NFTs

<div class="Section1"><br /> <br /> The creation of a non-fungible token does not, in and of itself, generate any type of tax liability. The creator of a non-fungible token will only be subject to taxation once the creator sells, exchanges or otherwise profits from the newly minted NFT.<br /> <br /> The creator of the underlying asset “tokenizes” the asset to create the NFT itself—which can result in tax liability once the asset is sold if the tokenization significantly increases the value of the asset itself. The entire purchase price would be taxable.<br /> <br /> The income received in the transaction will be classified as ordinary income (currently subject to a maximum 37% rate) and taxed as any other compensation received for work would be taxed. The creator is also entitled to deduct costs associated with creating the NFT, including trading fees. Many creators will also be subject to the self-employment tax.<br /> <br /> </div>

<div class="Section1"><br /> <br /> The mere purchase of an NFT using traditional currency does not create tax liability for the buyer. However, the result is different if the buyer purchases the NFT using cryptocurrency. In that case, it becomes possible that both the buyer and seller will be subject to taxation because any transaction where cryptocurrency is sold or traded is potentially a taxable event.<br /> <br /> Virtual currency is taxed according to the rules governing property transactions.<a href="#_ftn1" name="_ftnref1">¹</a> If the cryptocurrency appreciated in value while the taxpayer held it, that appreciated value is taxable when the cryptocurrency is sold or exchanged for other property. When the cryptocurrency is sold or exchanged, the holder will have a taxable gain (or loss) depending on the holder&rsquo;s tax basis in the cryptocurrency. <em><em>See</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="692">692</a> for a detailed explanation of the rules on determining tax basis.<br /> <br /> Generally speaking, if the NFT is exchanged for virtual currency and is worth more than the buyer&rsquo;s tax basis in the virtual currency used to purchase the NFT, the buyer will recognize gain on the transaction. For example, if the buyer purchases an NFT valued at $5,000 with $4,000 worth of bitcoin, the buyer creates a gain (the buyer could also create a loss in the transaction). Until the IRS specifies otherwise, that gain or loss is subject to the generally applicable capital gains rules (including the rules on collectibles, <em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>).<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; See IRS guidance in Notice 2014-21, Rev. Rul. 2019-24, CCA 202114020.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Determining the value of a non-fungible token can be difficult if there is no market value information available to which the asset can be compared. Typically, the fair market value of property is determine based on what a willing buyer will pay a seller, assuming all parties have all relevant information about the asset.<br /> <br /> One problem that may arise in valuation cases involving non-fungible tokens is that, by their nature, no two non-fungible tokens are exactly the same.<br /> <br /> However, in cases where the NFT’s value is substantial, it may be advisable to obtain an independent appraisal to establish valuation that will satisfy the IRS (similarly to when a taxpayer sells a unique work of art or antique).<br /> <br /> </div>

<div class="Section1"><br /> <br /> The tax treatment of NFTs at the state level can vary dramatically from state to state. Most state and local governments have yet to weigh in on whether NFTs will be subject to state and local sales tax.<br /> <br /> However, Washington state<a href="#_ftn1" name="_ftnref1">¹</a> has recently released guidance stating that NFTs are subject to state-level sales taxes when sold within the state. Pennsylvania has also added NFTs to its list of taxable digital products for sales tax purposes.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Taxpayers who buy and sell NFTs should be aware that it remains possible that the state will impose sales tax on the purchase of NFTs even if the product is not specifically referenced by statute. About 30 other states tax digital products in situations where the purchaser obtains full ownership rights over the product. It is therefore likely that these states will include NFTs in their list of digital products for sales tax purposes.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  See “Interim Statement Regarding the Taxability of Non-Fungible Tokens (NFTs),” available at <a href="https://dor.wa.gov/interim-statement-regarding-taxability-non-fungible-tokens-nfts">https://dor.wa.gov/interim-statement-regarding-taxability-non-fungible-tokens-nfts</a>.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  The Pennsylvania sales tax guide is available at <a href="https://www.revenue.pa.gov/FormsandPublications/FormsforBusinesses/SUT/Documents/rev-717.pdf">https://www.revenue.pa.gov/FormsandPublications/FormsforBusinesses/SUT/Documents/rev-717.pdf</a>.<br /> <br /> </div>

