Taxes on Restricted Crypto and Options Can Be Confusing: Expert Take

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There is considerable talk today about crypto investments for everyone, for individual retirement accounts, via index funds, and more. There are also plenty of crypto-related startups, some of which have gotten quite big and quite valuable. That means options, crypto bonuses, restricted crypto, etc. All of these raise tax issues, and can be confusing.

Before we address crypto itself that is awarded to workers in connection with services, let’s start with stock options, and options to acquire crypto.

Two types of options

There are two main types of options: incentive stock options (ISOs) and non-qualified stock options (NSOs). ISOs (only for stock) are taxed the most favorably. There is generally no tax at the time they are granted, and no "regular" tax at the time they are exercised. When you sell your shares afterwards, you pay tax, but hopefully as long-term capital gain.

The usual capital gains holding period is more than one year. But to get capital gains treatment for shares acquired via ISOs, you must: (a) hold the shares for more than a year after you exercise the options; and (b) sell the shares at least two years after your ISOs were granted. This two-year rule catches many people. Even though exercise of an ISO triggers no regular tax, it can trigger alternative minimum tax (AMT).

Non-qualified options

Non-qualified options are not taxed as favorably as ISOs, but there is no AMT trap. There is no tax when the option is granted. But when you exercise a non-qualified option, you owe ordinary income tax - and, if you are an employee, Medicare and other payroll taxes - on the difference between your price and the market value.

For example, you receive an option to buy stock at $5 per share when the stock is trading at $5. Two years later, you exercise when the stock is trading at $10 per share. You pay $5 when you exercise, but the value at that time is $10, so you have $5 of compensation income. If you hold the stock for more than a year and sell it, any sales price above $10 - your new basis - should be a long-term capital gain.

Options to buy crypto

Options to buy crypto are treated just like nonqualified options to buy stock. Usually the tax is applicable when you exercise the option, not when you are given the option.

Restricted stock or crypto means delayed tax

Suppose that you receive stock or any other property - including crypto - from your employer with conditions attached. Say you must stay at the employer for two years to get it or to keep it. Special restricted tax rules in Section 83 of the Internal Revenue Code kick in.

Let’s consider pure restricted property. As a carrot to stay with the company, your employer says if you stay for 36 months, you will be awarded $50,000 worth of crypto. You don't have to "pay" anything for them, but it is given to you in connection with performing services. You have no taxable income until you receive the crypto. In effect, the Inland Revenue Service (IRS) waits 36 months to see what will happen. When you receive the crypto, you have $50,000 of income - or more or less, depending on how the crypto has done in the meantime. This income is taxed as wages.

The IRS won't wait forever

With restrictions that will lapse with time, the IRS waits to see what happens before taxing it. Yet some restrictions will never lapse. With such "non-lapse" restrictions, the IRS values the property subject to those restrictions.

For example, your employer promises you crypto if you remain with the company for 18 months. When you receive it, it will be subject to permanent restrictions under a company buy/sell agreement to resell it for a fixed price if you ever leave the company's employ. The IRS will wait and see - no tax - for the first 18 months. At that point, you will be taxed on the value, which is likely to be stated fixed price in the resale restriction.

You can elect to be taxed sooner

The restricted property rules generally adopt a ‘wait and see’ approach for restrictions that will eventually lapse. Nevertheless, under what's known as an 83(b) election, you can choose to include the value of the property in your income earlier - in effect disregarding the restrictions.

It might sound counter-intuitive to elect to include something on your tax return before it is required. Yet the game here is to try to include it in income at a low value, locking in capital gain treatment for future appreciation. To elect current taxation, you must file a written 83(b) election with the IRS within 30 days of receiving the property. You must report on the election the value of what you received as compensation - which might be small or even zero.

For example, you are offered crypto by your employer at $5 per coin when it is worth $5. However, you must remain with the company for two years to be able to sell them. You are paying fair market value for the crypto. So filing an 83(b) election could report zero income. Yet by filing it, you convert what would be future ordinary income into capital gain. When you sell the crypto more than a year later, you'll be glad you filed the election.

Restrictions + options = confusion.

As if the restricted property rules and stock options rules were each not complicated enough, sometimes you have to deal with both sets of rules. For example, you may be awarded options that are restricted - your rights to them "vest" over time if you stay with the company. The IRS generally waits to see what happens in such a case.