On March 21, 2023, the Department of the Treasury and the Internal Revenue Service issued Notice 2023-27 (Notice), which discussed their intention to issue detailed guidance characterizing certain non-fungible tokens (NFTs) as collectibles for US federal income tax purposes under Internal Revenue Code Section 408(m). The notice took the unusual step of requesting comments before issuing formal guidance, strongly suggesting that the Treasury and IRS struggled to correctly define and characterize the ever-growing variety and flavors of NFTs. While the announcement may be a foreshadowing of the Treasury and IRS’ long-awaited guidance that has long been requested by tax professionals and enthusiasts of the Web3 ecosystem, it raises significant questions that will hopefully be reconciled and discussed in further guidance.
Definition
The message defined NFTs as “a unique digital identifier that is recorded using distributed ledger technology and can be used to certify the authenticity and ownership of an associated right or asset.” Furthermore, ownership of an NFT can give the holder two distinct sets of rights:
- The right to a digital file itself, such as a digital image, music file, trading card or sports moment; or
- A non-digital right, such as access to a ticketed event or NFT, works to confirm ownership of a physical object, such as real estate or a work of art.
The Notice proposes to use the definition of collectible under IRC Section 408(m)(2), which is “any work of art, rug or antique, metal, gem, stamp, certain coin, alcoholic beverage, musical instrument, historical object, or other thing of material personal property that the Minister of Finance determines is a collector’s item.” Because section 408(m)(2)(F) uses the phrase “any other tangible personal property,” an intangible property cannot be a collectible, contradicting the nature and use of many NFTs, especially those that would otherwise qualify as work of art. The notice proposes to use “look-through analysis” to determine whether the NFT’s associated right or asset is a collectible. The look-through analysis states that if an NFT certifies or represents ownership of a collectible, the sale of the NFT is a sale of a collectible. Conversely, if an NFT certifies or represents ownership of something other than a collectible, such as real estate or a membership in a club, the sale of the NFT is not a sale of a collectible.
The notice discusses two significant tax consequences of characterizing an NFT as a collector’s item. First, individual retirement accounts cannot contain collectibles. If an IRA purchases or holds a collectible, section 408(m)(1) deems the collectible (or a cash amount equal to its cost) to be distributed by the IRA. Second, collectibles are taxed at 28%, while capital gains can be taxed as high as 20%.
Unresolved issues
Although the notification is a positive step, many unresolved issues remain due to the broad nature of the definitions used. For example, the definition of collectible under § 408(m)(2) is limited to tangible personal property, excluding both intangible property and real property. Having different tax consequences for selling an NFT that is a digital representation of a physical object and one that does not represent a physical object creates different tax consequences that will make it more difficult to determine the correct characterization and create an incentive to take an aggressive position due to ambiguity in the definition. There are many NFTs that have such insignificant differences to other NFTs, such as a different color border, that they are essentially fungible. If one NFT represented ownership of a physical asset and the other did not, the one that did not represent physical ownership would be worth more because of the lower tax rate and not its underlying desirability or characteristics. The best way to solve this problem and ensure tax parity would be for Congress to change the definition of a collectible to include certain intangibles or at least NFTs.
An important question raised in the announcement is how to correctly characterize an NFT that has the potential to receive additional right(s) or asset(s) due to its attributes. Receipt of the additional rights or assets would be taxable as an airdrop under Revenue Ruling 2019-24, but the characterization of the underlying NFT would be important if it was sold prior to the receipt of rights or assets. Will an NFT entitled to receive NFTs that have indeterminate characteristics be considered a collectible for income tax purposes? Or would the fact that the nature of the potential future right(s) or asset(s) is indeterminate be decisive, that is, if it is not known to be a collector’s item, its sale would avoid being characterized as a sale of a collector’s item?
Effective date?
Somewhat unusually, there was no discussion of an effective date. This may indicate that the Treasury and the tax authorities believe that the NFTs in question are correctly characterized as collectibles, which makes it possible to issue future guidance in the form of a revenue decision, so that the Treasury and the tax authorities can take the position that the guidance is only to state the law as it always has been, thereby allowing the IRS to retroactively characterize certain NFTs as collectibles.
State taxes
Additionally, many states are studying this issue in the context of sales and use taxes. It would be advisable for Treasury and Revenue to work with states to develop a consistent and authoritative set of terminology and definitions, although they should not be bound by states’ views and should not delay providing guidance.
Comments requested
Finally, the notice requested comments to help resolve a number of issues related to definitions and terminology, how to characterize an NFT if it has less than full ownership or multiple underlying assets, and a number of other issues.
Matthew E. Foreman, JD, LL.M. is a consultant at Chiesa Shahinian & Giantomasi PC