<div class="Section1"><br /> <br /> A decentralized autonomous organization, or DAO, is a type of community-led organization. While there are many different types of DAOs, in the context of non-fungible tokens, the DAO structure allows smaller investors to purchase portions of a single non-fungible token. Because many non-fungible tokens are valued at extremely high dollar values, the DAO exists to facilitate smaller investments in more expensive digital assets.<br /> <br /> In addition to allowing small investors to participate in more expensive NFT projects, the DAO can also act as a facilitator so that owners of the NFT can collectively make decisions about the future of the NFT, including future sales or licensing agreements. The DAO can also provide the DAO community with a platform for fundraising to participate in future NFT projects. While the DAO itself is more akin to a group and is not a corporation, each participant may be granted voting rights via the underlying tokens.<br /> <br /> Like other digital assets, the rules of the DAO are contained in the blockchain (meaning that anyone can access their code and <em>see </em>their transaction records). Those rules govern the decisions made by the members of the DAO community.<br /> <br /> </div>

<div class="Section1"><br /> <br /> <em>Editor&rsquo;s Note:</em> In Notice 2023-27, the IRS has announced that it intends to provide guidance clarifying that nonfungible tokens (NFTs) will be taxed as collectibles. Pending release of that formal guidance, the IRS will use a look-through analysis to determine whether an NFT should be taxed as a collectible.&nbsp; In other words, it will determine whether the right or asset associated with the NFT will fall under the definition of &ldquo;collectible&rdquo; as it currently exists in the IRC.&nbsp; Taxpayers who hold NFTs should note that other types of capital assets are subject to more favorable tax treatment than the tax treatment afforded to collectibles.&nbsp; The IRS requested comments on this new guidance and the advisability of taxing NFTs as collectibles by June 19, 2023.<br /> <br /> According to the IRS, the term &ldquo;collectible&rdquo; is broadly defined to include works of art, rugs or antiques, metal or gems, stamps or coins (with exceptions) alcoholic beverages or any other tangible personal property that the IRS determines is a collectible.<a href="#_ftn1" name="_ftnref1">¹</a> Because of the broad definition, it&rsquo;s also possible that assets that are not specifically listed could be classified as collectibles (for example, rare baseball cards or comic books may be classified as collectibles although they are not specifically included in the IRS&rsquo; list).<br /> <br /> For the collectibles rates to apply, the NFT must be a capital asset that is held for more than one year. Further the collectible cannot be held as inventory in a trade or business (an asset that would otherwise be classified as a collectible would generate ordinary income tax liability if sold by a dealer).<br /> <br /> Collectibles are subject to special tax rules. Collectibles gain<a href="#_ftn2" name="_ftnref2">²</a> (i.e., gain on the sale or exchange of a collectible that is a capital asset held for more than one year, <em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="700">700</a>) is subject to separate tax rate of up to 28%. That treatment generally results in the collectible being subject to a capital gain rate that is less favorable than the generally applicable long-term capital gains rates, but more favorable than the ordinary income tax rates.<br /> <br /> When taxpayers have capital gains and losses that fall into both the collectibles category and the ordinary 0%/15%/20% long-term capital gains rate category, the taxpayer must use a netting process to determine the amount of gain or loss and its characterization (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8631">8631</a> for a detailed explanation of this netting process).<br /> <br /> It is expected that the IRS will eventually provide guidance on whether and when an NFT can be classified as a collectible for tax purposes. However, if the NFT can be considered art, taxpayers should be advised that it may be wise to treat any gain or loss as collectibles gain until that guidance is received.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect; 408(m)(2).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect; 1(h)(4)(A).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Non-fungible tokens are a type of unique digital asset or digital file. A non-fungible token, or NFT, can represent any type of real-world items, including artwork, images, recordings, gaming awards or other files. These digital assets can last indefinitely and can be sold or exchanged like any other piece of property. These digital assets have recently become extremely popular due to purchases by celebrities and are typically bought and sold online (popular sites include OpenSea and Rarible). Often, these assets are purchased with virtual currency.<br /> <br /> An NFT contains a unique identifying code and is linked to a certificate of authentication. Ownership of the NFT can be verified by the digital ledger, or blockchain, where that certificate/unique code is recorded. The actual value of the non-fungible token is found in the underlying asset and the “token” itself represents ownership. A common comparison is a car and the car’s title (the token would be similar to the car’s title, where the underlying asset is similar to the car itself).<br /> <br /> The unique ownership code is what makes NFTs different from virtual currency, such as bitcoin or Ethereum. Each type of cryptocurrency is fungible, meaning that the value of one unit of bitcoin is always equal to any other unit of bitcoin (although the IRS has held that different types of virtual currency are not of a “like kind”). The digital code linked to the NFT makes the NFT different from all other NFTs.<br /> <br /> The token/code associated with the NFT can also provide information about the creator’s rights in the property after sale. For example, an embedded contract in the NFT can give the creator the right to collect royalties any time the NFT is sold, licensed or transferred in the future. The imbedded contract can even give the NFT creator the right to receive payment anytime the NFT is viewed or downloaded.<br /> <br /> While each NFT has a unique code, it is possible for the creator to create multiple replicas of the same underlying image or asset. When the NFT creator “tokenizes” the asset, it does not always mean that the purchaser has sole rights to the underlying image or asset. It is possible that the image or work itself could remain available for downloading by members of the general public. Instead, it may be more helpful to compare the NFT to an autographed copy of the original asset.<br /> <br /> NFTs are often transferred in transactions involving virtual currency. While the IRS has begun to issue more robust guidance on virtual currency transactions, it has yet to fully weigh in on the tax treatment of NFTs themselves. Since the tax treatment of NFTs is evolving, it becomes particularly important that taxpayers who engage in transactions involving NFTs consult experienced tax counsel and pay close attention to this evolving area of taxation.<br /> <br /> </div>

