What are the tax implications of a smart contract? Because a smart contract delivers property in the future, this new technology raises an age-old tax question: when will the income be taxed?
A smart contract is a program that automatically transfers an asset after it verifies that a condition is satisfied. The condition may be as simple as the passage of time: transfer one bitcoin on January 1, 2019. Or it could be more complex such as an option contract where the program automatically executes after verifying the payment of the strike price or the market price of stock.
What if I get a haircut and execute a smart contract to transfer bitcoin to Ray, my barber, on January 1? Ray doesn’t need the cash now and wants to defer the tax hit. Will this work? To find out, first we need to review some of the tax concepts at play.
Cash Basis Taxpayers
Most individuals are only taxed when they receive cash. This makes them “cash basis” taxpayers. But even cash basis taxpayers can have taxable gain or income before receiving cash. In this area, bad things come in threes. You can be taxed if you: (1) acquire an asset that is a cash equivalent, (2) have constructive receipt of the cash or property or (3) receive an economic benefit. Trip up any one of these, and you will have taxable income.
If you receive a promise to pay from your employer, and you can assign or transfer the promise to a third party in exchange for cash, courts have decided that receiving this “promise to pay” is close enough to cash to be taxable. The cash equivalence doctrine is easy to understand – as long as it is transferable to a third party or payable on demand, a promise to pay by a credit-worthy company triggers immediate taxation. Although the taxpayer has not actually received cash, it is close enough.
To understand economic benefit, think of an escrow account. Imagine that you have sold your home, the buyer has transferred all the cash to escrow, and both you and the buyer have signed all the documents. But the escrow agent will only release the cash to you in three months, on January 1. Under economic benefit, even though you haven’t received the cash from escrow, you are still subject to tax.
The economic benefit doctrine asks if you have received a property right. It doesn’t matter if that property right is not transferable or that you do not enjoy immediate possession. If you have fully vested rights to the property, you have received an economic benefit.
If the cash or property is set aside for your benefit, and the only condition for receipt is the mere passage of time, then you have received an economic benefit and are immediately taxable. This can lead to harsh results. For example, in a series of cases, former E&Y partners who received stock in restricted escrow accounts argued against immediate taxation because they could not sell the stock. While the stock was in escrow and subject to selling restrictions, it suffered a steep decline in value. Nevertheless, the E&Y partners were taxable on the stock at the time it was placed in escrow, even though they could not sell or transfer the stock for lengthy periods of time.
Finally, when funds are set aside for your benefit or if funds are available on demand, you are in constructive receipt, even if you haven’t actually received the funds. You cannot “turn your back” on income when you have the right to demand payment. The rules for constructive receipt aren’t easy to summarize because much depends on the facts. For example, not surprisingly a court is more likely to find constructive receipt when the taxpayer or related parties are in control of the company obligated to make the payment.
Imagine that Max just finished creating a website for Jennifer, and now payment is due in bitcoin. Max is planning to make some major investments in his business next year, so he doesn’t need the cash now and wants to defer the tax liability to the next year. Jennifer executes a smart contract that will transfer a fixed amount of bitcoin to Max on January 1.
Unfortunately, Max’s plan probably won’t work. While Max doesn’t enjoy possession of the bitcoin today, he has the right to the bitcoin because he will receive it on January 1. This is similar to the concept of an escrow account, which triggers immediate taxation. Indeed, you could make the argument that a smart contract to deliver bitcoin is even more secure than escrow! (Escrow agents, watch out for this technology…)
Now imagine that, instead of automatically delivering the bitcoin on January 1, Jennifer only pays Max if the website achieves certain SEO goals within a certain time period. Because Jennifer drives a hard bargain, the SEO goals are meaningful and will require work to achieve. Max only receives the bitcoin when the website reaches those goals.
In this scenario, when the smart contract is executed, Max does not have a right to the bitcoin. If he fails to meet the SEO goals, he will never receive it. Therefore, Max will only be taxed when the condition is satisfied and the bitcoin is delivered.
Smart contracts have fascinating new applications in the financial world. But when it comes to the timing of taxable income, without careful planning, the parties to these contracts may encounter unexpected tax results!