For over 50 years, Bloomberg Tax’s renowned flagship daily news service, Daily Tax Report® has helped leading practitioners and policymakers stay on the cutting edge of taxation and...
By Crystal Stranger
Many startups that now raise money in an initial coin offering (ICO) aren’t thinking about the tax consequences of doing so, and may very likely end up with a big surprise the following year when they go to file their taxes. But how much of this money is taxable, and what should a company set aside for tax purposes? That depends on a number of questions, the first of which is the type of token that is offered.
There is a long-standing debate in the crypto investment community on whether tokens issued are actually utility tokens or if they are all securities. Even the Director of the Securities and Exchange Commission’s Division of Corporation Finance seems to be releasing his hard line stance that all tokens are securities, saying that “In theory, there is a time when a coin may achieve a sort of decentralized utility in the marketplace.”
And with the recent Zaslavskiy case, we may soon get some clarification about which crypto tokens would be considered utility and which would be security tokens.
The way it works for most token sales is that a simple agreement for future tokens (SAFT) is created in exchange for money, then this contract entitles the buyer to obtain tokens once they are issued. This is similar to an option contract in the equity markets, but for crypto tokens. It could be argued that all SAFT contracts are securities, but there are likely still some pure utility tokens underlying this if marketed and sold properly.
Regardless of how tokens are classified by the SEC, for tax purposes it is a bit more straightforward. The general rule under U.S. law is that any and all income is taxable unless it is a contribution of capital or a gift. Most other countries only tax individuals on their worldwide income when a resident, but the U.S. taxes on worldwide income for U.S. persons regardless of where they live or where the business is formed. And most token offerings have at least some U.S. investors, so for most companies, it’s critical to understand U.S. tax laws.
When a company issues a token that can be exchanged for goods or services inside the company’s ecosystem, it is essentially making a pre-sale of the product that it intends to sell later. This is analogous to crowdfunding when a company sells a physical item like clothing or the next-best gadget, and then uses that money to produce and distribute the goods. The Internal Revenue Service issued guidance about crowdfunding activities in Information Letter 2016-0036. A number of people make the comparison to gift cards. The trouble with this logic, though, is if this token were a gift card, would it have a gain or loss in value if the prices of the goods or services offered change? For example, If you buy a Starbucks gift card today, will it buy you more Macchiatos in six months? Most likely not, but this is clearly what happens with crypto tokens, and as such it makes the classification of this income much less clear.
Regardless, this is a distinct instance where the income is taxable. However, there are some methods by which prepayment for goods or services can be deferred. There are two methods that can be used to receive this income deferral. One is under the Revenue Procedure 2004-34 which gives guidance as to how income can be deferred for up to one year. The other method relies on whether the company uses accrual-based accounting, and only recognizes the income when the goods or services are provided. However, applying accrual-based accounting to token sales is a bit of a stretch as the company will most likely not have the history where this could be seen as having a business purpose beyond tax avoidance, and thus disallowed.
Traditional securities, such as stocks or partnership interests, when sold are not considered business income. When a company sells equity to investors, this is a capital contribution and is a non-taxable event. However, it is unclear if this same treatment will apply to security token offerings (STOs).
You may be wondering why an STO would be treated differently. As the IRS has determined tokens to be intangible personal property, it would be challenging to draw a clear line calling STOs a security under tax law. However, in the future, this distinction is likely to be drawn, as with foreign investment tokens known as decentralized autonomous organizations (DAOs) that are likely to have default treatment under the passive foreign investment company (PFIC) rules down the line.
One way of looking at it is that all tokens issued under a SAFT could be determined securities, giving potential for income deferral until the token is actually issued. However, it’s not clear if the token could be considered a capital asset if it can later be used to obtain goods or services.
Founders tokens are only taxable when tokens are received at a future date. For example, if a company issues tokens in July, but the founders don’t receive their shares on a vesting schedule until the product is live in January, then the founders do not pay tax on the shares until they are granted in January.
