Withholding and Tax Considerations for Restricted Token Units

Offering compensation incentives to workers that promote the growth and adoption of a business is nothing new for the start-up world. What is novel is offering those incentives utilizing blockchain. For Web3 startups, compensation packages may appear identical to that of their traditional counterparts, but upon further investigation, one will notice that a critical term has been changed: “stock” has been swapped for “token.” Whether it’s token options, restricted token awards, or restricted token units, each is analogous to their stock predecessor but have unique considerations. This article will specifically focus on the use of restricted token units as employee compensation and incentives and the similarities and differences with restricted stock units. 

Restricted Token Units 

RTUs are functionally similar to RSUs. Like RSUs, they have restrictions on how the recipient will gain ownership of the underlying asset, they are usually subject to vesting, and they are ineligible for an 83(b) election. Unlike RSUs, the tokens issued do not typically convey ownership or equity in a company. Due to their nature, RTUs can offer unique tax challenges when it comes to things such as timing, fair market valuation, and tax withholding considerations.  

RTUs can be used as part of an overall compensation package for employees or contract workers (worker). This means that when the property is transferred (as defined by the Internal Revenue Code), the total fair market value (FMV) of the units transferred is included in the worker’s taxable income. This income is subject to employment and payroll taxes in addition to income tax. Remittance of withholding taxes to the IRS is due either one or three days after the realization event, depending on the amount of payroll tax liability. Due to the general volatility of digital assets, this means that the FMV of RTUs can fluctuate dramatically during the term covered by the agreement, which has downstream consequences for both the employer and worker.  

As mentioned, one downside of RTUs is that they are not eligible for an 83(b) election. Under 83(b), certain transfers of property that have restrictions may be included in the recipient’s taxable income in the year of the grant, as opposed to the year the restriction lapses. An 83(b) election can generate significant tax savings in situations where the property greatly appreciates in value. RTUs are not eligible for this special treatment as they are not considered a transfer of property under Sec. 83, but rather a promise to provide a number of tokens at a later date. (Those who wish to offer an 83(b) eligible option should look to restricted token awards or grants, which are analogous to restricted stock awards)  

Timing 

Because RTUs are generally income once vested, timing of receipt becomes an important consideration, especially due to the high volatility of digital assets and the obligation of employers to collect and remit tax withholdings on wages in a timely manner. Generally, the timing of inclusion in income is determined by when the property is considered to have been transferred under the Internal Revenue Code. Timing can be determined by the vesting or transfer provisions contained in the agreement between the worker and the company. There are some important considerations with timing, including whether the deferral of income must meet certain requirements under IRC. Sec. 409A and how tokens will vest, both discussed below.   

409A Considerations 

Generally, RSUs and RTUs are considered “Non-Qualified Deferred Compensation” (NQDC), meaning the worker does not have an absolute right to the compensation until a later date. By deferring compensation to a later date, the worker may be able to save on taxes in the current year. However, they run the risk of the company failing to honor the promise or even no longer being in existence at the time the compensation would be due. NQDC plans must meet certain requirements under 409A. Failure to do so can result in the deferred compensation being included in income earlier than intended, regardless of the intentions of the parties, and subject to significant penalties.  

Vesting 

RTUs usually vest, meaning they are not available until certain conditions are met. Typically, the condition is a length of employment, though performance metrics can be used as well. Vesting either occurs over time (incremental vesting), after a cliff period, or some combination of the two.  

Example: A Company enters into an agreement for a restricted token unit grant with an employee for 10,000 tokens. The agreement states the RTUs will vest over 5 years with a 1-year cliff.  

In this example, the company requires this employee to work for one year before vesting begins, then vests 25% of the tokens each year thereafter. The employee would vest 2,500 tokens in years 2 through 5, with all 10,000 tokens vested at the end of year 5. 

Typically, RSUs and RTUs are included in a worker’s compensation upon vesting. However, RTUs may need to be settled on-chain, which can occur sometime at or subsequent to vesting. This date is then used for determining the employee’s income based on the fair market value of tokens issued. Again, when a token is considered vested or settled is governed by the terms of the agreement. If we return to our example, the employee would recognize income upon receipt (settlement) of the tokens related to the RTU agreement. 

