Tokens, liquidity and taxes

Determining fair market value (FMV) for cryptocurrency tokens for tax purposes involves far more than multiplying market quotes by token quantity. Accurate valuations must account for market dynamics, liquidity profiles, marketability discounts, and execution realities, while also aligning with tax guidance set forth in the Internal Revenue Code and Treasury Regulations. Understanding the specific type of token—whether utility, payment, security or another type of token—is also an important determination for any valuation process.

Founders, legal counsel, and tax advisors supporting Web3 teams are increasingly encountering complex tax reporting challenges tied to token-related transactions. Whether tokens are granted as compensation, transferred across jurisdictions, or sold in large blocks, each event can carry significant tax implications, and determining FMV in these scenarios is rarely straightforward. Below, we look at some of the key considerations that valuators can help with.

Fair market value is more than P×Q

Token markets often exhibit variable depth, meaning large block sales can significantly impact price. For example, a trader attempting to sell 10 million tokens when the order book depth is limited would cause significant slippage. As a result, the average realized price per token would be at a significant discount relative to the quoted spot price. Valuation analyses account for this by modeling order book consumption, mapping liquidity tiers, and estimating the price impact of incremental trade sizes. These models are typically calibrated using historical trade data to produce realistic slippage curves. In parallel, valuation models analyze bid-ask spreads to assess real-time trading friction.

From a tax perspective, these adjusted price estimates inform basis and gain calculations under IRC § 1001, while Reg. § 1.61-2(d) emphasizes the importance of documenting the methodology used to determine fair market value. Valuation becomes particularly challenging when liquidity is limited. Aside from a few highly liquid tokens like Bitcoin, Ether, and Solana, most assets trade in relatively thin markets, making large-position pricing especially complex.

Airdrops and FMV at receipt

Cryptocurrency airdrop valuation rests squarely on foundational FMV principles. Valuators typically identify a set of comparable tokens based on market capitalization, trading volume, and governance characteristics, then analyze early secondary-market trades to establish initial pricing benchmarks. Block-size discounts, which can vary significantly based on the depth and liquidity of the market, are applied to account for recipients’ limited ability to immediately liquidate without affecting market prices. Each of these inputs (peer comparables, trading data, and discount rationale) should align with Reg. § 1.170A-1(c)(2) documentation expectations, including detailed source references and timestamped records.

This approach supports compliance with IRC § 61(a) income recognition rules while reflecting the market realities of token dispersals. It also remains consistent with IRS Notice 2014-21, which, though still in effect, was partially modified by Notice 2023-34 to remove the statement that “virtual currency does not have legal tender status in any jurisdiction,” acknowledging the evolving regulatory landscape.

Token compensation and Section 83 elections

Many Web3 startups compensate founders and employees with tokens that vest or unlock over time. Tokens subject to vesting or transfer restrictions are treated as property under IRC § 83(a), triggering ordinary income based on FMV at the time of vesting.

However, the most advantageous tax treatment for founder tokens is likely found in filing for an § 83(b) election, shifting income recognition to the grant date, often pre-TGE, and therefore potentially at a significantly lower FMV than at the time of vesting. The FMV for § 83(b) election purposes can potentially reflect discounts for lack of marketability (DLOM), informed by token-specific constraints such as lockup periods, multisig controls, or governance-imposed restrictions. Reg. § 20.2031-3(f) provides regulatory precedent for applying marketability discounts in cases where assets cannot be freely sold. The only risk of taking the § 83(b) election is pre-paying taxes on a token that never makes it to launch or ends up failing.

When a timely § 83(b) election is not filed, the IRS—like similar tax authorities in Europe, the UK, and other jurisdictions—taxes the value of the tokens at the vesting date. When tokens are taxed at vesting milestones, especially at a one-year cliff unlocking 25% of a grant, the resulting tax liability can be quite substantial. However, calculating FMV at the time of said milestones requires more than referencing CoinGecko or a 24-hour volume-weighted average price because a liquidation of a large token block relative to its liquidity on centralized and decentralized markets may materially affect token prices if sold.

A defensible valuation should consider market depth, trading volume, and the size of the token grant relative to liquidity. Since tax authorities recognize value at the vesting or unlock date, FMV must reflect prevailing market conditions, which can fluctuate dramatically from day to day.