Valuation Considerations for Cryptocurrency and Tokens in Tax Reporting

Valuations for blockchain, crypto, and Web3-related companies have many tax implications.[1] Following are a couple of hot topics we have noted recently in the valuation of digital assets like cryptocurrencies and tokens.

1)     Appraisals for Cryptocurrency Donations

2)     Valuations for Cryptocurrency Awards and Compensation

Appraisals for Cryptocurrency Donations

On January 10, 2023, the Office of the Chief Counsel provided an important reminder about the qualified appraiser rules governing cryptocurrency donations. According to Aaron Fox, a partner with Marcum LLP, the expressed result of cryptocurrency memo (CCA 202302012) is “the disallowance of the taxpayer’s charitable contribution due to incomplete documentation on the Form 8283 — a result of no appraisal being performed.”[2]

Although many cryptocurrencies are traded on public exchanges, they are not treated as publicly traded assets for IRS reporting purposes. Further, some blocks of cryptocurrency are large enough relative to their trading volume to necessitate consideration of a blockage discount in determining fair market value. Other cryptocurrency holdings or token assets may be subject to lock-up periods that require consideration of a liquidity discount. These are just a couple of examples of the many complicating factors in cryptocurrency valuations. Thus, the requirement for a qualified appraisal of such assets for tax purposes remains in effect.

According to IRS guidance, a qualified appraiser is one who has earned a relevant appraisal designation or has met certain education and experience standards and regularly performs such appraisals for which they are paid, among other requirements. At Redwood, our team has more than a decade of combined experience in valuing cryptocurrencies and tokens and has relevant professional designations, including ASA, CFA, and CPA, with over 150 years of combined valuation experience.

Cryptocurrency Awards and Compensation

Over the past few years and continuing into 2023, we have frequently seen token-related instruments allocated to employees and advisors as deferred consideration for services, typically before the tokens become tradeable or have achieved liquidity. This creates tax implications for both the issuer and recipient of such tokens. There are also tax and valuation issues related to entity legal structure and domicile, due to a rapidly shifting regulatory landscape and other factors. This often leads to the need for valuations of illiquid tokens, intangible assets, and ownership interests being transferred among entities or investors.

In terms of cryptocurrency consideration, a token incentive plan is a form of incentive compensation plan, similar in some ways to traditional equity incentive plans. Token incentives include award types such as fully vested tokens, restricted tokens, restricted token units (also referred to as RTUs or future token interests), SAFTs, token warrants, and other awards based in some way on tokens and their value.

As noted in an expert Q&A with Nyron Persaud and Mary Lewis of Cooley LLP, “Restricted tokens can be a tax-efficient vehicle for early-stage companies. Recipients of restricted token awards may file an election under Section 83(b) of the Internal Revenue Code (an 83(b) election) to take the value of the tokens into account for ordinary income tax purposes at the time of grant rather than at the time of vesting. Because the full value of a restricted token award can be taken into income at the time of grant, the recipient does not incur any additional taxation until they transfer the tokens (following the lock-up and vesting periods). Any gain at the time of the transfer is eligible for capital gains tax treatment, which may be short-term or long-term depending on how long the tokens have been held.”[3]

We are often asked how long an independent third-party valuation, such as Redwood provides, may be relied upon. While a 409A valuation may be relied on for up to 12 months in the absence of other material events, a token valuation generally goes “stale” much sooner, potentially even within a couple of months or even weeks, due to the volatile nature of token values and rapid change in token value due to token sale events or significant development milestones.

The Redwood Valuation team has performed hundreds of independent valuations for blockchain-enabled companies, various forms of digital assets, including fungible tokens, and related financial instruments. We ensure these valuations are properly performed based on our considerable experience completing projects that combine technical valuation expertise with industry specific knowledge. Redwood provides bespoke valuation work to support private token grants and issuances and stays up to date by maintaining proximity to the most cutting-edge advisors in the space.

[1] Redwood Valuation and its affiliates do not provide tax, legal or accounting advice. This article has been prepared for informational purposes only. It is not intended to provide and should not be relied on for tax, legal or accounting advice. Consult your own tax, legal and accounting advisors before engaging in any transaction.

[2] https://www.marcumllp.com/insights/irs-clarifies-qualified-appraisal-requirements-for-cryptocurrency-donations

[3] https://www.cooley.com/-/media/cooley/pdf/reprints/expert-qanda-on-cryptocurrency-compensation.ashx