However, this deferral of income may not be beneficial, since the tokens most likely increased in value from the time of the ICO until the vesting date, and the amount of income due will be based on the fair market value at the time of vesting. There is a way around this, though. If a founder receiving vested shares wishes to pay tax on tokens at the time of grant rather than when they vest, they can make an election under tax code Section 83(b). By filing this election, the recipient pays tax in the current year but at a potentially much lower valuation than at the time the tokens vest. This only pays off if the tokens gain value; however, if they lose value, or become worthless, then the founder can take a loss on their taxes. But, from experience, that typically is in a lower income year and this loss is less valuable to the individual than the amount they paid in tax earlier.
Forming companies abroad is very popular these days for companies that are running ICOs, and many countries are competing to be the home of new tech companies by passing beneficial legislation. However, for tax purposes, there are additional complications and consequences to consider.
If more than 50 percent of the owners are either U.S. or EU citizens, you will run into the controlled foreign corporation (CFC) rules. This has been an issue in U.S. tax law for a number of years, but with more recent legislation to reduce inversions, these rules are now impacting EU-based companies. All EU member countries are required to insert these rules into legislation before Jan. 1, 2019.
Under U.S. law, CFCs can be subject to Subpart F income if they are investment companies, which makes all income taxable in the current year. Or they may be subject to U.S. repatriation rules. Additionally, the new tax reform concepts of the global intangible low-taxed income ( GILTI) and foreign derived intangible income ( FDII) may apply. Head spinning yet?
Tokens or Ethereum (ETH) sent out as part of bounties in airdrop campaigns are not taxable to the company. There is next to zero guidance on requirements for information reporting based on crypto payments. However, it’s highly likely that the IRS will require informational returns be filed for anyone the company pays more than $600 within the year. Filing these now protects the company from penalties related to non-filing of informational returns. For most bounty programs, this would be form 1099-Misc with payments categorized as either “other income” or “non-employee compensation.” This depends on what the ICO promoter is asking the participants in an airdrop to do.
A company should be extra cautious with paid promotions as these may violate Federal Trade Commission consumer protection laws. Additionally, marketing efforts are reviewed in securities cases and can potentially lose the coveted utility token status for the ICO if not handled properly.
Crystal Stranger, EA, author of The Small Business Tax Guide (Clear Advantage, 2014), wanted to help her tax clients who struggled when it came to bookkeeping. Looking to help entrepreneurs focus on business instead of finances, she co-founded PeaCounts, an accounting software using AI and blockchain. PeaCounts was created to be the easiest automated accounting platform for small businesses by providing a simple and intuitive bookkeeping system that improves the financial system of any small business, helping to save time and money. PeaCounts is tokenizing their payroll system using the token PEA with an ICO starting in July.
Copyright © 2018 The Bureau of National Affairs, Inc. All Rights Reserved.
All Bloomberg BNA treatises are available on standing order, which ensures you will always receive the most current edition of the book or supplement of the title you have ordered from Bloomberg BNA’s book division. As soon as a new supplement or edition is published (usually annually) for a title you’ve previously purchased and requested to be placed on standing order, we’ll ship it to you to review for 30 days without any obligation. During this period, you can either (a) honor the invoice and receive a 5% discount (in addition to any other discounts you may qualify for) off the then-current price of the update, plus shipping and handling or (b) return the book(s), in which case, your invoice will be cancelled upon receipt of the book(s). Call us for a prepaid UPS label for your return. It’s as simple and easy as that. Most importantly, standing orders mean you will never have to worry about the timeliness of the information you’re relying on. And, you may discontinue standing orders at any time by contacting us at 1.800.960.1220 or by sending an email to firstname.lastname@example.org.
Put me on standing order at a 5% discount off list price of all future updates, in addition to any other discounts I may quality for. (Returnable within 30 days.)
Notify me when updates are available (No standing order will be created).
This Bloomberg BNA report is available on standing order, which ensures you will all receive the latest edition. This report is updated annually and we will send you the latest edition once it has been published. By signing up for standing order you will never have to worry about the timeliness of the information you need. And, you may discontinue standing orders at any time by contacting us at 1.800.372.1033, option 5, or by sending us an email to email@example.com.
Put me on standing order
Notify me when new releases are available (no standing order will be created)