Token Compensation Income -- to 83(b) or not to 83(b)

 

Token Compensation Income

 

As I’ve said multiple times in this blog, I don’t think that conventional wisdom from the VC world translates all that well into the crypto world.  One example relates to tokens issued as compensation.  Leaving aside all the questions about whether a four year vest makes sense, and more significantly, whether a double trigger acceleration on change of control is even relevant (on Network Launch I get it), there are some significant economic questions for employees.

 

In the VC world, you may often want to early exercise a stock option, make an 83(b) election (which causes you to be taxed as if you’d received the shares on the exercise date without any restriction (vesting)), and then hope that the stock appreciates so that you have income that is taxed as long term capital gain.  That’s a good plan where the exercise price is low enough and there is no market for the stock. 

 

But outside the VC world where the stock is already publicly traded (and almost more important when you can go buy more shares), it doesn’t make sense to make the 83(b) election – even if you expect post grant appreciation to be enormous.  Moreover, in the case of stock options or stock grants, it’s much better for the employer if the recipient doesn’t make the 83(b) election, because it will get a bigger deduction (assuming the stock appreciates).

 

The same is true for Tokens after the Network Launch (although in this case there is no benefit to the employer because the larger tax deduction is offset by a larger amount of taxable income from delivering zero basis tokens).

 

So why is this true?  Intuitively, it would seem better to have a smaller amount of money included in income at ordinary income rates and a larger amount of money taxed at capital gains rates – but that’s not true if you can take the money you would otherwise pay in tax at grant and buy more tokens.

 

Assume for the moment that you are granted 100 tokens today when they are trading for $1 each and that a year later when they vest they are worth $100 each.  Pre-tax, you are now the owner of $10,000 of tokens.

 

If you make an 83(b) election at grant (and it’s not always clear that you can), you’d owe $45 of tax at grant (assuming a combined state and federal ordinary income rate of 45%), and then at maturity you’d have $9,900 of long term capital gain income and owe $2,970 of tax (assuming a combined state and federal long term capital gains rate of 30%), at that time for a net of $6,985.  That seems much better than paying $4,500 of tax on the vesting date, right?  Strangely not.

 

Assume that instead of making the 83(b) election, you took the $45 you would have paid in tax and bought 45 tokens.  Now, at the end of the year, you have $14,500 of gross proceeds (because you own 145 Tokens), and you’d pay (i) $1,337 of tax on the long term capital on the 45 additional tokens you bought and (ii) $4,500 of ordinary income tax on the original 100 Tokens.  With the result that your net proceeds are $8,619, or $1,634 more (23% more on these facts). 

You might also simply want to minimize your out of pocket and not buy any additional tokens.  In that event you have $10,000 of ordinary income on the vesting date, $4,500 of tax and you net $5,500 (around 21% less on these facts).

 

		Income at Grant	Tax at Grant	Cost of New Tokens	Proceeds at Sale	Taxable Income at Sale	Tax at Sale	Net Proceeds
A	Make 83(b) Election:	$100	($45)	$0	$10,000	$9,900	($2,970)	$6,985
B-1	No 83(b) Election: Buy Tokens with Tax money	$0	$0	($45)	$14,500	OI: $10,000 CG: $4,455	($4,500) ($1,337)	$8,619
B-2	Don’t buy Tokens with Tax Money	$0	$0	$0	$10,000	$10,000	($4,500)	$5,500

 

The above analysis shows that if the tokens appreciate in value during the relevant period, you are much better off buying tokens with the money you’d otherwise pay in tax if you made the 83(b) election. 

 

However, if the tokens decline in value, you lose money if you buy more tokens.  If at the end of the year, the tokens are worth $0.01, in the first situation (where you made the 83(b) election), you have $1 of proceeds, a $99 capital loss worth about $30, so you’d be net out of pocket $14.30.  In the second case, you’d have a $44.55 loss from the 45 purchased tokens, which generates a tax benefit of around $15 – and you’d be out of pocket $28.45.  So while buying more tokens may be a better idea if tokens appreciate, it is worse if they decline in value. 