<div class="Section1"><br /> <br /> Taxpayers who sell, trade or exchange a non-fungible token must recognize gain or loss on the transaction (holding the NFT alone will not generate tax liability on unrealized gains). The exact nature of the taxable transaction will depend on the circumstances.<br /> <br /> While the IRS has yet to provide clear guidance, many expect that gain or loss on the NFT sale will be subject to capital gains treatment if the NFT was held for investment purposes. Like any other property transaction, amounts received in exchange for the NFT will be offset by the seller&rsquo;s basis in the property to determine whether the seller has created a taxable gain or loss. That gain or loss may be long-term or short-term, depending on the seller&rsquo;s holding period.<br /> <br /> However, it is also possible that the NFT will be classified as a collectible. Collectibles are subject to a special 28% tax rate (higher than current long-term capital gains rates, <em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8605">8605</a>.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> In Notice 2023-27, the IRS announced that it intends to provide guidance clarifying that nonfungible tokens (NFTs) will be taxed as collectibles.&nbsp; Pending release of that formal guidance, the IRS will use a look-through analysis to determine whether an NFT should be taxed as a collectible.&nbsp; In other words, it will determine whether the right or asset associated with the NFT will fall under the definition of "collectible" as it currently exists in the IRC.&nbsp; Taxpayers who hold NFTs should note that other types of capital assets are subject to more favorable tax treatment than the tax treatment afforded to collectibles. The IRS accepted comments through June 19, 2023.<br /> <br /> <hr><br /> <br /> For tax years beginning in 2018 and before 2026, the long-term capital gain brackets no longer neatly align with the ordinary income tax brackets.<br /> <br /> For 2025, the 0 percent rate will apply to joint filers who earn less than $96,700 (half the amount for married taxpayers filing separately), heads of households who earn less than $64,750, single filers who earn less than $48,350 and trusts and estates with less than $3,250 in income.<br /> <br /> For 2025, the 15 percent rate will apply to joint filers who earn more than $96,700 but less than $600,050 (half the amount for married taxpayers filing separately), heads of households who earn more than $64,750 but less than $566,700, single filers who earn more than $48,350 but less than $533,400 and trusts and estates with more than $3,250, but less than $15,900 in income.<br /> <br /> For 2025, the 20 percent rate will apply to joint filers who earn more than $600,050 (half that amount for married taxpayers filing separately), heads of households who earn more than $566,700, single filers who earn more than $533,400 and trusts and estates with more than $15,900 in income.<br /> <br /> The capital gains tax rates for 2024 are: 0 percent for joint filers who earn less than $94,050 (half the amount for married taxpayers filing separately), heads of households who earn less than $63,000, single filers who earn less than $47,025 and trusts and estates with less than $3,150 in income.<br /> <br /> 15 percent for joint filers who earn more than $94,050 but less than $583,750 (half the amount for married taxpayers filing separately), heads of house&shy;holds who earn more than $63,000 but less than $551,350, single filers who earn more than $47,025 but less than $518,900, and trusts and estates with more than $3,150 but less than $15,450 in income.<br /> <br /> 20 percent for joint filers who earn more than $583,750 (half that amount for married taxpayers filing separately), heads of households who earn more than $551,350, single filers who earn more than $518,900, and trusts and estates with more than $15, 450 in income.<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> Many NFTs have embedded contracts that give the seller or creator the right to a royalty any time the NFT is sold in subsequent transactions. Royalty payments are generally taxed as ordinary income to the seller under the basic gross income principles contained in IRC<br /> Section 61.<br /> <br /> If the creator of an NFT was an employee and was granted royalty payments by their employer for use of the NFT, the amounts likely will not be subject to FICA and FUTA taxes based on otherwise applicable tax principles that apply in the context of intellectual property in employment relationships. The IRS has provided guidance on a situation where a company paid royalties to five individuals for licenses to manufacture certain articles to which the individuals held the patent. Under Sections 3121(a) and 3306(b) of the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA), the term “wages” means all compensation for employment, including the cash value of any property paid as compensation to the employee. The term employment generally means any service performed by an employee for his employer.<br /> <br /> Based on the definition of wages, the IRS found that the royalties were paid for licenses to manufacture certain articles, rather than as compensation for services rendered in the course of an employment relationship. Thus, the IRS held that the royalty payments were not wages for FICA and FUTA tax purposes.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <hr /><br /> <br /> <strong>Planning Point:</strong> Note that the tax issues vary depending on whether a transaction involving an NFT is treated as a license or a sale of the actual NFT. The IRS has cautioned that the treatment as either a sale or a license must be consistent across all parties to the transaction.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <hr /><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  See Rev. Rul. 68-499.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  FAA 20131201F.<br /> <br /> </div>

