The IRS has issued extensive guidance on treating payments to employees and other service providers as compensation
The IRS has issued extensive guidance on treating payments to employees and other service providers as compensation, including how to report such compensation and the deductions and related treatment of the payments from the company side. This item uses the term "employee," but similar rules apply to other service providers, such as contractors, board members, or even certain service companies earning compensation.
As digital assets become a means of compensation, employers need to understand how Sec. 83 applies when using such means as payment.
The Internal Revenue Code addresses the taxation of any payment by a company to an employee for the performance of services. Companies are familiar with the fact that a payment by cash, check, or bank account deposit for an employee based on the employee’s service is taxable as compensation and subject to payroll tax withholding (Social Security and Medicare taxes, as well as federal and state income withholding, as applicable). However, the Code also addresses the treatment of "property" (other than cash) transferred to employees.
The transfer of any property to an employee "in connection with" the performance of service is compensation (Sec. 83). The company is required to report the value of the property transferred as compensation (e.g., on a Form W-2, Wage and Tax Statement, for an employee; a Form 1099-NEC, Nonemployee Compensation, for an independent contractor or director; or a Schedule K-1, Partner's Share of Current Year Income, Deductions, Credits, and Other Items, as a guaranteed payment for a partner; reporting may be different for nonresident aliens who perform services within the United States). The company is also allowed a tax deduction equal to the FMV of the property less the amount the employee pays for the property as it is included in the employee's compensation (there can be special timing rules for these compensation deductions, not discussed here).
Since companies often provide property (such as company stock, or even a company car) subject to a substantial risk of forfeiture, Section 83 generally delays taxation until the property "vests" (i.e., the substantial risk of forfeiture lapses). The employee has compensation equal to the fair market value (FMV) of the property, less any amount the employee paid for the property, on the date of transfer or on the date that the employee vests in the property, if later. For yet another twist, even though the property is subject to a substantial risk of forfeiture, the employee may elect to take the FMV of the property less the amount the employee pays for the property into compensation income on the date of grant by making a Section 83(b) election. This is a formal election that the employee must send to the IRS and the person to whom the services are provided within 30 days after the date of transfer, notifying all parties that the employee elects to be taxed upfront and not at the later vesting dates. This election is not without risk and is generally used as a tax planning mechanism if the property has a fairly low value and is likely to increase in value, as the election closes the compensation element, and any further appreciation after the transfer would be considered capital gain. The risk, of course, is that the value decreases over time, or the property is later forfeited, and the employee will have paid more tax on the property than would otherwise have been required without the election.
Recently, companies have started to pay some regular compensation by using a digital asset or reward an employee with a bonus using cryptocurrency, a token, or some other form of digital asset. As a note, 29 C.F.R. Section 531.27 (Department of Labor regulations under the Fair Labor Standards Act of 1938, P.L. 75–718, as amended) requires certain "prescribed wages" (minimum wage and overtime compensation) to be paid in cash or negotiable instruments. State law also may restrict the types of property that can be used to pay wages. Thus, companies need to take care when paying compensation using digital assets.
The IRS and other governmental agencies have taken the position that cryptocurrency is not "currency" and is instead property (IRS Notice 2014-21, as modified by Notice 2023-34 and supplemented by Rev. Rul. 2019-24). This means that any cryptocurrency received by an employee as compensation is subject to payroll tax withholding under Section 83. Such required withholding might be fairly easily accomplished if the company can hold back some of the cryptocurrency and then pay cash to the IRS equal to the payroll tax amounts. As with payments in cash, the employee is taxed on the entire amount, including the cash or cryptocurrency withheld.
Some digital assets can be a bit more challenging for payroll tax withholding. This is a problem even with regular Section 83 property transfers. For example, if a company transfers a car to an employee, the company must tax the employee on the full FM
