The proliferation of NFT transactions raises quite a few US tax points to Skadden, Arps, Slate, Meagher & Flom LLP

Background information on NFTs

With the exploding market for non-fungible tokens (NFTs), NFTs associated with art, music, video clips, tweets, and other digital collectibles have been selling for significant sums: one NFT of an animated flying pop-tart cat for $ 600,000 and one Artist Beeple's NFT sold for $ 69 million. The demand for such tokens does not seem to be slowing, and the Internal Revenue Service (IRS) and state tax authorities have no doubt taken note of (or will take note) of this.

An NFT is a digital certificate for certain rights attached to an asset. NFTs are usually associated with digital assets, but NFTs, which represent rights to physical assets or experiences, have also been coined. For example, the band Kings of Leon coined an NFT that gave the holder the right to front row concert tickets, and professional tennis Oleksandra Oliynykova auctioned an NFT to determine which tattoo to put on her arm.

For example, as noted by other authors in a Bloomberg Law article dated March 30, 2021, "NFTs raise novel and traditional IP and contract issues," NFTs raise a wide variety of intellectual property (IP) and contract law issues. While two NFT transactions apply for tax considerations, two points generally apply. First, NFT mints, buyers, and platforms that allow users to buy and sell NFTs must address a variety of tax issues in the United States given the novel nature of the transactions. Second, no direct guidance is currently available to address these issues. Therefore, there are numerous unanswered questions about the tax treatment of NFT. The following discussion outlines some of the key tax issues relevant to NFT and examines how existing guidance could be applied to analyze these issues.

Digital asset taxation background

Few guidelines address the taxation of digital assets. The U.S. Internal Revenue Code was generally written for transactions in physical assets and more traditional intellectual property rights (e.g. patents), and the IRS has endeavored to issue timely guidance clarifying how tax law applies to rapidly evolving technology applies. For example, taxpayers are still waiting for the final rules on taxation of cloud-based transactions.

The IRS has advised taxpayers that virtual currencies (e.g., bitcoin, ether, or other cryptocurrencies) will be "treated as property" 1 for US income tax purposes, but has not yet issued guidance specifically addressing other digital assets, use blockchain technology, such as B. NFTs. However, the IRS guidelines on virtual currencies are clearly relevant to many NFT transactions as NFTs are generally acquired in exchange for virtual currencies. For example, taxpayers who purchase virtual currency NFTs should be aware that such purchase will result in the recognition of gains or losses from the taxpayer's virtual currency

Therefore, if and until guidance is issued directly to NFTs, taxpayers must analyze NFT transactions using general tax law principles, possibly using the prism of the existing (albeit sparse) IRS virtual currency guidance.

How to characterize NFTs and NFT transactions

As mentioned above, an NFT is essentially a digital certificate that entitles the holder to certain rights associated with an asset. Similar to the protocol with any other such certificate (e.g., a title deed or a stock certificate), the underlying rights and assets should determine how transfers and ownership of the certificate should be taxed.

NFTs are generally associated with digital assets that are treated as intellectual property or intangible property for tax reasons. Under US law, every IP article contains a “set of rights,” and the owner of such rights may transfer some or all of them. For example, the copyright owner of a work generally has the exclusive right to reproduce that work for a specified period of time, to prepare derivative works, to perform in public, and to show publicly. The owner could choose to transfer all of these rights to a single acquirer or to assign certain limited rights (e.g. the right to publicly display the work on certain platforms) to one or more acquirers. These rights can be transferred for the entire term or for a limited period of time and can be transferred either non-exclusively or exclusively. The scope of intellectual property rights transferred with an NFT can also vary widely.

For US tax purposes, an important threshold question for a transfer of intellectual property rights is whether the transfer is a sale or a license. If the transfer is a sale, the transferor can set off the amount realized in the sale using his basis in the IP rights. In other words, taxable income from the transaction is limited to the transferor's profit in the property. If the intellectual property rights were a capital asset for the transferor, that gain on the sale is likely to be eligible for long-term capital gains rates (in the case of individuals) if the rights have been held for more than a year. If instead the transfer is treated as a license, the transferor will: (i) generally record the ordinary income (i.e. royalties on the license); and (ii) will not be able to offset its income from the license directly against its intellectual property rights basis, although that basis will continue to be amortized in years to come.

