The 83(b) Election: Implications for vesting tokens
Companies in the crypto space often include tokens as a part of compensation for employees and other team members. To incentivize these employees to stick around for many years, tokens are often granted with a vesting schedule – the longer you stay, the more of those tokens that you earn.
These token grants are taxed by default on their fair market value at the time of vesting. So if you’re vesting monthly, you owe taxes on the value on those tokens that vest each month based on their value at that time. In most cases, employees are working at a company or project that they think has upside potential and that the value of their token grant will go up over time. But that means that if the token price increases 10x or 100x, your taxes owed would increase proportionally.
There is a unique provision under the U.S. tax code, the 83(b) election, that lets recipients of vesting assets opt to be taxed at the time of grant based on the token grant's value at that time instead of as they vest. The 83(b) election essentially allows an employee to pay taxes early when the token price might be very low. That way, as tokens increase in value, there are no surprise tax bills and the recipient can generally then only pay taxes when they sell tokens. The 83(b) must be filed within 30 days of the time of the grant, and is usually only applicable to grants of vesting tokens or in some cases future token interests.
The 83(b) ends up being a useful option to founders and early employees that have an opportunity to make this election before the token price increases significantly.
Why would a token recipient opt for an 83(b) Election?
There are several reasons why a token recipient may choose to make an 83(b) election.
- Predictability: The tax bill is known upfront, instead of based on future price increases and potential tax bracket changes
- Anticipation of token value appreciation: If an employee thinks that the token price will go up in the future, filing an 83(b) election allows them to lock in a lower tax bill now rather than paying more in taxes over time as the token price increases. The employee may also fall into a lower tax bracket based on the value of the grant at grant time than they might if the tokens increase significantly in value.
Breaking it down with an example
For example, let’s say an employee starts working for an early-stage protocol where they are offered tokens. They receive a vesting token grant for $TOKEN (an example token) with the following parameters:
- Total tokens subject to vesting: 1,000,000 $TOKEN
- Token price at time of grant: $0.001
- Total value at time of grant: $1,000
- Vesting schedule: Monthly over four years.
- Assumed tax rate: 37%
Assuming the token price remains unchanged ($0.001), the total taxable amount in each case would be:
- With 83(b) election: $1,000 in taxable income, recognized at time of grant.
- Without 83(b) election: $1,000 in total taxable income ($20.83 recognized monthly at the time of vesting over 48 months)
If the price remains unchanged, the total tax paid is still the same, though with an 83(b) it is owed up front and without it is owed over time.
What if the token price goes up 100x after the grant is finalized to $0.10? What are the taxes owed?
- With an 83(b): $1,000 in taxable income, recognized at time of grant.
- Without an 83(b): Potentially $100,000 in total taxable income ($2,083.33 vesting every month over 48 months)
If the token price goes up significantly, the tax bill would increase as those tokens that vest every month are worth more at the time that they vest. With an 83(b) election, the recipient can pay a tax bill on the original $1,000 fair market value at the time of grant and not worry about surprise tax bills as the value increases.
How is the value of the tokens determined?
Taxes are owed based on the fair market value of the tokens at the time of grant or at the time of vesting, depending on whether an 83(b) election was filed. To determine this value, projects will usually work with a Token Valuation Firm (such as Teknos or Redwood Valuation) that will issue a token valuation that is valid for a certain number of weeks or months.
The token valuation can take into account various factors including lockups, vesting, other restrictions, as well as the liquidity of the token itself.
When can an 83(b) Election be filed?
The window for filing an 83(b) election is quite narrow, and strict adherence is required. The 83(b) election must be postmarked within 30 days of the grant date. The IRS considers the 30-day clock to start from the date that the rights to the tokens were legally “transferred”, which usually means when the grant is consummated. Depending on the legal arrangement, the 30-day clock may start once the obligations to finalize the agreement are fulfilled by both parties (including the employee paying the company for the grant, and any requisite board approvals).
To have increased assurance that the 83(b) was received, it’s common to include a self-addressed stamped envelope with the election alongside a second copy that the IRS can stamp as received and then mail back.
What can a recipient do if they missed the 83(b) window?
The first question is to determine if they really missed the 83(b) window. If the payment for the tokens by the recipient was not made, a lawyer could interpret the 30-day clock to not yet have started. Additionally, if the token grant was contingent on a board approval that was never made, the token grant could be considered to be invalid and a new one would have to be issued (though at the fair market value at the time of the new grant). But if the token grant was fully consummated, then the default tax rules would take over and the tokens would be taxed as they vest. There are other workarounds for such cases that may be best discussed with your lawyer.
When is an 83(b) applicable?
An 83(b) election can be filed on transfers of property (e.g. token grants) that have a substantial risk of forfeiture, such as a vesting schedule or liquidity vesting trigger (so long as there is a substantial risk of it not happening). An 83(b) election cannot be filed on contractual rights such as options or token units.
Some lawyers will structure Future Token Interests to be compatible with 83(b) filings. For questions such as these, you should definitely consult a lawyer. If you want to learn more about 83(b), you can read this article by Carta or read the legal code here. It's essential to keep in mind that this is a one-time decision; once the election has been filed, it cannot be reversed.
When might a token recipient decide to not file an 83(b)?
The 83(b) election means you are choosing to be taxed on the grant date based on the value of the tokens at that time. If the tokens have an elevated price or value, the tax bill may be too high for this to be an option.
The 83(b) is also usually a bet that the asset’s price will increase over time; if instead the token price crashes, the employee would have paid taxes more taxes than without the 83(b) election.
Risks associated with 83(b) election
Of course, there are also some risks associated with making an 83(b) election. Here are some additional considerations to keep in mind when deciding whether or not to make an 83(b) election:
- The risk that the value of the tokens could decline significantly: If the value of the tokens decreases significantly after the election is made, the employee could end up paying taxes on more than they actually received.
- The likelihood that the government will impose new taxes on token-based compensation.
- The possibility that the employee may leave the company before the tokens vest: If the employee leaves the company before the tokens vest, they may have to forfeit their right to unvested tokens, even if they made an 83(b) election and paid taxes on the values of those tokens.
Conclusion
Overall, whether or not to make an 83(b) election is a complex decision that should be made on a case-by-case basis in consultation with tax specialists. However, for employees who are considering receiving token compensation, the protection from future changes in tax law can be a significant benefit. If you’re trying to determine whether or not an 83(b) election is the right choice for your circumstances, always consult with a tax advisor on topics like these.
This article is provided for informational purposes only and is not intended to be construed as legal, financial, or tax advice. Readers should not rely solely on the information presented herein and should consult with their own legal, financial, or tax professionals regarding their specific situations. The author(s) and publisher make no representations or warranties concerning the accuracy or completeness of the information contained in this article. Reliance on any information provided in this article is solely at your own risk.