As a new asset class, tokens and coins are upending traditional funding in ever-changing new and creative ways. This creative destruction has been mostly positive, but sometimes difficult as such capital raise structures add an increasing layer of complexity and risk that many issuers and investors have not previously encountered. Securities laws and tax considerations are two areas where Initial Coin Offerings (ICOs) have seen healthy debate–and for good reason. Consequently, both regulators (SEC and IRS) and advisors (investment bankers and consultants) have been forced to scramble as they seek to play catch-up to the quickly evolving industry landscape. Understanding how token offerings are treated for tax purposes, how they might be structured and how the offering should be timed can all be critical considerations for issuers and investors alike. Here, we discuss the details at a high level. As we do, be advised: this is not tax, legal or investing advice. Please seek competent professional advise when making legal, tax and investment decisions.
Understanding the tax status of a coin or token offering will provide both issuers and investors more clear insight into their decision making, allowing them to both benefit. In particular, both groups may take a more critical look at the structure of the company, the timing of the offering, the liquidity of the token, the use of funds and the overall incentives for investors.
Taxing a Coin or Token Offering
According to the IRS, virtual currency is property and treated much differently than cash infusions for an equity investment. When it comes taxation, the tokens or coins generated by a company in an ICO will be taxed in accordance with property received at standard tax rates. Remember, when an entity takes in an equity investment, it is treated as a basis infusion into the business and resides on the balance sheet and does not flow through revenue on the profit and loss. When tokens are generated on the other hand, there is a taxable event, creating very differing incentives and needs for all parties to a deal.
For greater insight into the tax treatment for ICOs and cryptocurrency, the Unchained podcast’s interview with Tyson Cross and Jason Tyra has some great insight. In the podcast, they cover a broad range of topics, but they sprinkle in some great insights into taxation considerations for ICOs and token events.
Considering Structure of the Entity
C-corps and S-Corps are taxed very differently. C-corps are taxed at both the corporate level and the shareholder level. S-corps are flow-through entities whose shareholders are taxed on their personal K-1. Limited Liability Companies do not have their own tax structure and elect to be taxed as either a C-corp or S-corp via IRS form 2553.
Thanks to the recent changes in the tax code, corporate taxes are as low as they have been in quite some time. This further pushes an incentives to perform coin and token offerings under a more traditional C-corp tax structure. If an entity performing an ICO raised substantial funds, the shareholders (or holders of membership units in the case of an LLC) would be taxed at their personal income tax rates as the remaining funds after all expenses in the year in question would flow to their personal K-1. It is guaranteed that the personal tax bracket would be much more onerous in this case, than the current C-corp taxation rate. Certain circumstances may create differing incentives, but it is most likely that a traditional corporation would save more on taxes from an ICO than other structures.
Timing on the Offering & Use of Funds
Because non-equity-driven coin and token offerings are taxed in the year in which the event occurs, it stands to reason that issuers would be best served by timing their offerings earlier in the year, rather than later. This will give them ample time to write-off legitimate expenses relative to things like software development, marketing, legal and operations in the year in which the offering occured. Considering this, should also cause both issuers and investors to look critically at two things. First, when the offering occurs in the year in question. Better earlier than later. Second, scrutiny on the detailed use of funds for the capital raised in the offering. The use of funds, if not thought through in detail may not show an issuer has thought seriously enough about tax considerations for the first few months following an offering. Understanding how a larger amount of capital can be deployed in an efficient and rapid fashion following an token or coin offering can and should get investors more comfortable.
In addition, as more offerings include six and twelve month selling restrictions per SEC Rule 144, we are likely to see less pump-and-dump ICO deals, tied to crazy bounties. However, it also impacts investor incentives for buying and holding a token, particularly when they know liquidity may not be immediate and automatic and taxes are to concurrently occur within the year.
Equity & Risk Considerations
Given some of the nuanced issues related to offering tokens as opposed to equity, many newer token and coin issuers have been providing sweeteners to entice investors to buy-in to the longer-term vision of their deals. Simple Agreements for Future Equity (SAFEs), including options, warrants and convertible debt as well as direct equity incentives are becoming more prevalent. In fact, as time progresses, I personally expect to see more ICOs that include both tokens and equity and even some hybrid models where tokenized equity is involved. By rethinking the offering issuers are likely to provide greater incentives to investors and mitigate tax and securities liability risk concurrently. As usage of securities exemptions (e.g. Reg D, Reg A+ and Reg S) become more the norm, including true equity in the deals will certainly provide a differentiator for would-be issuers looking to stand out from the overabundance of available deals in the market.
Conclusion
As my own tax advisor has stated to me on numerous occasions, “you should not pay more taxes than you are legally obligated to pay.” That is, it is in your best interest to create an environment where taxation is minimized. It somewhat follows the age-old philosophy, that I can obtain a better return on my investment than Uncle Sam. When it comes to taxation with an ICO, it is first beneficial to understand the big picture and then consult with a taxation expert to understand how tax can be the tail that wags the dog for your initial coin or token offering.
About the Author
Nate Nead is an investment banking and finance professional with InvestmentBank.com. He is passionate about the impact of smart contracts and tokenized equity on traditional securities and investment banking. He covers tokens coin investment banking at ROI.me. He resides in Seattle, WA with his family.
