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
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.
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.
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.