Cryptocurrencies, NFTs, And State Tax – There’s Lots That We Don’t Know Yet – Fin Tech

Every so often something new and different comes along in the
world of state and local tax that does not fit within the existing
conceptual frameworks and rules. For example, the delivery of
digital books and other digital media in place of physical media
upended sales tax systems that historically had applied mainly to
sales of tangible property. Now the increased use of
cryptocurrencies and the growing marketplace for nonfungible tokens
(NFTs) is another instance of such technological innovation. This
innovation will require governments and their taxing authorities to
consider how to apply existing tax law, and whether existing tax
law should be expanded and/or modified. Unfortunately, seldom do
state taxing authorities adopt standardized, uniform approaches
when addressing most any aspect of tax policy and procedure.
Therefore, we expect that purchasers, sellers, and owners of
cryptocurrency and NFTs will be faced with a non-uniform,
ever-changing state tax landscape.

In this alert we discuss generally the issues that purchasers,
sellers, and owners of cryptocurrency and NFTs will likely face
with respect to state taxes and trends that can be foreseen. This
alert focuses primarily on state income and sales taxes, but also
touches on other types of state taxes. We also discuss certain tax
issues that state tax authorities have generally not yet
addressed.

For background on blockchain, cryptocurrency, and NFTs see the
Insight provided by our Venable colleagues.
Both cryptocurrency and NFTs are based on blockchain technology,
which allows for the creation of a decentralized, digital ledger in
which data are stored in “blocks” that are connected to a
chronological “chain.” Bitcoin and Ethereum are currently
the most traded cryptocurrencies and possess the largest market
share. Thousands of other currencies are traded on various
exchanges. Cryptocurrencies are fungible units of value. NFTs are
nonfungible, digital data stored in a blockchain that are most used
to represent ownership of an asset (often digital art or
memorabilia). A growing use of NFTs is for a ticket or access to a
live event, or as a coupon (utility NFTs). And while state tax
authorities move forward to address how their tax laws apply to
these existing facts and uses for cryptocurrencies and NFTs, the
facts and uses of both will continue to morph and raise new tax
issues for resolution.

State Income Taxes

For income taxes, states generally rely on federal income tax
law and guidance. Therefore, the federal income tax treatment of
cryptocurrency and NFTs will typically govern the state income tax
treatment. In Notice 2014-21, the IRS published limited guidance on
the tax treatment of common types of cryptocurrency (such as
Bitcoin and Ethereum). The IRS supplemented that 2014 guidance with
an online posting of “Frequently Asked Questions on Virtual
Currency Transactions,” addressing the tax treatment of
specific cryptocurrency transactions such as “airdrops”
(sending free cryptocurrency coins or tokens to promote awareness
of a new currency) and “hard forks” (a change to a
cryptocurrency network that effectively splits one currency into
two currencies). In this guidance, the IRS has taken the position
that common types of cryptocurrency are generally classified as
property for federal income tax purposes and that tax principles
common to transactions in property, such as recognizing taxable
gain and loss on dispositions of property, apply to transactions in
cryptocurrency.

At the time of this writing, the IRS has not published any
federal tax guidance dealing specifically with NFTs, so for the
time being state tax authorities and tax professionals must make
judgments regarding the tax treatment of NFTs by applying general
federal tax rules to the characteristics of the NFT. Here we
present an overview of what we know at this point regarding federal
income tax treatment that can be expected to carry over the state
treatment.

Sales or Exchange of Cryptocurrencies and NFTs

Because cryptocurrency is treated as property (and not as a form
of currency) for tax purposes, the sale or exchange of
cryptocurrency, including the use of cryptocurrency to purchase
goods or services, results in taxable gain or loss. Notably, the
“wash sale” rules, which typically prohibit an investor
from claiming a taxable loss when the investor sells a security and
then replaces it with the same (or a substantially identical)
security 30 days before or after the sale, do not apply to
cryptocurrencies. Because cryptocurrencies are not treated as
securities for federal tax purposes, under current law a holder of
cryptocurrency can “harvest” a loss by selling a
cryptocurrency that has lost value, then use the sales proceeds to
repurchase the same cryptocurrency. For cryptocurrency, the
character of the gain will generally be capital gain for investment
assets (which will be relevant only for states that tax capital
gain differently than ordinary gain) or ordinary gain for assets
held for noninvestment purposes.