It should be noted that the IRS has not issued significant guidance on employer withholding obligations for digital assets outside its Frequently Asked Questions on Virtual Currency Transactions. Answer 11 states that “the fair market value of virtual currency paid as wages, measured in U.S. dollars at the date of receipt, is subject to Federal income tax withholding.”  Answer 12 states that “in an on-chain transaction, you receive the virtual currency on the date and at the time the transaction is recorded on the distributed ledger.” Taken together, this indicates that the token is includable in taxable wages when received (settled), not when the transfer is initiated as is the case with RSUs. Unfortunately, FAQs are not binding IRS guidance, and this is subject to change at any time.  

Fair Market Valuation 

Another complication with RTUs can be the valuation of the tokens at the time of the transfer. Generally, the amount of income recognized by the recipient of RSUs is the FMV of the stock at the time the transfer is initiated or the restrictions lapse. For publicly traded companies, this is often determined by taking the average of the opening and closing value of the stock. For companies that do not have a readily ascertainable FMV, the IRS provides guidance on how to determine the FMV, based on certain factors including the overall value of the company and the equity gained.  

Similar to private companies that are not publicly traded, it can be more difficult to value tokens. A token that is readily available on exchanges will be more akin to a publicly traded stock, while a token that is not offered on large exchanges or broadly to the public will be more difficult to value, like a privately held company. However, tokens, unlike stock, are not equity in a company; meaning the value of the tokens is not tied to the value of the company in the same way stock is. If the RTUs are settled in cash, the FMV would simply be the cash received. But in situations where actual tokens are received; the valuation can be more difficult.  

The IRS has gradually given more guidance on how to determine the FMV of a token. In the final broker-dealer regulations released June 28, 2024, the IRS clarified that the FMV of a digital asset is determined as of the exact date and time the exchange or transaction occurred. However, there was still no guidance given on methodologies to value the digital asset.  

Payroll Tax and Withholding Considerations  

Because RTUs are considered compensation, RTUs are subject to income and payroll tax withholding upon recognition. This includes federal and state income tax, Social Security tax, Medicare tax, and possibly the additional Medicare tax. Depending on the classification of the worker, the tax burden may fall solely on the worker, or may be split by the worker and the company.  

Contract workers who receive a Form 1099 are solely responsible for the full amount of employment and income taxes. Employees who receive Forms W-2 are treated differently. These workers are only responsible for paying one half of the employment taxes. The onus of withholding and remitting both the employment and income taxes falls to the employer in this situation. RTUs are also considered “supplemental income,” which means they are usually subject to the statutory federal supplemental withholding rate – currently, 22% for amounts under $1 million; 37% if over.  

Example: A W-2 employee vests in 100,000 tokens, each with a FMV of $1, for a total FMV of $100,000. The company will be responsible for withholding and remitting on behalf of the employee $1,450 in Medicare taxes, $6,200 in Social Security tax, and $22,000 in supplemental federal income tax withholding. If the employee’s compensation is over $200,000, the employer will also be responsible for remitting $900 in Additional Medicare tax on behalf of the employee.  

Companies also need to consider state income tax withholding. While the federal supplemental withholding rate is 22%, states will have different requirements. Some states do not have a separate supplemental income tax rate, while others, such as California, Maryland, and New York, do.  

Employer Choices for Withholding 

Companies have different options for how they may deal with withholding as it pertains to RTUs:  

• The company may choose to do a “net settlement,” where the company withholds a number of tokens from the settlement equal to the amount of withholding tax to sell the tokens to raise liquidity for the tax payment.
• The settlement may be made in cash equal to the value of the tokens; less the amounts withheld for taxes.
• For independent contractors, the settlement may be for the full amount of tokens, with the full tax burden falling on the worker who receives the tokens. 

RTU Consideration 

Before committing to the use of RTUs, you should first consider the following question: 

• Do you want to offer the ability to make an 83(b) election? 

If your company would like to give your employees this possible tax advantage, then using an RTU may not be right for your company. 

Assuming you do prefer using RTU, then you should consider the following:  

• Who is paying the taxes and is there liquidity to cover withholding taxes?
• What type of vesting schedule makes sense – incremental, cliff, or a combination of both? 
• What is the appropriate timing for vesting (annually, monthly, or other)? 
• What policies will you have for employees with vested balances who leave? 
• What tax withholding policies will you have? 
• What withholding and FICA rates are applicable for the employees?
• Are there any state tax considerations? 

Companies that wish to use tokens as part of their overall compensation package should keep these issues in mind. The intricacies of the tax code are only heightened when they are applied to emerging business models such as those involving digital assets and tokens. Failure to meet all the requirements when offering options like RTUs can be costly for workers and businesses alike.