Initial coin offerings are an increasingly popular means for companies to raise funds. While the federal securities law issues raised by ICOs have dominated the media conversation around digital currency in recent months, there are many novel and, in some cases, unresolved accounting and tax issues that have received considerably less attention.
For issuers of digital currency, and their tax and accounting consultants, there are a range of potential challenges that could dramatically impact ICO strategy, a few of which are discussed below.
ICOTalk, a popular ICO information and ratings website, estimates that there could be as many as 5,000-plus ICOs in 2018, up from 1,300-plus in 2017. ICOs typically are used to raise funding for the development of a distributed ledger software system, including the issuance of tokens (“Tokens”) which can be used on that system; examples of Tokens would include Bitcoin and Ethereum.
Some ICOs consist of the issuance of a combination of traditional equity, such as Seed Common or Seed Preferred Stock, together with an agreement to issue Tokens at some later date. Other ICOs consist solely of any agreement to issue Tokens at a later date. In addition, Tokens may be only exchangeable for other Tokens, goods and services or fiat currency, or may participate in the profits of the issuer.
The accounting and tax issues raised by the first type of ICO is more straightforward. The Seed Common or Seed Preferred typically is provided for in the articles of incorporation for the issuer, and almost certainly constitute “equity securities” for both accounting and tax purposes. The amounts raised by the ICO would generally be reflected as capital stock or additional paid in capital for GAAP purposes in the equity section of the issuer’s balance sheet, and would not be included in income. In addition, for income tax purposes, the amounts raised would generally be excluded from income by virtue of Section 1032.
There are a number of issues arise, however, with respect to how to account for the future issuance of Tokens. If the issuer has a legally binding obligation to issue the Tokens, then the issuer may need to allocate the proceeds from the ICO between the equity and the Tokens. If the equity involves preferred stock, then “Preferred OID” may have been created since a portion of the proceeds should be allocated to the Tokens and not to the Preferred Stock. The issuance of the Tokens is likely to be accounted for as a liability; a possible accounting treatment could be as follows:
Dr. Cash $1,000
Cr. Tokens Payable $200
Cr. Preferred Stock $800
The subsequent issuance of the Tokens could give rise to gain recognition for both accounting and tax purposes if the fair market value of the Tokens exceeds the portion of the proceeds allocated to the Tokens. For example, if the Tokens have a cost of development of $300 and a value of $400 when issued, then for accounting purposes, perhaps:
Dr. Tokens $300
Cr. Cash/Capitalized Expenses $300
Dr. Tokens Payable $200
Dr. Gain on Repayment $100
Cr. Tokens $300
What if the cost of the Tokens was expensed rather than capitalized for tax purposes, as is frequently permissible? Then the full amount of the tokens payable would presumably constitute taxable gain given the use of appreciated property, the Tokens, to repay a liability.
Furthermore, what would be the accounting and tax treatment if the obligation to issue the Tokens is not legally binding on the issuer, but just a possibility based upon the occurrence of future facts, such as the completion of the software, issuance of the Tokens, approval by the board of directors etc.? In such case, the proceeds would presumably be allocated solely to the preferred stock since there is no binding obligation on the part of the issuer.
Dr. Cash $1,000
Cr. Preferred Stock $1,000
It follows that the subsequent issuance of the Tokens would likely be accounted for as a distribution with respect to the Preferred Stock (provided such a distribution does not violate applicable corporate law restrictions). The treatment of the distribution of the Tokens depends on a number of factors, including whether the issuer has any retained earnings, or sufficient additional capital, and the value of the Tokens on the date of the distribution.
Dr. Preferred Stock $500
Cr. Additional Paid in Capital $500
Dr. Tokens $500
Cr. Additional Paid in Capital $500
Note that for income tax purposes, if the Tokens have a fair market value that exceeds tax basis, which could arise where the software development expenses have been expensed, then the distribution of the Tokens could give rise to a taxable gain at the issuer level under Section 311(b) with a resulting taxable dividend for the investors.
The accounting and tax treatment of ICOs that do not involve the issuance of instruments that constitute “equity” for accounting and tax purposes could be very different that that discussed above. Where no actual equity securities are issued, but the issuer has a binding obligation to issue the Tokens, then perhaps for accounting purposes that obligation is properly accounted for as a liability:
Dr. Cash $1,000
Cr. Tokens Payable $1,000
The accounting treatment of a subsequent distribution of the Tokens most likely would follow the treatment outlined above.
However, for income tax purposes, where there is no fixed maturity date, no stated interest rate, etc., then the ICO may not constitute a liability; if that is the case then the proceeds from the ICOs most likely constitute taxable income to the issuer — a very unexpected result!
Dr. Cash $1,000
Cr. Income $1,000
What happens when Tokens are transferred to the investors? There is no liability at the issuer level for tax purposes, nor are the investors holders of equity securities. Therefore, such a transfer would presumably not be a loan repayment, or a dividend distribution (both of which would result in gain recognition as outlined above). However, because it involves a transfer of appreciated property, it is likely to result in a taxable gain to the issuer nonetheless.
ICOs are tremendously valuable for entrepreneurs needing to raise capital but can be incredibly tricky from an accounting perspective. The above analysis just barely scratches the surface of the myriad tax implications of ICOs. As ICOs proliferate, tax and accounting professionals will be put to the test.
