IRS releases notice on taxation of NFTs as collectibles

TAXATION OF COLLECTIVE GOODS IN GENERAL

In general, capital assets that have been held for more than one year are subject to favorable tax rates, which depending on the taxpayer’s tax profile can be equal to either 0%, 15% or 20%. However, if the capital gain relates to a collectible, the maximum long-term capital gain is 28%. For this purpose, collectibles generally include any work of art, carpet or antique, metal (except certain coins), gemstones, postage stamps, coins, alcoholic beverages (e.gvintage wines), musical instrument, historical object (e.ga document or clothing) or other tangible personal property that the IRS determines is a collectible.

In addition, an IRA that purchases a collectible is treated as having made a distribution in an amount equal to the cost of the collectible (i.e, fair market value at the time of acquisition) to the IRA account holder. Such a constructive distribution is taxable and subject to the 10% additional tax on distributions to the IRA account holder before age 59 and a half. Upon actual distribution of the collectible from the IRA to the account holder, the amount of the constructive distribution is not included in income, but any fair market value in excess of this amount will be taxable. Assessment of the collectible’s value is tax-deferred within the IRA for distribution.

NFTS AS COLLECTOR

NFTs

The notice defines an NFT as a unique digital identifier that is recorded using distributed ledger technology and that can be used to certify the authenticity and ownership of an associated right or asset. Ownership of an NFT may give the holder a right in respect of a digital file that is typically separate from the NFT. These rights may also relate to other types of assets, such as a right to attend a ticketed event or certification of ownership of physical assets. Sometimes ownership means rights to multiple assets, such as artwork and club memberships.

Review rule

The IRS intends to issue guidance determining whether an NFT constitutes a collectible for U.S. federal income tax purposes by looking directly through the NFT to the underlying related right or asset and determining whether such related right or asset is a collectible under existing guidance. For example, an NFT that certifies ownership of a gemstone constitutes a collector’s item. Likewise, if the underlying associated right or asset is not a collectible under existing guidance, the NFT does not constitute a collectible. For example, a right to use or develop a “lot” in a virtual environment is generally not a collectible, and therefore an NFT that grants a right to use or develop the “lot” in the virtual environment generally does not constitute a collectible.

The IRS also considers whether the underlying associated right or asset of an NFT (such as a digital file containing an image) is considered a “work of art,” in which case the NFT would be a collectible under existing guidance.

CONCLUSION

As the first published guidance to address NFTs, the announcement demonstrates the importance of the IRS addressing issues in an area where taxpayers have historically operated with little or no guidance. NFTs came into existence around 2014 and have gained mainstream attention as of 2020, with the price of at least one NFT reaching approximately $91.8 million.

Although the notice may imply that under the look-through rule, if the underlying associated right or asset is not a collectible, the proceeds from the sale of such NFT will be subject to a maximum 20% long-term capital gains tax rate, the look-through rule raises several questions that taxpayers may need to consider , for example:

• Does the review rule only apply if an NFT is treated as a collectible, or will it be more widely used?
• Under the look-through analysis, if an NFT entitles its holder to legal ownership of shares or a partnership interest, withholding is required under applicable law (e.gbackup withholding or withholding under sections 1445 or 1446(f) of the Internal Revenue Code of 1986, as amended)?
• If the underlying asset is inventory used in the transferor of an NFT’s trade or business, is the sale of the NFT subject to taxation at ordinary income tax rates?
• Is the associated right to an NFT a right to passive income? How is such income collected or taxed?

The creativity of various uses of NFTs continues to expand, including a netizen uploading a video of using an NFT to act as a car key. Other use cases may include NFTs storing records, serving as tickets to entertainment events, or transferring land documents.

The notice does not address all tax issues related to NFTs (such as those identified above), and specifically requests comments from taxpayers on the definition of an NFT, the transparency analysis and if there are any other important issues that the IRS should consider. with respect to taxation of NFTs.

If the announcement’s approach is adopted, NFT holders and tax professionals will need to conduct a thorough analysis of the rights and assets associated with NFTs. Given the evolving nature of NFTs and their associated rights and underlying assets, this analysis will not be straightforward.

If you have any questions about the tax implications of NFTs, please contact the authors of this article or your regular McDermott attorney.