The 2017 Tax Cuts and Jobs Act eliminated like-kind exchange
treatment for assets other than real estate. Thus, the exchange of
one cryptocurrency for another (i.e., Bitcoin for Ethereum) or one
NFT for another is a recognition event, with gain or loss
recognized by each party to the exchange based on the fair market
value of the acquired asset minus the basis of the exchanged asset.
IRS guidance published in 2019 states that exchanges of
cryptocurrency before 2018 (when like-kind exchange treatment was
available for assets other than real estate) did not qualify for
like-kind exchange treatment and thus were taxable. At the federal
level, the sale of cryptocurrency is a capital gain or loss unless
the seller is a “dealer” in cryptocurrency. The sale of
an NFT by the person that created the NFT likely results in
ordinary income, whereas the sale of an NFT by a purchaser likely
results in a capital gain or loss. This treatment is primarily
relevant for federal income taxes, as nearly all states tax capital
gains at the same rate as ordinary income.

Legislation introduced in June 2022 by Senators Cynthia Loomis
(R-WY) and Kirsten Gillibrand (D-NY) would create specific rules
for the treatment of certain cryptocurrency transactions. These
include a de minimis exception for nonrecognition of gain or loss
in cryptocurrency transactions of $200 or less (adjusted annually
for inflation in increments of $50). Legislation creating a $200 de
minimis exception was also introduced in the House of
Representatives. These proposed de minimis exceptions indicate a
potential trend in the thinking of policy makers toward changing
the tax treatment of cryptocurrency to make it more usable in
everyday transactions.

Cryptocurrency Received in Exchange for Mining or Staking

Cryptocurrency transactions are typically validated through
either a proof-of-work (“mining”) system or a
proof-of-stake (“staking”) system. Mining involves users
with powerful computational hardware solving complex puzzles to
validate transactions and store transactional data in the
blockchain. Miners are awarded units of cryptocurrencies for
solving puzzles and validating transactions on the blockchain.
Guidance issued by the IRS in 2014 states that cryptocurrency
received in exchange for mining services is taxable income.

Staking involves cryptocurrency holders “locking”
their coins on the blockchain network for a fixed period. The
pledged coins are then used by the cryptocurrency protocol to
confirm transactions. New coins are distributed to holders who have
staked their coins. In Jarrett v. United States, a
cryptocurrency staker reported staking rewards as taxable income,
then later filed an amended income tax return seeking a refund of
those income taxes. The taxpayer’s lawsuit (which is pending)
claims that staking rewards are “self-created” property,
and, thus, income is not realized until the coins received from
staking are sold. Importantly, if staking rewards are treated as
self-created property, then the income from the sale of those
rewards is taxable as ordinary income. The legislation introduced
by Senators Lummis and Gillibrand would codify Jarrett’s
position and defer recognition of income from mining and staking
activities until the staking rewards received from such activities
are sold.

Cryptocurrency and NFTs Received via Airdrop

The existing IRS guidance takes the position that cryptocurrency
received via an airdrop following a cryptocurrency hard fork is
taxable income to the recipient. IRS guidance does not discuss
airdrops generally, though based on the IRS’s position,
cryptocurrency received via an airdrop would likely be considered
taxable income. Arizona recently adopted a provision stating that
cryptocurrency or NFTs received via an airdrop are not subject to
Arizona income tax.

State Sales Taxes

To date, only two states have issued guidance explicitly
addressing the treatment of NFTs for sales tax purposes.
Pennsylvania recently updated its sales tax guide to add NFTs to
its list of taxable digital products. Washington state issued
guidance on July 1, 2022 stating that NFTs are subject to sales
tax. Approximately 30 other states impose sales tax on the sale of
digital products if the buyer has full ownership or the right to
use the product. This would generally include NFTs. In these
states, NFTs are likely subject to sales tax even without a
statutory change or the issuance of state guidance explicitly
stating that NFTs are subject to sales tax. Conversely, the
acquisition of cryptocurrency should not be subject to sales tax
because the purchaser is merely acquiring intangible property, not
a digital product. Sourcing the sale of an NFT to a particular
state may prove difficult, since the NFT is delivered to a digital
wallet, rather than to a physical address. Marketplace operators
with an obligation to collect sales tax will likely need to
implement systems requiring buyers and sellers to provide physical
addresses to better enable sales tax compliance.

