1. So you want to do an ICO
Disclaimer
The number of token offerings through ICOs or otherwise that have crossed my desk in the last 12 months has exploded. Many of those transactions have been put together with such speed that corporate structure and tax treatment are an afterthought with expensive consequences. Even now, most of the focus seems to be on the securities law treatment of Tokens. The following is a brief outline of some issues that are worth considering -- primarily in order to avoid adverse tax issues for founders, issuers and investors. Following posts will discuss different structures mentioned below in greater detail.
Before we get to actual structures, however, it's important to understand what kinds of adverse things can happen to you. Many people think that selling Tokens should be taxed the same way as a stock sale is taxed -- but there is a specific Internal Revenue Code section that provides stock sales are tax free -- and it doesn't apply to Token sales.
TAXATION OF TOKENS
The first adverse issue to manage relates to the timing and amount of income with respect to the Tokens themselves. The US Treasury says that taxable income is "recognized" with respect to a Token on the day they are mined and on the day they are transferred. The key is not to have a "recognition event" at a time when the Token value is high and you don't have the ability to convert it into FIAT -- and any analysis is subject to the Treasury changing its view. The current model is designed to mimic the treatment of gold, but probably a treatment more like "found property" or "sharecropping" or even software development is more appropriate -- so the treatment of Tokens could change. The one thing that is reasonably certain is that they are not "currency".
The importance that they not be currency is that with you don't have a taxable event when you use currency to buy goods. So for example if you exchange 100 Dollars for 100 Euros on day one, and on day 100 you buy goods for $100 Euro when those Euros are worth $110, you don't have $10 of income -- but the same is not true if you had done the same thing with Crypto Currency. With Crypto Currency you'd have $10 of income when you bought those goods.
Furthermore, it is important to keep in mind not only the taxation of Tokens that are sold, distributed or included in a SAFT ("Simple Agreement for Future Tokens"), but also the taxation of the Tokens retained by the creator of the White Paper ("Founders"). In order to minimize the risk that a Founder has to recognize income with respect to retained Tokens when their value is high, but they are not liquid, I generally recommend that Founders create a Genesis Block very early in the process and allocate all Founder Tokens to that Block. That allows the Founders to argue (a) the Tokens weren't mined at all, so no recognition event has occurred (and won't occur until the Tokens are exchanged), and (b) even if such allocation is deemed to be a recognition event, the value on that day is very low (because there is lots of work to be done before the Network is live).
TAXATION OF SAFTs
Many Token offerings completed prior to the Network launch are structured as "SAFTs". The theory is that the Founders have sold a "variable prepaid future contract" calling for the delivery of Tokens in the future or perhaps has entered into an "open transaction" (a transaction in which the tax treatment cannot be determined because one or more elements have not been completed -- originally described in Burnet v. Logan). Most issuers take the position that the issuance of a SAFT does not generate taxable income until the SAFT settles (and the Tokens are issued) -- at which point the Founders have an amount realized equal to the sale price of the SAFT. It is possible, however that the IRS might say that a Founder is taxable on the day the SAFT is issued because there is no variability to the contract other than timing (the number of Tokens is set).
I am concerned about trying to delay taxation of the SAFT until it settles, particularly if that treatment is based on the argument that the SAFT is an "open transaction" because the Tokens don't exist. The risk is not actually that Founders get unfavorable treatment of the SAFT, but rather that the unsold Founder Tokens are taxable on the day the Tokens are delivered to SAFT holders based on the value on that day (technically you can still argue that because they weren't "mined" they aren't income on the day they are created, but the term "mined" is not well defined and the IRS could clearly take the position that taxation on the creation date is appropriate). That is why I prefer to create a Genesis Block as early as possible in order to buttress the argument that if the creation of the Tokens is a taxable event for Founders, that event happened when the Tokens had almost no value, rather than at the moment trading begins on the Network.
In future posts (see Structural Alternatives (Outline)), I'll discuss alternative structures for capitalizing a vehicle for Founders, including (a) the use of a foreign subsidiary (only works in very limited circumstances), (b) the use of an LLC holding Company, and (c) the use of a standard corporate structure. Of course, the optimal structure depends upon the facts of each offering. Before you dive into the other posts on structure, you might consider the following questions:
The number of token offerings through ICOs or otherwise that have crossed my desk in the last 12 months has exploded. Many of those transactions have been put together with such speed that corporate structure and tax treatment are an afterthought with expensive consequences. Even now, most of the focus seems to be on the securities law treatment of Tokens. The following is a brief outline of some issues that are worth considering -- primarily in order to avoid adverse tax issues for founders, issuers and investors. Following posts will discuss different structures mentioned below in greater detail.