<div class="Section1"><br /> <br /> The owner of a non-fungible token can donate the NFT to charity like any other property. The donor will not be required to recognize capital gain if the donation is to a qualifying charitable organization and the transaction complies with the generally applicable rules governing charitable donations (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9059">9059</a>- Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9073">9073</a>).<br /> <br /> According to generally applicable tax principles, if the sale of the NFT would result in long-term capital gain, a taxpayer may deduct the property&rsquo;s full fair market value up to 30 percent of the individual&rsquo;s adjusted gross income, if the charity makes use of the property in a way that is related to its charitable purpose or function (i.e., it is a &ldquo;related-use&rdquo; gift). The limit is 20% in most cases involving private foundations. If the item deducted isn&rsquo;t related to the charity&rsquo;s purpose or function, the amount of the charitable contribution taken into account is generally limited to the donor&rsquo;s adjusted basis in the donated property.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> For example, a donation of a non-fungible token that represents a work of art may be a &ldquo;related use&rdquo; donation if the recipient charitable organization is a museum.<br /> <br /> <hr><br /> <br /> Assuming that NFTs are treated as non-cash contributions to a charity, the donor should also pay close attention to the substantiation and appraisal requirements. Donors should exercise caution because of the potential for extreme fluctuations in the NFT&rsquo;s value and the general lack of market data and qualified appraisers. Donors should also research to ensure that the charitable organization has a process in place for accepting donations of digital assets.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Because of these complexities, many NFT owners have sold the NFT and simply donated the proceeds to charity. Those taxpayers must be advised that while the sale simplifies the donation process, it can also generate capital gains tax liability.<br /> <br /> <hr><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&sect; 170(e)(1)(B), 170(b)(1)(C).<br /> <br /> </div></div><br />