Most NFTs are sold through marketplaces (OpenSea, CryptoPunks,
CoinBase NFT, etc.). In the wake of the Supreme Court’s 2018
Wayfair decision, all states with general sales taxes have
enacted “marketplace facilitator” laws imposing primary
responsibility for collection of sales taxes on the operator of a
marketplace through which the sale of taxable goods is facilitated.
Therefore, operators of NFT marketplaces likely have an obligation
to collect and remit sales tax in those states imposing sales tax
on the sale of digital products. In some states, the marketplace
seller could be secondarily liable for sales tax if the marketplace
operator does not collect and remit sales tax.

NFT sales are typically settled in cryptocurrency, rather than
dollars or other fiat currency. If a taxable sale of an NFT or any
other transaction is settled in cryptocurrency, alternative methods
of quantifying the sales price have been adopted by the several
states that have considered the issue. Most states that have issued
guidance on the topic follow the New York position (TSB-M-14(5)C,
(7)I, (17)S) that the cryptocurrency should be converted to U.S.
dollars to determine the amount subject to sales tax. In contrast,
Kansas guidance (Notice 20-04) provides that the sales price is
measured by the list price in U.S. dollars of the good or service
that is being received in exchange for the cryptocurrency, not the
value of the virtual currency used to purchase the taxable good or
service.

Sales of utility NFTs for admission to events (such as a concert
or other live performance) would likely be treated as a taxable
admission in states and localities that have a separate admissions
or amusements tax. Sales of admissions are commonly subject to
higher tax rates than general sales tax rates.

Other State Taxes

Property Taxes

While cryptocurrency is treated as property for tax purposes, it
is generally considered intangible property. Some states have
expressly listed cryptocurrencies as tax-exempt assets, though
these states, like most others, do not levy property taxes on
intangible property in the first place. Thus, except for a few
states with broad property taxes on all types of intangible
personal property, cryptocurrencies and NFTs are likely not subject
to state property taxes.

Unclaimed Property

All 50 states and the District of Columbia have adopted
unclaimed property laws, which generally require holders of
unclaimed property to report and remit such property to the state
once the property has been “abandoned.” Unclaimed
property laws are often enforced through audits conducted by
private contractors, which often receive a percentage of the
property recovered. Several states’ unclaimed property laws
explicitly include cryptocurrency within the definition of
unclaimed property that is subject to remittance to the state.

Other states may treat cryptocurrency as unclaimed property
subject to remittance under so-called catch-all provisions, even if
no specific provision applies. While some states provide guidance
on when cryptocurrency is considered abandoned and required to be
remitted to the state, others do not. Given the ease with which
passwords and digital wallets and keys evidencing ownership and/or
control of cryptocurrencies and NFTs can be lost, compliance with
unclaimed property laws can be a significant issue for companies
operating in the cryptocurrency or NFT arena.

Foreseeable Trends

New technologies typically raise a host of tax questions that
make state and local tax compliance difficult when the technology
first arises and is evolving. Evaluating how and when to implement
compliance is further complicated by the varying approaches to
taxation among the states. Existing tax guidance may be useful but
often fails to fit perfectly when applied to new technology. We
expect that much like the long, slow adoption of sales tax nexus
rules to e-commerce, the application of state tax laws to
cryptocurrency and NFTs will play out over years as the
technologies continue to evolve and state tax authorities work to
keep up.

But as sketched out above, some trends are already foreseeable
and can be expected to persist as that evolution and adoption
process goes forward. For example, states with sales taxes
generally can be expected to follow Pennsylvania and Washington
along the general theme that NFTs are digital goods subject to
sales tax. State income tax laws generally can be expected to
follow any new guidance issued by the IRS as to federal income tax
treatment. And of course, where uncertainty remains and the tax
dollars at stake are sufficient, the tax controversy process, from
audit through litigation, will serve to refine and resolve the
gaps.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.