A legal guide to NFTs

Companies looking to get into the NFT (non-fungible token) space have a chance to reap serious profits if they do it right. Rare NFTs can sell for tens of millions of dollars. In 2021, The Merge sold for $91.8 million on the Nifty Gateway, making it the most expensive NFT to date.

Due to the decentralized and anonymous nature of the crypto world, NFTs come with a number of legal issues that regulators haven’t caught up to yet.

What are NFTs?

Non-fungible tokens are unique digital tokens that represent proof of ownership of a tangible or intangible asset (or both). Each NFT’s metadata and identification code is unique, so no two are identical. This is why NFTs are non-fungible (not fungible).

When an NFT is created, or minted, it is time-stamped and stored in an open blockchain. The blockchain is essentially a public digital ledger, which proves ownership and transfers of ownership.

Information on the blockchain cannot be edited, so NFT’s block acts as permanent proof of ownership. Most NFTs run on the Ethereum blockchain, although you can find some that use other blockchains such as EOS, TRON, and Flow.

The asset represented by NFT can be practically anything, from artwork and songs to virtual real estate and even academic certifications. For example, you can buy an NFT of a digital copy of a famous painting.

It is important to note that the asset itself is usually not the same as the NFT. NFT is the blockchain token that contains the asset’s web address. So when you buy an NFT, you’re essentially buying a piece of code that connects to an asset. The rights that come with that piece of code are critical to understand.

Are NFTs legal?

As long as you follow copyright laws and sell legitimate assets, it is legal to create, sell and resell NFTs. However, as with most digital innovations, regulatory legislation has been slow to catch on and clear guidelines have yet to be established.

At the US federal level, NFTs have not yet been defined among the range of personal and business assets as securities or commodities – and laws applicable to NFTs depend on whether they are classified as securities or commodities. NFTs have been of particular interest to the US Securities and Exchange Commission recently, which will remain the case unless lawmakers decide to formally and universally classify NFTs as commodities or something else.

Fractional NFTs (f-NFTs) are of particular interest when it comes to classification, as they divide NFT ownership into profit shares. Because this arrangement enables buyers to profit from the efforts of others (usually the creator), buying a share of an NFT can be considered investing in a security or investment contract.

When it comes to classifying NFTs as commodities, the rationale comes from the similarities NFTs share with other blockchain-based digital assets, such as cryptocurrency, although the classification issue of cryptocurrency has yet to be settled, as well. Throughout 2023, the House of Representatives will consider proposed cryptocurrency regulatory measures and related bills, meaning we may have a clearer picture of NFTs and other crypto-assets that last by the end of the year.

What are some of the legal issues with NFTs?

Because NFTs are still so new, little official regulatory guidance has been issued so far. Understanding the following NFT legal issues is critical for businesses looking to successfully move into the digital asset space.

Copyright, Licensing and Intellectual Property

Are NFTs legally protected under copyright law? The answer is both yes and no.

The artwork or asset NFT links to is protected under copyright law. However, the token on the blockchain is not. It’s like hanging a print of a modern painting on the wall. You do not own the original work or the rights to reproduce it – you only own a copy of the work.

Here, the conversation around intellectual property rights and NFTs can become difficult. The creator or owner of the original work can transfer the copyright through the sale using legally binding smart contracts if they wish. A smart contract is an often immutable program stored on a blockchain that automatically performs specific actions when certain conditions are met. The terms in this case will be the purchase of NFT.

Once the buyer provided payment for the NFT, the smart contract would complete the sale and the buyer would own the rights to the original work if that was the seller’s intent and reflected in the code. Smart contracts only contain code that performs actions when specified conditions are met. They rarely include legal language, terms or agreements beyond the minimum to complete the transaction.

However, there are copyright laws that can prevent unauthorized NFT creation. Copyright holders can block NFT production unless they grant rights to the developer. For example, if a company wanted to sell NFTs using Disney’s characters, they would have to license the intellectual property from Disney before making the NFTs or face Disney’s army of IP lawyers.

In short, the owner or creator decides who gets the rights to the intangible property in the NFT, and the seller decides what rights the buyer gets through the sale. Sellers must make clear what buyers receive when they buy NFT.

Ownership and succession planning

Blockchains form permanent, immutable ledgers that serve as proof of ownership. Because it is impossible to go back and edit them, the transaction record is safe and secure. But what happens when someone wants to transfer NFT to someone else?

Take NFT property, for example. If you were to buy virtual land in the metaverse, it would be treated like any other asset. You can even bequeath it in your will as long as you’ve given your executors and beneficiaries enough information to identify, access and transfer it.

This also means that your NFT collection may be subject to probate when it comes time to carry out your succession plans. The methods to ensure these assets go where they should continue to evolve as NFTs mature. This is especially important due to the complexity of unique passphrases for blockchain wallets.

Whitewashing

As NFTs continue to rise in value, they become increasingly profitable targets, like other cryptoassets. Because digital assets offer a degree of anonymity that traditional currency does not, criminals have an easy way to discreetly launder funds, making collection nearly impossible for most non-state parties.

If someone wants to launder funds using an NFT, all they need to do is create a fake record of sales on the blockchain by selling it to themselves using different accounts. Once they’re done, they just have to sell it to an unsuspecting buyer and repeat the process.

Whether anti-money laundering provisions apply to NFTs depends on their classification. If NFTs are classified as currency, or substitutes for currency, the Bank Secrecy Act will extend to NFTs. The Ministry of Justice is currently pushing for this treatment, although no official guidance has yet been issued as of February 2023.

Fraud

The crypto landscape is anonymous and decentralized, making NFT fraud a very real risk for buyers. Some of the most common NFT scams include:

• Phishing: This is the most common NFT scam. A scammer sends fake links for sale using popular social media channels. When an unsuspecting NFT holder clicks on the link, the fraudster accesses their NFT wallet and steals their assets.
• Carpet covers: In a rug pull, fraudsters generate buzz around an unreleased NFT and suddenly shut down the project and disappear as soon as they receive the purchase or investor funds.
• Plagiarism: Although NFTs are fundamentally unique, plagiarism is a major problem in many marketplaces. For example, someone can make and sell a copy of a rare NFT they don’t own, which is essentially worthless and infringes on the original NFT.

There is no official legislation that applies specifically to NFT fraud, but there are ways to prosecute fraudsters using existing prohibitions against deceptive and manipulative trading. Jurisdiction is the real issue here, as it remains unclear who will regulate crypto trading going forward and how to identify individuals who trade in largely anonymous ways, often across international borders.

Tax

While it remains unclear what will happen to NFTs and tax laws in the future, we do know that the IRS considers NFTs to be digital assets, meaning they are subject to ordinary income and capital gains taxes everywhere in the United States. Anyone who sells, receives, or gives NFTs must also answer “yes” to the crypto tax question on their 1040 tax form.

That said, creating or purchasing an NFT is not considered a taxable event. Companies and individuals can create and buy as many NFTs as they want tax-free. However, when they start selling them, they have to file taxes accordingly. All creators should discuss R&D tax credits or other R&D-related benefits with their accountants related to their NFT portfolios.

The legal future of NFTs

As with other web3 technologies, it remains unclear how NFTs will affect legislation going forward. Will they work like any other asset, or will more specific laws need to be drawn up? Stay tuned for the latest on web3, crypto and digital assets by staying updated on our blog.

Where do you see things going for digital assets and NFTs?