In general, whether a transfer of intellectual property rights is treated as a sale or a license for tax purposes depends on whether the transferor transfers all of the "material rights" it owns in the intellectual property. Whether all essential rights are transferred depends on general facts and circumstances. It is irrelevant whether the transfer is officially marked as a "sale" or a "license". The more rights that are transferred, the more likely it is that the transfer will be properly treated as a sale. For example, if a transferor owns all of the rights to a copyright, an exclusive license to all of those rights for the duration of the copyright would generally be a sale for tax purposes. In contrast, a non-exclusive license to certain rights in that copyright (e.g. the right to publicly display the work) by the same transferor would generally be a license for tax purposes. However, if the transferor only has certain rights to the copyright in the first place (e.g. the transferor only has the right to publicly display the work), a later transfer of all those limited rights would likely be a sale for tax purposes. regardless of whether the transferred rights constitute a license for intellectual property purposes. 3

As set out in the Bloomberg Act March 30, 2021 article referenced above, the IP rights associated with an NFT may vary from NFT to NFT. In general, however, purchasing an NFT does not give the purchaser exclusive ownership of all intellectual property rights in the related work, but rather provides a very limited license, often limited to viewing the related work for personal use. This can lead to a different tax treatment of the "primary" and "secondary" sender of the NFT.

  • In the primary transfer of an NFT – where the originator / owner of the copyright for the work associated with the NFT transfers the NFT to an initial assignee – the assignor must determine whether they are selling the work associated with the NFT or simply granted a license. As noted above, since an NFT does not typically provide exclusive ownership of all IP rights to the associated work, most primary NFT transfers are likely to be treated as licenses for tax purposes.
  • The secondary transfer of an NFT – where the NFT trades in the secondary market after that primary transfer – is likely to be treated as a sale. This is because in a secondary transfer, the transferor is likely to transfer all of their limited rights in the associated work.

In other words, because the primary owner's rights associated with the NFT are likely to be limited, that secondary owner is more likely to transfer "substantially all" of their NFT-associated rights. This applies regardless of whether the primary transfer is properly treated as a sale or a license.

As described above, if the transfer of an NFT is treated as a sale, the transferor can generally offset his realized amount against his base in the NFT. For such a sale, the tax consequences of a gain or loss will depend on several factors, including in addition to the quantum and character considerations described above: (i) whether the transferor has written off a foundation in the NFT and the underlying work (which would) generally recovered at normal income rates); (ii) whether the transferor is trading NFTs as a mere hobby (which would limit the transferor's ability to deduct losses incurred in connection with NFT transfers); and (iii) whether the NFT is properly treated as a collector's item (for which profits are generally subject to higher interest rates than normal capital transactions).

If the transfer of an NFT is treated as a license, the transferor will generally recognize ordinary income as stated above, but will have to take into account a number of other tax consequences. In particular, any payment would generally be treated as a tax fee for the NFT, which can lead to procurement issues and may require a US transferee to withhold payment if the transferor does not certify as a US taxpayer.

NFT holders must carefully review the terms of their NFT transactions in order to properly identify and report the resulting tax consequences.

Handling of costs incurred in creating an NFT

NFT creators need to determine how to handle the cost of developing and marketing their NFTs. Generally, when an originator manufactures NFTs as part of a trade or business, they can deduct or capitalize costs for tax purposes. A taxpayer usually prefers to deduct costs rather than capitalize them, as a deduction will reduce the taxpayer's tax liability for the current year while recovering capitalized costs over time. Subject to certain exceptions, tax law generally stipulates that costs incurred in creating or improving a separate and standalone asset with a useful life beyond the current tax year must be capitalized. Capitalized costs are part of the base of an asset and can be reimbursed by amortizing the costs over the useful life of the asset if the asset is sold or in circumstances where the asset has an identifiable useful life.

When considering the tax consequences of creating NFTs, the creators must therefore take into account whether they are active in a trade or business that creates NFTs (a factually intensive question) and, if so, whether the costs incurred in creating NFTs have been deducted or should be activated.

Large companies trying to monetize existing intellectual property through NFTs (e.g. professional sports leagues or entertainment companies) need to evaluate how best to structure their NFT agreements for tax purposes. For example, such companies need to consider how to contract their existing intellectual property into their NFT business and design the terms of their NFT agreements to ensure an efficient tax return. In addition, such companies must determine how to account for a range of costs incurred in acquiring, developing, and marketing the intellectual property in question long before the company considered monetizing that intellectual property through NFTs. In many cases, all underlying costs may have previously been deducted, while some of these costs could be better capitalized or deferred in the future to offset potential NFT revenue streams. Smaller NFT manufacturers need to quickly become familiar with the tax rules that apply to intellectual property creators and marketers.

How to report NFT transactions

The IRS has shown it has a strong focus on tax compliance and reporting for digital asset transactions. The agency's efforts included a wide-ranging campaign in which the IRS sent letters to thousands of taxpayers about possible errors in reporting virtual currency transactions and general requirements for exchanging virtual currencies to provide user information.

Most recently, the IRS added the following question to the first page of Form 1040 (US Individual Income Tax Return) for 2020: “Have you received, sold, sent, exchanged, or otherwise acquired any financial interest at any time during 2020? in any virtual currency? "As mentioned above, most NFT transactions have so far been conducted in virtual currency. Individual taxpayers exchanging NFTs for virtual currency should be prepared to answer yes to this question and report the tax ramifications of such transfers on their 1040s .4 Individual taxpayers who exchange NFTs for fiat currencies should consider whether this could itself be an NFT for the purposes of the 1040 question as “virtual currency.” In addition, the IRS may expand the scope of this question in future filings, in particular to record other transactions involving digital assets such as NFTs.

