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  1. How To Characterize NFTs and NFT Transactions

How To Characterize NFTs and NFT Transactions

As noted above, an NFT is essentially a digital certificate that entitles the holder to certain rights associated with an asset. Similar to the protocol with any other such certificate (e.g., a deed of ownership or a stock certificate), the underlying rights and asset should dictate how to tax transfers and ownership of the certificate.

NFTs are generally associated with digital assets, which are treated as IP or intangible property, for tax purposes. Under U.S. law, any article of IP includes a “bundle of rights,” and the holder of such rights can transfer some or all of them. For example, the copyright holder of a work generally has the exclusive right to reproduce, prepare derivative works of, publicly perform and publicly display that work for a certain period of time. The holder could choose to transfer all of these rights to a single transferee or to transfer certain limited rights (e.g., the right to publicly display the work on certain platforms) to one or more transferees. Such rights can be transferred for the entire term or for a limited period, and can be transferred on either a nonexclusive or an exclusive basis. The scope of IP rights conveyed with an NFT can similarly vary widely.

For U.S. tax purposes, an important threshold question for a transfer of IP rights is whether the transfer constitutes a sale or a license. If the transfer is a sale, then the transferor can offset its amount realized on the sale by its basis in the IP rights. In other words, the taxable income on the transaction is limited to the transferor’s gain in the property. If the IP rights were a capital asset to the transferor, then that gain on the sale is presumably eligible for long-term capital gains rates (in the case of individuals) if the rights were held for more than a year. If, instead, the transfer is treated as a license, then the transferor: (i) will generally recognize ordinary income (i.e., royalties on the license); and (ii) will not be able to directly offset its income from the license with its basis in the IP rights, though such basis will continue to be amortized over future years.

Whether a transfer of IP rights is treated as a sale or license for tax purposes generally depends on whether the transferor transfers all “substantial rights” it holds in the IP. Whether all substantial rights are transferred depends on the overall facts and circumstances; whether the transfer is formally labeled a “sale” or “license” is not controlling. The more rights that are transferred, the more likely that the transfer is properly treated as a sale. For example, where a transferor holds all rights to a copyright, an exclusive license of all those rights for the term of the copyright would

2 Id. at A-6.

generally be a sale for tax purposes. By contrast, a nonexclusive license of certain rights to that copyright (e.g., the right to publicly display the work) by that same transferor would generally be a license for tax purposes. However, if the transferor only holds certain rights to the copyright in the first instance (e.g., the transferor only owns the right to publicly display the work), a subsequent transfer of all of those limited rights would likely be a sale for tax purposes, regardless of whether the transferred rights constitute a license for IP law purposes.3

As outlined in the March 30, 2021, Bloomberg Law article referenced above, the IP rights associated with an NFT can vary from one NFT to another. In general, however, purchasing an NFT does not provide the purchaser with exclusive ownership of all IP rights in the associated work, and instead conveys a very limited license, often limited to display of the associated work for personal purposes. This can result in differing tax treatment for the “primary” and “secondary” transferors of the NFT.

  • In the primary transfer of an NFT — where the creator of/copyright holder for the work associated with the NFT transfers the NFT to an initial transferee — the transferor will need to determine whether it has sold the work associated with the NFT or merely granted a license. Because, as noted above, an NFT usually does not provide exclusive ownership of all IP rights in the associated work, most primary NFT transfers are likely to be treated as licenses for tax purposes.

  • The secondary transfer of an NFT — where the NFT trades in the secondary market after that primary transfer — is likely to be treated as a sale. This is because in a secondary transfer, the transferor presumably transfers all of its limited rights in the associated work.

Put another way, because the secondary holder’s rights associated with the NFT are likely to be limited in the first instance, that secondary holder is more likely to be transferring “substantially all” of its rights associated with the NFT. This is true regardless of whether the primary transfer is properly treated as a sale or license.

As described above, if the transfer of an NFT is treated as a sale, the transferor can generally offset its amount realized with its basis in the NFT. For such a sale, the tax consequences of any gain or loss will depend on several factors, including, in addition to the quantum and character considerations described above: (i) whether the transferor amortized any basis in the NFT and the underlying work (which would generally be subject to recapture at ordinary income rates); (ii) whether the transferor trades in NFTs as a mere hobby (which would limit the transferor’s ability to deduct losses incurred in connection with NFT transfers); and (iii) whether the NFT is properly treated as a collectible (for which gains are generally subject to higher rates than they are in normal capital asset transactions).

If the transfer of an NFT is treated as a license, the transferor generally recognizes ordinary income, as noted above, but must consider a number of other tax consequences. In particular, any

3 Mylan Inc. v. Commissioner, 111 T.C.M. (CCH) 1199 (2016); MacDonald v. Commissioner, 55 T.C. 840 (1971).

payment for the NFT would generally be treated as a royalty for tax purposes, which may raise sourcing questions and may require a U.S. transferee to withhold on the payment if the transferor does not certify itself as a U.S. taxpayer.

Holders of NFTs will have to carefully consider the terms of their NFT transactions to properly determine and report the resulting tax consequences.

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