State and Local Tax Considerations

State and Local Tax Considerations

State and Local Tax Considerations

State and local tax authorities have issued even less guidance than the IRS has regarding the taxation of digital assets. Additionally, tax laws differ across states and localities. NFT stakeholders will therefore have to navigate a maze of questions in determining how to characterize and report NFT transactions for state and local tax purposes.

Most states impose an income tax. Generally, these states follow federal tax principles for purposes of computing taxable income.⁵ A state then usually taxes resident individuals on all taxable income, and nonresident individuals and corporations on taxable income “sourced” to the state. For corporations, and in some states other types of entities, doing business in multiple jurisdictions, such sourcing is generally determined based on an apportionment formula.⁶

Whether the transfer of an NFT is treated as a sale or license for federal tax purposes will thus generally determine how the transfer is treated for state income tax purposes. However, certain transferors still must determine the source of any income resulting from such transfer. For an individual that transfers an NFT, as a hobby, where the associated asset is digital, the sourcing

⁴ Under current IRS guidance, the original acquisition of that virtual currency may not have been reportable if that virtual currency was acquired for fiat currency. See Frequently Asked Questions on Virtual Currency Transactions, A-5, IRS.gov (visited April 11, 2021).

⁵ For example, in California, corporations and individuals generally calculate their income tax liability by starting with their federal taxable or adjusted gross income respectively and then make state-specific adjustments. See 2020 California Form 100 (California Corporation Franchise or Income Tax Return); 2020 California Form 540 (California Resident Income Tax Return).

⁶ California, for example, requires most corporations to pay state income tax based on a “single sales factor apportionment” method (Cal. Rev. & Tax. Cd. § 25128.7). This generally requires that a corporation pay California income tax based on the portion of its total sales that are made in or to California.

question is probably not imperative, as income from the transfer would likely only be taxed by the individual’s resident state. However, individuals that transfer NFTs as a trade or business, corporations and other business entities will likely need to determine the source of any income from their NFT transfers in order to properly apportion such income among different states. For personal income tax purposes, states usually source income from the transfer of a tangible asset based on where the asset is located, but income from transfers of intangible assets is generally sourced only to the state of the transferor’s domicile unless the transferor is transferring that intangible asset as part of a trade or business. Corporations or other entities conducting a trade or business would generally source such income by reference to the state of domicile or principal place of business of the transferee. Because NFTs associated with digital assets can easily be transferred without any information regarding the transferee’s location, transferors may have difficulty sourcing income from NFT transfers.

In addition to income tax, states and localities often impose sales and use taxes. Most states impose such tax on sales of tangible personal property and certain services. Some jurisdictions also impose such tax on transfers of certain types of digital property. For example, Texas imposes sales tax on the transfer of a digital product if the product would be taxable if delivered in physical form.⁷

Sales tax, if applicable, is generally imposed by the jurisdiction where the transfer of possession occurs. Use tax is generally imposed by the jurisdiction where the good or service is used or consumed. Where a physical asset is sold, where the good is transferred or used, and thus which jurisdiction could impose tax, is usually easy to determine. For the sale of a digital asset, however, this determination can be significantly more difficult. The location of the sale is likely to be determined based on the state of residence of the transferee, or the state where the digital asset is stored, used or viewed. Taxpayers will need to collect this information even though NFT transfers often occur without noting any information regarding the location of the transferee. In addition, since NFTs are stored on blockchains, which are computer networks distributed over multiple geographic locations, determining where an NFT is “stored” is not readily apparent. The same might also be true of the underlying digital asset, which may be stored on a form of distributed network. Further complicating matters is that states have different standards regarding whether remote sellers (i.e., sellers based outside the state or making only casual or isolated sales) are obligated to collect and remit any applicable sales and use tax.

Given the above, NFT transferors and marketplaces will have to carefully consider what information they need from transferees in order to comply with state and local tax obligations. States may issue direct guidance regarding the taxation of digital asset transfers, but until then, NFT stakeholders will have to answer their state and local tax questions by reference to law enacted long before anyone contemplated paying $600,000 for certain rights to a flying Pop-Tart cat image.

⁷ See Texas Policy Letter Ruling No. 200101966L (Jan. 3, 2001).

State and Local Tax Considerations

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