Treatment of digital assets transferred to employees

Editor: Mo Bell-Jacobs, J.D.

The IRS has issued extensive guidance on treating payments to employees and other service providers as compensation, including how to report such compensation and the deductions and related treatment of the payments from the company side. This item uses the term “employee,” but similar rules apply to other service providers, such as contractors, board members, or even certain service companies earning compensation.

As digital assets become a means of compensation, employers need to understand how Sec. 83 applies when using such means as payment.

Operation of Sec. 83 in general

Companies are aware that a payment by cash, check, or bank account deposit for an employee based on the employee’s service is taxable as compensation and subject to payroll tax withholding (Social Security and Medicare taxes, as well as federal and state income withholding, as applicable). Companies should be aware that the Internal Revenue Code also addresses the treatment of “property” (other than cash) transferred to employees. However, under Sec. 83 and underlying regulations, the rules are a bit more complex than for cash.

The transfer of any property to an employee “in connection with” the performance of service is compensation (Sec. 83). Since companies often provide property (such as company stock, or even a company car) subject to a substantial risk of forfeiture, Sec. 83 generally delays taxation until the property “vests” (once the substantial risk of forfeiture lapses). Thus, the employee has compensation equal to the fair market value (FMV) of the property, less any amount the employee paid for the property, on the date of transfer or on the date that the employee vests in the property, if later.

For yet another twist, even though the property is subject to a substantial risk of forfeiture, the employee may elect to take the FMV of the property less the amount the employee pays for the property into compensation income on the date of grant by making a Sec. 83(b) election. This is a formal election that the employee must send to the IRS and the person to whom the services are provided within 30 days after the date of transfer, notifying all parties that the employee elects to be taxed upfront and not at the later vesting dates. This election is not without risk and is generally used as a tax planning mechanism if the property has a fairly low value and is likely to increase in value, as the election closes the compensation element, and any further appreciation after the transfer would be considered capital gain. The risk, of course, is that the value decreases over time, or the property is later forfeited, and the employee will have paid more tax on the property than would otherwise have been required without the election.

Digital assets and Sec. 83

More recently, companies have started to transfer digital assets to employees. This might mean paying some regular compensation by using a digital asset or rewarding an employee with a bonus using cryptocurrency, a token, or some other form of digital asset. As a note, 29 C.F.R. Section 531.27 (Department of Labor regulations under the Fair Labor Standards Act of 1938, P.L. 75–718, as amended) requires certain “prescribed wages” (minimum wage and overtime compensation) to be paid in cash or negotiable instruments. States may also have rules that prohibit the payment of regular wages in any medium other than cash or its equivalent. Thus, companies need to take care when paying compensation using digital assets.

The IRS and other governmental agencies have taken the position that cryptocurrency is not “currency” and is instead property (IRS Notice 2014–21, as modified by Notice 2023–34 and supplemented by Rev. Rul. 2019–24). As discussed above, payment of any sort of property to an employee is taxable and is subject to payroll tax withholding under Sec. 83. Required withholding on cryptocurrency might be fairly easy if the company can hold back some of the cryptocurrency and then pay cash to the IRS equal to the payroll tax amounts. As with payments in cash, the employee is taxed on the entire amount, including the cash or cryptocurrency withheld.

Some digital assets can be a bit more challenging for payroll tax withholding. This is a problem even with regular Sec. 83 property transfers. For example, if a company transfers a car to an employee, the company must tax the employee on the full FMV of the car but cannot withhold on the car. The company needs to work with the employee so the company can deposit enough cash with the IRS to satisfy the payroll tax withholding requirements on the transferred property. In some cases, the company withholds from the employee’s regular cash compensation. In other cases, the company asks the employee to remit a check equal to the required employee withholding, provides an employee payroll tax loan (officially, in writing, and meeting state loan requirements), or may “gross–up” the payment and pay the employee’s share of tax.

Compensation deduction

Sec. 83 addresses not only the treatment and timing of property as compensation but also the company’s tax deduction amount and the timing of the tax deduction for the transfer of property. For U.S. taxpayers, the value of the property transferred must be reported as compensation (e.g., on a Form W–2, Wage and Tax Statement, for an employee; a Form 1099–NEC, Nonemployee Compensation, for an independent contractor or director; or a Schedule K–1, Partner’s Share of Current Year Income, Deductions, Credits, and Other Items, as a guaranteed payment for a partner; reporting may be different for nonresident aliens who perform services within the United States).

