How 83(b) Elections for crypto token grants can fail and cost you millions

What is a Section 83(b) Election for Crypto Tokens?

An 83(b) Election for crypto tokens is a document someone sends to the Internal Revenue Service (“IRS”) when that person receives a grant from a Restricted Token Award (“RTA”)¹ agreement or Token Purchase Agreement (“TPA”) provided by a company as part of an incentive compensation plan. 

The 83(b) Election declares that the worker chooses to be taxed on the fair market value of their tokens at the time they're granted, rather than waiting until the tokens vest according to the grant agreement. Essentially, the 83(b) Election allows token holders to be taxed on the tokens received now to potentially benefit from lower taxes on future gains at long term capital gains rates, which is available so long as the tokens are held for more than a year following the grant and date of transfer. All of this needs to be tracked and reported to the IRS to be effective for tax purposes.

Background on Cryptocurrency and Taxes

Cryptocurrency is subject to various tax regulations in the United States, with the IRS categorizing it as property for tax purposes.² This property classification means that standard capital gains tax rules apply to cryptocurrency transactions.

‍Application to Restricted Crypto Tokens

When you're granted restricted crypto tokens for RTAs or TPAs, such as part of a crypto project or a crypto company compensation plan, the fair market value of these tokens at the time of grant can be declared as income. If a Section 83(b) Election is timely made by the worker, the grant will be taxed on this amount at your ordinary income tax rate (up to 37% as of 2024). 

Any subsequent increase in the token's value when the worker sells or exchanges the tokens longer than a year after the 83(b) Election is made will be taxed at the lower long-term capital gains rate (up to 20% as of 2024). An employer could use a service like Toku to track and record these elections and handle the calculation and payment of withholding taxes related to them to the government.

‍Examples in the Crypto Context

Imagine a worker has been granted 100,000 restricted tokens by a new blockchain project. At the time of the grant, the tokens are worth $0.01 each. If the worker timely files a Section 83(b) Election, he or she will pay income tax based on the $1,000 total value immediately. If the worker doesn’t timely file the 83(b) Election, and the tokens increase to $1.00 each by the time they vest more than a year later, the worker will be taxed on the $100,000 value at ordinary income tax rate. 

Only later, when selling the tokens after they've appreciated even more after they have vested, that additional gain is subject to tax at the lower capital gains rate if held for more than a year after the time of vesting. However, if an 83(b) Election was timely filed by the worker, this tax outcome would have been very different.

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‍Why Make a Section 83(b) Election with Crypto?

Filing a Section 83(b) Election for crypto tokens can be advantageous for the same reasons as for stock: to potentially reduce overall tax liability by accelerating income recognition and taking advantage of lower capital gains rates on subsequent growth. It's particularly appealing if you believe the value of the tokens will increase significantly though you have to pay taxes on the full grant immediately upon filing the election.

‍Risks and Considerations

The risk of making a Section 83(b) Election lies in the uncertainty around the future value of the crypto tokens. If the project fails or the value of the tokens decreases, you may end up paying taxes on income that far exceeds the eventual worth of the tokens. 

Furthermore, the volatile nature of cryptocurrencies adds an extra layer of risk compared to traditional stock. Lastly and quite importantly, if the value of the tokens declines or the project goes bust entirely such as a rug pull, you cannot claim any refund, credit or deduction for any of the taxes paid with an 83(b) Election.

‍Timely Filing a Section 83(b) Election for Crypto Tokens

The process for filing a Section 83(b) Election with the IRS involves submitting a written statement within 30 days of receiving the restricted tokens, detailing the election and including specific information about the grant. The election applies the same way it does for stocks, with the need for timely filing and careful adherence to IRS guidelines. The IRS does not make any exceptions for forgiveness for late filing the election, period.

‍How an 83(b) Election for crypto tokens can Fail

1. Not timely filed. The first way an 83(b) Election can fail is if the worker, or the workers agent, fails to timely file the election with the IRS within 30 days of grant. As said before, there are no exceptions to this deadline. 

2. Not effectively transferred. Another way the 83(b) Election can fail is if there was not an effective transfer of property under Section 83 of the Internal Revenue Code. The effective transfer of property for Section 83 purposes requires that the recipient be able to fully exercise their property rights to the tokens, such as with voting, staking, receiving airdrops, etc. 

3. Can’t get the tokens back. A company must both: (1) make the transfer of tokens effective for Section 83 purposes, and (2) must also transfer them in such a way that they can get the tokens back if the grant recipient leaves the company or becomes disqualified in some other way before vesting completes. some text
   • While that won’t invalidate the 83(b) Election, it will ruin the incentive structure because those who leave can take their full grant before vesting. It requires careful consideration and technical and legal expertise to make sure that both of these requirements are met for RTA and TPA grants.

4. 83(b) Election documentation is not retained. Also, an employer needs to retain the 83(b) Elections in cases of investment or other due diligence because the employer remains responsible for any tax deficiencies if the 83(b) Election fails for some reason. Toku helps track and capture the 83(b) Elections in its dashboard.

‍Conclusion

The application of Section 83(b) Elections to the cryptocurrency domain can offer significant tax advantages under the right circumstances. But 83(b) Elections for crypto tokens require specialist advice and systems to avoid the key ways that 83(b) Elections can fail. Toku provides the systems to help you administer your token grant program and achieve the desired incentive, compliance and tax outcomes for the company and workers.  Talk to Toku today to make sure you have the proper set up to file 83(b) elections on the tokens you receive as compensation. 

Footnotes

¹ _{“Restricted” means that the tokens are subject to some type of legal limitation on resale until that limitation is lifted.}

² _{IRS Notice 2014-21}