The devil is in the details when dealing with NFTs and government taxes

Few people have considered the government tax implications of buying or selling non-fungible tokens. Pennsylvania recently became the first state to provide direct guidance on the tax liability of NFTs, and other states are likely to follow suit.

Background

Fungible means fungible, or mutually interchangeable; an NFT is non-fungible because each one is unique. An NFT buyer receives a unique piece of data that acts as a reference to another file and as a certificate of ownership of the referring file. The file referenced by an NFT can be virtually any digital item and can give its owner access to a website or real-world event.

The word NFT is popularly used to refer to the digital object referred to by the NFT. But the NFT itself is just the data that contains the reference to the digital item, and a right to have its ownership of the reference reflected on a blockchain. This distinction is important for sales and use tax analysis purposes.

Sales tax

It is unclear whether an NFT is taxable at all for sales and use tax purposes. At its core, an NFT is a piece of data that is a key to another piece of data that comes with a range of rights. Purchasing an NFT does not necessarily grant a license to use an original work or a copy of an original work other than to view it. If the data and corresponding rights fall within the scope of a state’s laws and regulations, they are likely to be considered taxable.

A state may take the position that the sale of an NFT is taxable and that the seller or buyer may have sales or use tax obligations. If NFTs are taxable for sales or use tax purposes, a seller may have an obligation to collect and pay tax on the sale of an NFT, provided the seller has nexus with the state in which the sale is completed. Websites where sales of NFTs are made may also be responsible for collecting and paying sales tax on each sale made through their platforms due to the state’s marketplace facilitation rules if the website has a nexus with the state where the sale is completed.

Sellers or website platforms do not need to have a physical presence in a state to have a connection with a state. Depending on state law, a seller who completes a certain number of transactions with in-state buyers or who receives a certain amount of income from sales to in-state buyers may have nexus. If the transaction is taxable and the seller does not collect sales tax, the seller will be responsible for the sales tax it failed to collect – and at the same time the buyer will be required to pay use tax to the state.

Very few states have issued guidance explaining whether the sale of an NFT is subject to sales and use tax. However, in most states, the foundations have been laid for taxing NFTs, although specific guidelines have not been issued. Many states tax digital goods or digital products, even if they do not treat them as a type of tangible personal property. For example, Indiana taxes electronic transfers of specified digital products, which include digital audiovisual works. Digital audiovisual works can include many types of animated digital objects, including those that do not have sound elements.

Some other states tax digital goods as a type of tangible personal property. In states that broadly define the term “digital product” or “digital goods”, an NFT may fall within the term. For example, Pennsylvania taxes “all otherwise taxable tangible personal property electronically or digitally delivered, streamed or accessed.” Pennsylvania recently issued direct guidance stating that retail sales of NFTs are subject to state sales and use tax as a digital good. The Pennsylvania Department of Revenue can, and likely will, assert that retail sales of NFTs have been taxable under this statute since its inception.

The State of Washington recently issued interim guidance explaining how and under what circumstances NFTs will be considered taxable.

State income tax

If a resident person sells an NFT, the resident may owe personal income tax on the income or gain from the sale. Many states use federal taxable income as the basis for calculating state taxable income for personal income tax purposes. In these states, if income or gain from the sale of NFTs is taxable for federal income tax purposes, it will likely be included in a state income tax basis unless an applicable exclusion applies.

In states that do not use federal taxable income as a basis for calculating state taxable income for personal income tax purposes, what the state taxes may include income or gain from the sale of an NFT. For example, Pennsylvania is unique in that a resident’s personal income tax base does not begin with federal taxable income; however, it taxes income from the sale of all types of property, including intangible property by residents. Thus, a Pennsylvania resident should be subject to Pennsylvania personal income tax on income or gains from the sale of NFTs. Non-residents of Pennsylvania may be subject to tax on income from the sale of NFTs attributable to Pennsylvania during purchase and allotment.

Companies should be just as careful as individuals. In states that follow the federal treatment of cryptocurrencies by classifying them as intangible property, it would not be difficult to apply the same reasoning to NFTs. For example, the Illinois Department of Revenue stated in informal guidance that income from the sale of bitcoin is income from a sale of intangible property for the purpose of apportioning a corporation’s income to the state. If the same rationale were applied to NFTs, capital gains could be taxable for corporation tax purposes.

New York recently published draft distribution regulations that would be subject to state income tax to provide access to certain types of digital property, which would include cryptocurrency and similar digital assets. If these regulations become final, NFTs may be considered a digital asset within their scope.

New Jersey has issued guidance to taxpayers on how to track transactions completed with cryptocurrency for various state taxes.

Going forward

If a state asserts the tax liability of NFTs, a taxpayer needs to know whether it is required to collect sales tax on a sale, or whether it must pay sales tax or incur use tax on a purchase. An NFT in itself may not be taxable at all; it is essentially a digital address with a certificate showing ownership of that address. If the NFT in question is accompanied by certain rights, the question becomes whether these constitute a transfer of ownership, custody or possession – the usual definition of the sale of a taxable object.

Regardless of which description the tax authority gives of what is liable to tax, the question is whether this description is in accordance with the law and regulations. It may be that many, but not all, NFTs are taxable items. The devil is in the details.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author information

Joseph C. Bright is a member of Cozen O’Connor’s tax practice, concentrating on state and local taxation and assisting businesses and individual taxpayers with respect to corporate, financial institution, sales and use, income, estate, transfer and all other state and local taxes.

Cheryl A. Upham is co-chair of Cozen O’Connor’s tax practice, focusing on state and local tax law, including corporate and personal income, net worth/franchise, sales/use, real estate, payroll and estate tax matters.

Heidi R. Schwartz is an associate in Cozen O’Connor’s tax practice, advising clients on state and local tax issues for individual and business taxpayers regarding sales and use, income, estate, transfer and other state and local taxes.

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