The company is allowed a tax deduction equal to the FMV of the property less the amount the employee pays for the property as it is included in the employee’s compensation (there can be special timing rules for these compensation deductions, not discussed here). Where hard–to–value assets are transferred, the company may have to take additional steps to provide a reasonable and consistent FMV determination. For transfers of digital assets that have publicly reported values, this is easily done. For unique assets or assets that are not widely traded, this may take additional work, particularly when cryptocurrency values are highly volatile.

Cryptocurrency vesting and lockups

Cryptocurrency lockups are a mechanism designed to place predefined parameters or limits on when crypto tokens can be transferred or sold. The reason for the lockup may be to prevent tokens from being sold before the digital protocol releases the tokens or to enforce restrictions on open market sales after a token launch. Lockups can also be used with crypto rewards received from mining on a proof–of–work blockchain network or staking on a proof–of–stake network. (A detailed discussion of the income–inclusion rules for mining and staking is beyond the scope of this item.) Similar sales restrictions can apply to other types of property, such as public shares. With a few exceptions, lockups or sales restrictions on property that is otherwise vested do not cause the property to be treated as subject to a substantial risk of forfeiture under the Sec. 83 rules, and thus the property may be taxed at transfer, even if the employee is not yet able to sell the property.

Vesting, on the other hand, relates to the process by which the owner earns the right to property, such as a digital asset, over time (often cliff or graded time vesting). Companies may grant tokens to an employee that are earned over time and are subject to a substantial risk of forfeiture (e.g., any unvested tokens are forfeited if the employee voluntarily quits or is terminated for cause). Tokens subject to a substantial risk of forfeiture are governed under the Sec. 83 rules discussed above.

Basis and loss of deduction

Sec. 83 regulations also separately address the treatment when the property transferred is not stock of the company (i.e., the employer or a parent of the employer) and has a basis lower than the current value at transfer. If the company has a basis in the property being transferred but the property has appreciated in value by the time of the transfer, the company may have to recognize gain on the transfer under Regs. Sec. 1.83–6(b) on the value of the property above the company’s basis in the property. Gain recognition can reduce the value of the company’s tax deduction on the transfer of the appreciated property.

Example 1: Company A buys a piece of land for $90,000, intending to use it for business. After failing to get it rezoned for business use, Company A transfers the land to an executive in lieu of a cash bonus. An appraisal determines that the land is now worth $200,000. When the land is transferred to the executive, the employee has $200,000 of compensation income, and Company A gets a compensation deduction of $200,000 but has a gain on the asset of $110,000 (appreciation above the basis), offsetting more than half of the compensation deduction.

Example 2: Company B transfers an unlocked token to an employee as part of an incentive compensation plan. For illustrative purposes, Company B purchased the token and has a basis of $1, but the token has an FMV of $10,000 at the date of transfer. The employee has $10,000 of compensation income, and Company B has a compensation deduction of $10,000 but may have gain on the token of $9,999 (appreciation above the basis), offsetting the compensation deduction.

Example 3: Company C transfers title of a company vehicle to a retiring executive as a parting gift. The vehicle was fully depreciated in the prior year and has an FMV of $50,000 at the date of transfer. The employee has $50,000 of compensation income, and Company C has a compensation deduction of $50,000 but has a gain on the asset of $50,000 (zero basis in the vehicle), thereby fully offsetting the compensation deduction.

Example 4: Company D transfers a locked but fully vested cryptocurrency to an employee as part of an annual incentive bonus plan. For illustrative purposes, Company D created the cryptocurrency and it has zero basis, but the cryptocurrency has an FMV of $100,000 at the date of transfer. The employee has $100,000 of compensation income at the time of transfer, and Company B has a compensation deduction of $100,000. But Company B has a gain on the cryptocurrency of $100,000 (appreciation above the basis), thereby fully offsetting the compensation deduction.

Compensation deduction reduced by gain

Sec. 83 and the regulations thereunder apply when digital assets are transferred to a service provider as compensation. The Sec. 83 rules may reduce or eliminate the compensation deduction depending on the basis of the digital asset and if there is gain. The gain issue needs to be considered and taken into account when transferring digital assets as compensation.

Editor

Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP.

For additional information about these items, contact the author(s) at the email address(es) below.

Contributors are members of or associated with RSM US LLP.

Authors

Karen Field, J.D. (Karen.Field@rsmus.com), Washington, D.C.; Rachel Simon, E.A. (Rachel.Simon@rsmus.com), Minneapolis; and Catherine Davis, CPA, J.D. (Catherine.Davis@rsmus.com), Cleveland