Despite the tanking of the crypto market this year and the uncertain regulatory environment in the USA, companies are still looking to token sales, or “initial coin offerings” (ICOs), as a way of raising funds. One of the key considerations is the taxation of ICO proceeds, and the subsequent accounting. The Blockchain CFO is here to shed some light on these topics.Let’s break it down into two sections:
Accounting. Everyone loves accounting, so let’s start with that. First of all, you’re not going to be able to peruse the Accounting Standards Codification (login required) and find specific guidance on cryptocurrency accounting. Industry groups like the Accounting Blockchain Coalition are tackling crypto/blockchain accounting issues by convening working groups of industry professionals. Pending the outcome of this work, however, here are some thoughts:The accounting for a token sale depends on the sort of token that being issued, whether it is a security or is being positioned as a “utility”.
Security tokens are rare in the USA but should become more popular as the regulatory noose tightens. Companies can issue a token that is backed by equity, debt, some sort of asset, or even a promise of future payment (e.g. revenue share). However, in doing so the token would likely pass the Howey Test, and thus represent an “investment contract”, or security. This would subject the issuer to SEC regulation, either in the form of a full registration for the token issuance, or the need to seek an exemption from registration. A securities attorney would be needed to work through the related issues. The question in accounting for a security token issuance would be the credit side of the transaction. An equity token would be accounted for as DR cash, CR equity; for a debt token the credit would be to a debt liability account – short-term or long-term depending on the terms of the offering and the timing of repayment.
For a token that gives the holder ownership of a share of an asset, the accounting would be a little more complicated. The initial sale of the tokens could be accounted for with a contra-asset account tied to the tokenized asset. The net value of the asset owned by the company would be net of the asset book value and the contra-asset account.
A cleaner approach would be to create a legal entity with the sole purpose of holding the asset, and sell equity tokens in that entity. However, that would create other accounting complications including the need to consolidate entities during the accounting close process. Lastly, for a revenue share token, the company would be selling a right to future cash flows. The sale of the token would create a liability account (split into a short-term and long-term portion) that represents the present value of the anticipated revenue share. Initial valuation would be set by the market, but the liability would likely need to be revalued on a periodic basis using either token market prices, discounted cash flow calculations, or other methods. Changes in the value of the liability would be taken to a gain/loss account.Note that the above does not include a discussion of currency translation issues. Some accounting systems do allow for the selection of crypto (BTC, ETH, LTC, etc) as a type of “currency”, but best practice now is to place the debits and credits on the books in USD and periodically revalue.
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“Utility” tokens seek to avoid being classified as a security by claiming that the primary purpose of the token is use on the issuer’s (to-be-developed) platform. Therefore, the ICO is essentially the pre-sale of services, and should be accounted for accordingly.
However, in reality most investors will buy the token not for future use on the platform, but for investment purposes. Or, the tokens will simply not be used on the platform. So it would make sense that the estimated portion of the proceeds representing future utilization would be booked as a deferred revenue liability, with the balance as revenue from the token sale, booked in the period that the proceeds are received.
But how to estimate this portion? Since so few ICO-funded platforms have launched, it’s nearly impossible to estimate the portion of the tokens that get “HODL‘d”. One way might to make a conservative estimate – say 2/3 – and periodically test that estimate based on data. The amount of deferred revenue recognized when a token is used can be adjusted on a periodic basis so that the remaining balance represents the number of sold tokens outstanding anticipated to be used on the platform times this “recognition rate”. Example:
15M tokens sold in ICO. Total raise $7.5M
5M assumed will be used on the platform at a future date
Initial deferred revenue is 5M * $0.50 = $2.5M
1 year after platform launch – 2.5M tokens have been used on platform
12.5M remaining; estimate is now that 5M of the remaining will be used on platform in future
Current deferred revenue balance is $1.25M, new recognition rate is $1.25M/5M = $0.25.
Currently companies are taking 100% of ICO proceeds to revenue when received, but I consider this an overly aggressive approach – and does not back up the companies’ claim of “utility token” status.
Taxes. The tax treatment of proceeds from an ICO is a bit more straight forward. For cash basis taxpayers (most LLCs, S-corps, small C-corps) the proceeds are taxable in the year they are received. The accounting treatment is not relevant. However, for C-corps choosing the accrual method of accounting any deferred revenue portion of the proceeds would be taxable when the associated services are delivered, in future periods.IRS pub. 542 has a fairly concise discussion of accounting methods for tax purposes.