 

In the third scenario, if you don’t buy any new tokens, you simply get $1 of compensation when the tokens vest, owe $0.45 of tax, and keep $0.55.

 

		Income at Grant	Tax at Grant	Cost of New Tokens	Proceeds at Sale	Taxable Income at Sale	Tax at Sale	Net Proceeds
A	Make 83(b) Election:	$100	($45)	$0	$1	($99)	$29.70	($14.30)
B-1	No 83(b) Election: Buy Tokens with Tax money	$0	$0	($45)	$1.45	OI: $1.00 CG: ($44.55)	($0.45) $13.06	($30.64)
B-2	Don’t buy Tokens with Tax Money	$0	$0	$0	$1.00	$1.00	($0.45)	$0.55

 

So clearly, if you’re bullish on the tokens, you’re better off not making the 83(b) election and buying more tokens.  If you’re less bullish and want downside protection, you’re better off not making the 83(b) election and not investing.

 

In view of the above, many employers ask how they can optimize the result for their employees.

 

One approach is for the employer to give the employee a choice between (a) 100 tokens and no cash, or (b) 55 tokens and 45 Tokens worth of cash (measured either on the grant date, if you make the 83(b) election, or on the vesting date, if you don’t).  Note, your employer shouldn’t care whether it measures the cash on the grant date or the vesting date, it is fully hedged either way (it simply sells the 45 tokens on the relevant date)

 

In that situation, in both the 83(b) case (getting paid $45 at grant to cover the tax) and the no 83(b) case (getting paid $4,500 at vest to cover the tax), you end up owning 55 Tokens, and all the cash goes to pay your tax on the compensation.  However, your tax basis in the tokens is very different (much higher in the second case).  So, when you sell those tokens for $100 each, in the first case (C below) you have $5,445 of gain (generating tax of $ $1,634), so you keep $3,866.  But in the second case (D-1 below), you would have no additional income and you’d keep all $5,500.

 

Even if your employer is unwilling to wait for your vesting date to pay you the cash and you took the $45 on the grant date, paid your tax on that cash and reinvested the net proceed (D-2 below), you end up with $4,765 in the upside case.

 

	Grant	Income at Grant	Net Tax out of pocket at Grant	Net Cost of New Tokens	Proceeds at Sale	Taxable Income at Sale	Tax at Sale	Net Proceeds
C	55 Tokens, $45 Cash, make 83(b) Election	$100	$0	$0	$5,500	$5,445	($1,634)	$3,867
		$100	$0	$0	$0.55	($54.45)	$16.34	$16.89
D-1	No 83(b) Election: 55 Tokens, Cash for 45 Tokens on Vesting Date	$0	$0	$0	$10,000	$10,000	($4,500)	$5,500
		$0	$0	$	$1.00	$1.00	($0.45)	$0.55
D-2	5 No 83(b) Election: 5 Tokens, $45 Cash, invest $24.75 in tokens	$45	$0	$24.75	$7,975	OI: $5,500 CG: $2,450	($2,475) ($735)	$4,765
		$45	$0	$24.75	$0.80	OI: $0.55 CG: ($24.50)	($0.25) $7.35	$7.90

 

So to summarize:

 

		Upside Net Proceeds	Downside Net Proceeds
A	Make 83(b) Election:	$6,985	($14.30)
B-1	No 83(b) Election: Buy Tokens with Tax money	$8,619	($30.64)
B-2	No 83(b) Election: Don’t buy Tokens with Tax Money	$5,500	$0.55
C	55 Tokens, $45 Cash, make 83(b) Election	$3,867	$16.89
D-1	No 83(b) Election: 55 Tokens, Cash for 45 Tokens on Vesting Date	$5,500	$0.55
D-2	No 83(b) Election: 55 Tokens, $45 Cash, invest $24.75 in tokens	$4,765	$7.90

 

Clearly the best result in the upside world is B-1 and the worst result in a downside world is also B-1.  Choices C and D have no net out of pocket in the downside world, but skipping the 83(b) gives you more upside. 

 

So the real decision is not whether to make the 83(b) election, it’s whether to invest in more tokens.

 

                                                                        J.B.D.