Before we get to actual structures, however, it's important to understand what kinds of adverse things can happen to you. Many people think that selling Tokens should be taxed the same way as a stock sale is taxed -- but there is a specific Internal Revenue Code section that provides stock sales are tax free -- and it doesn't apply to Token sales.
TAXATION OF TOKENS
The first adverse issue to manage relates to the timing and amount of income with respect to the Tokens themselves. The US Treasury says that taxable income is "recognized" with respect to a Token on the day they are mined and on the day they are transferred. The key is not to have a "recognition event" at a time when the Token value is high and you don't have the ability to convert it into FIAT -- and any analysis is subject to the Treasury changing its view. The current model is designed to mimic the treatment of gold, but probably a treatment more like "found property" or "sharecropping" or even software development is more appropriate -- so the treatment of Tokens could change. The one thing that is reasonably certain is that they are not "currency".
The importance that they not be currency is that with you don't have a taxable event when you use currency to buy goods. So for example if you exchange 100 Dollars for 100 Euros on day one, and on day 100 you buy goods for $100 Euro when those Euros are worth $110, you don't have $10 of income -- but the same is not true if you had done the same thing with Crypto Currency. With Crypto Currency you'd have $10 of income when you bought those goods.
Furthermore, it is important to keep in mind not only the taxation of Tokens that are sold, distributed or included in a SAFT ("Simple Agreement for Future Tokens"), but also the taxation of the Tokens retained by the creator of the White Paper ("Founders"). In order to minimize the risk that a Founder has to recognize income with respect to retained Tokens when their value is high, but they are not liquid, I generally recommend that Founders create a Genesis Block very early in the process and allocate all Founder Tokens to that Block. That allows the Founders to argue (a) the Tokens weren't mined at all, so no recognition event has occurred (and won't occur until the Tokens are exchanged), and (b) even if such allocation is deemed to be a recognition event, the value on that day is very low (because there is lots of work to be done before the Network is live).
TAXATION OF SAFTs
Many Token offerings completed prior to the Network launch are structured as "SAFTs". The theory is that the Founders have sold a "variable prepaid future contract" calling for the delivery of Tokens in the future or perhaps has entered into an "open transaction" (a transaction in which the tax treatment cannot be determined because one or more elements have not been completed -- originally described in Burnet v. Logan). Most issuers take the position that the issuance of a SAFT does not generate taxable income until the SAFT settles (and the Tokens are issued) -- at which point the Founders have an amount realized equal to the sale price of the SAFT. It is possible, however that the IRS might say that a Founder is taxable on the day the SAFT is issued because there is no variability to the contract other than timing (the number of Tokens is set).
I am concerned about trying to delay taxation of the SAFT until it settles, particularly if that treatment is based on the argument that the SAFT is an "open transaction" because the Tokens don't exist. The risk is not actually that Founders get unfavorable treatment of the SAFT, but rather that the unsold Founder Tokens are taxable on the day the Tokens are delivered to SAFT holders based on the value on that day (technically you can still argue that because they weren't "mined" they aren't income on the day they are created, but the term "mined" is not well defined and the IRS could clearly take the position that taxation on the creation date is appropriate). That is why I prefer to create a Genesis Block as early as possible in order to buttress the argument that if the creation of the Tokens is a taxable event for Founders, that event happened when the Tokens had almost no value, rather than at the moment trading begins on the Network.
In future posts (see Structural Alternatives (Outline)), I'll discuss alternative structures for capitalizing a vehicle for Founders, including (a) the use of a foreign subsidiary (only works in very limited circumstances), (b) the use of an LLC holding Company, and (c) the use of a standard corporate structure. Of course, the optimal structure depends upon the facts of each offering. Before you dive into the other posts on structure, you might consider the following questions:
- Is the Token a true virtual currency, or is it more in the nature of a prepayment for a future service (e.g., a company might issue gift cards allowing the future purchase of goods or services which people could trade like currency);
- Will the Tokens be used in a closed ecosystem, or
- Are they intended to be used for a wider variety of transactions;
- Was the White Paper written by an unaffiliated individual, or by an employee of a corporation whose employer owns the related intellectual property;
- If the White Paper was written by an employee of a corporation, it is likely that the corporation owns the related IP;
- In that event, it is much more complex to get the Tokens in the hands of individuals (because any transfer by the corporation to its shareholders or employees is a taxable event for both the employee/shareholder and the corporation).
- Are the Founders all US Citizens/Residents?
- Do you believe that there is value in the Intellectual Property separate from the Tokens?
- will you be able to use it to create other types of Tokens?
- will it be needed to run your closed ecosystem?
Thanks for sharing such a helpful post! This is a very informative & great Post. I got too much information about upcoming ICO list & updates from this post. Keep Posting!
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