at the time of acquisition. However, an employee may choose to tax the action at the time the employee receives it by making an “83 (b) choice.” By making the choice, the employee avoids being taxed on the value of the share 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 choice may turn out to be a very bad idea, because if the stock is lost, the employee can only receive a capital loss as a result of the lapse, 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.
The same dynamic would be at play if an employee’s ownership of an employer-transferred cryptocurrency were to meet earnings requirements.
Consider an employee who receives 100 digital tokens worth $ 10,000, does not pay for tokens, and must work for the employer for four years to acquire tokens. If the employee makes an 83 (b) choice and then loses tokens, the employee would have $ 10,000 in ordinary income on receipt, but no set-off deduction at the time of forfeiture. On the other hand, if the employee does not choose 83 (b) and the tokens are worth $ 100,000 at the time of earning, the employee would have $ 100,000 in ordinary income and the employer would be required to make a withholding tax deposit with the IRS based on the value of $ 100,000.
Deferred payments and buying opportunities for cryptocurrency
Instead of transferring the cryptocurrency that an employee has to acquire, an employer can transfer the cryptocurrency when it is acquired. According to this approach, the taxation of cryptocurrency coincides with the employee’s receipt of the currency.
An employer who wants their employees to pay for cryptocurrency that is subject to an accrual scheme creates the same tax dilemma as described in the example above, except that a forfeiture after an election 83 (b) results in a capital loss equal to the amount per. which the employee has paid for the cryptocurrency in addition to the amount that the employer must pay the employee in connection with the forfeiture. Even if there is no forfeiture, a decrease 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 salary.
To avoid this difficult outcome, an employer may consider giving their employees options, which are earned over time, to buy cryptocurrency at its value when the option is granted. The option will be taxable on exercise, where the employee has a wage income corresponding to the difference between the strike price and the value of the cryptocurrency on the exercise date. Again, the taxation of cryptocurrency will take place at the same time as the receipt of currency.
There is a particularly important proviso that applies to both an employer’s deferred transfer of cryptocurrency and an employer’s allotment of an option to purchase cryptocurrency. According to the Tax Act, the transfer and exercise of the option can only take place on dates previously stated in a written document. These dates may include a specific date (eg the date of acquisition); a change in the control of the employer; or the employee’s death, disability or termination of employment. 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 shares and therefore requires well-thought-out planning on the part of both employer and employee.
Volatility in the value of exchange-traded cryptocurrency can create tax surprises that receiving shares 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, allowing the employee to sell the cryptocurrency to hedge his tax debt. The same does not apply to 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 that the employer has transferred to employees.
“Cryptocurrency as Compensation: A Tax Primer,” by Daniel L. Morgan was published in Bloomberg Law on June 2, 2022. Reprinted with permission.