In April 2021, IRS Commissioner Charles Rettig told the Senate Finance Committee that the IRS was prioritizing new rules for reporting information on virtual currency transactions. So far, marketplaces on which virtual currencies are transferred have operated without clear guidelines. Any marketplace that effects transfers of NFTs must consider whether it is required to report NFT transactions to the IRS and what documentation users need to comply with these reporting requirements (e.g. an IRS Form W-8 or W-9).

State and local tax considerations

State and local tax authorities have issued even fewer guidelines than the IRS when it comes to taxing digital assets. In addition, tax laws differ between states and municipalities. NFT stakeholders therefore need to navigate a maze of questions to determine how NFT transactions should be characterized and reported for state and local tax purposes.

Most states impose an income tax. In general, these states follow federal tax principles to calculate taxable income.5 A state then typically taxes residents on all taxable income and non-residents and corporations on taxable income "drawn" from the state. For companies, and in some states other types of companies doing business in multiple jurisdictions, such procurement is generally determined based on an apportionment formula

Thus, whether the transfer of an NFT is treated as a sale or a license for federal tax purposes generally determines how the transfer is treated for state income tax purposes. However, certain transferors have yet to determine the revenue stream that will result from such transfer. For a person transferring an NFT as a hobby where the associated asset is digital, the procurement question is likely not a mandatory requirement as the proceeds from the transfer are likely to be taxed only by the person's state of residence. However, individuals transferring NFTs as a business or company, corporation, and other business entity will likely need to determine the source of income from their NFT transfers in order to properly apportion that revenue among different states. For personal income tax purposes, states typically derive income from the transfer of a tangible asset based on the location of the asset. However, income from transfers of intangible assets will generally only come from the state of residence of the transferor, unless the transferor transfers that intangible asset as part of a trade or business. Corporations or other businesses engaged in any trade or business would generally obtain these revenues by reference to the acquirer's state of residence or principal place of business. Because NFTs associated with digital assets can be easily broadcast without information about the location of the broadcast recipient, broadcast recipients may have difficulty generating income from NFT broadcasts.

In addition to income tax, states and municipalities often levy sales and use taxes. Most states impose such a tax on the sale of tangible personal property and certain services. Some jurisdictions also impose such a tax on transfers of certain types of digital property. For example, Texas charges sales tax on the transfer of a digital product if the product would be taxable if it were delivered in physical form

Sales tax, if any, is typically collected by the jurisdiction in which the transfer of ownership occurs. The use tax is generally levied by the jurisdiction in which the good or service is used or consumed. Where a physical asset will be sold, where the goods will be transferred or used, and which jurisdiction might collect taxes are usually easy to determine. However, when it comes to selling a digital asset, this determination can be significantly more difficult. The location of sale is likely to be determined based on the acquirer's state of residence or the state in which the digital asset is stored, used, or displayed. Taxpayers need to collect this information even though NFT transfers are often made without providing any information about the transferee's location. Because NFTs are stored in blockchains, which are computer networks spread across multiple geographic locations, it is not readily apparent where an NFT is “stored”. The same may also be true of the underlying digital asset, which can be stored in some form of a distributed network. Another complication is that states have different standards on whether distance sellers (i.e. sellers based out of state or only occasional or isolated sales) are required to collect and remit applicable sales and use taxes.

With this in mind, NFT sellers and marketplaces need to carefully consider what information they need from transferees in order to comply with state and local tax obligations. States may issue direct guidance on taxing digital asset transfers. Until then, NFT advocacy groups will have to answer their state and local tax questions by referring to the law, which picture long before anyone considered paying $ 600,000 for certain rights to a flying pop-tart cat.


1 Notice 2014-21, 2014-16 I.R.B. 938

2 Id. At A-6.

3 Mylan Inc. v Commissioner, 111 T.C.M. (CCH) 1199 (2016); MacDonald v Commissioner, 55 T.C. 840 (1971).

4 Under current IRS guidelines, the original purchase of this virtual currency may not be reportable if that virtual currency was purchased for the fiat currency. See Frequently Asked Questions about Virtual Currency Transactions, A-5, (accessed April 11, 2021).

5 For example, in California, businesses and individuals generally calculate their income tax liability by starting with their gross taxable or adjusted income and then making country-specific adjustments. See 2020 California Form 100 (California Corporation Franchise or Income Tax Return); 2020 California Form 540 (California Residential Income Tax Return).

6 For example, in California, most corporations must pay state income tax based on a single sales factor apportionment method (Cal. Rev. & Tax. Cd. § 25128.7). This generally requires a corporation to pay California income tax based on that portion of its total sales made in or to California.

7 See Texas Policy Letter Ruling No. 200101966L (Jan. 3, 2001).

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