Between Amazon launching next month its NFT Marketplace – tentatively called the “Amazon Digital Marketplace”, Sotheby’s already launched high-end secondary marketplace for “digital artwork”, and Christie’s launching last year its Christie’s 3.0 – a platform allowing for fully on-chain sales that demonstrates “the auction house’s commitment to both artists and collectors in the Web3 space”, programmable digital assets/NFTs are simultaneously entering both ends of the mainstream market.
Probably the most important takeaway from such broad initiatives turns on the fact foundational brands have decided to supplant the prior NFT free-for-all initiated by PFP projects, artists and collectors. Despite potentially risking the same fate of Dapper Labs, Amazon will rely on a private blockchain that takes credit cards while Sotheby’s eliminates “NFTs” from the equation altogether to focus on what it calls “digital artwork” even though digital art has already been around for decades. What is clear is that Amazon’s use of its own “brand worthy” naming convention – “Amazon Digital”, elevates rather than hinders this new ecosystem.
Being swept aside by this establishment wave is OpenSea – the newly-displaced old guard and wild-west pioneer who likely never contemplated insider trading as a risk until a former OpenSea Manager was recently convicted of it. Not surprisingly, OpenSea offloads tax obligations and refers its users to CoinTracker for tax calculations. OpenSea even explicitly points out to users of the marketplace that “[y[ou are responsible for determining what, if any, taxes apply to your purchases, sales, and transfers of NFTs. If you have specific questions regarding taxes, please consult with a professional tax advisor.” OpenSea’s sole Help Center entry regarding taxes further drives home the point: “Users are responsible for determining what, if any, taxes apply to their purchases, sales, and transfers of NFTs. If you have questions about taxes, please consult with a professional tax advisor.”
In sharp contrast, the government is certainly rooting for reliable tax collectors such as Amazon, Christie’s and Sotheby’s to enter the NFT sandbox. Since 2018 – when the Supreme Court overruled decades of precedent, taxation of online sales no longer depends on physical presence within a particular state. The new guard will create the proper recipe for mass profitable usage, namely removing tech geek elements, improving user interfaces, adding brand allure, and ensuring government is happy and remaining on the right side of the regulatory fence.
As Grace Kyne of EY informed attendees at the April 13, 2023 NFT.NYC session “NFTs and Marketplaces: Opening Pandora’s Box”, there are state-specific marketplace facilitator rules that make most marketplaces subject to state tax. Not surprisingly, Amazon is front and center in pointing that hard fact out to its market participants: “Marketplace Facilitator legislation is a set of laws that shifts the sales tax collection and remittance obligations from a third party seller to the marketplace facilitator. As the marketplace facilitator, Amazon will now be responsible to calculate, collect, remit, and refund state sales tax on sales sold by third party sellers for transactions destined to states where Marketplace Facilitator and/or Marketplace collection legislation is enacted.”
In other words, pushing digital asset sales to Amazon is really every state treasurer’s dream.
This should not come as any surprise. Ever since the 2019 tax year, IRS Form 1040 has included a question regarding a taxpayer’s cryptocurrency activity. In 2021, the IRS slightly broadened the scope of its inquiry: “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” In 2022, the scope of the latest IRS Form 1040 broadened yet again: “At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?
In other words, the IRS expressly seeks disclosure of all digital asset transactions and not merely those involving cryptocurrencies. The IRS now wants to know about a taxpayer’s NFT sales and any income generating activities where digital assets are received as payment. On April 5, 2023, the IRS released its IRS Tax Tip 2023-45 which elaborated on this new position regarding a taxpayer’s obligation to report digital asset transactions – including citation to applicable supplemental forms. By informing taxpayers of their new obligations – by way of tax forms and “tax tips”, it becomes increasingly difficult for them to argue any lack of knowledge on the topic. The easiest approach will always be one which just assumes all realized digital asset gains are taxable.
And, to the extent there was any ambiguity regarding more specific tax treatment of NFTs, that might soon evaporate given the IRS – in its March 13, 2023 Notice 2023-27, seeks to classify most NFTs as “collectibles” – a lesser form of asset for purposes of capital gains and other tax purposes.
Specifically, Notice 2023-27 – which seeks comments before June 19, 2023, announces the IRS’s and Treasury’s intention to issue guidance as to whether certain NFTs are “collectibles” under IRS Section 408(m). Currently, the only available categories of “collectibles” under this section are: “(A) any work of art, (B) any rug or antique, (C) any metal or gem, (D) any stamp or coin, (E) any alcoholic beverage, or (F) any other tangible personal property specified by the Secretary for purposes of this subsection.” See 26 USC § 408(m)(2). The IRS recognizes that NFTs do not presently constitute any of the above – including “art” given an NFT is not the art itself, it is a digital file pointing to the actual digital art typically found using an IPFS gateway such as Pinata. Moreover, Section (F) expressly references “tangible personal property” so that catchall also does not squarely fit.
While waiting for comments, the IRS will deploy a “look-through” analysis: “Under the look-through analysis, an NFT constitutes a section 408(m) collectible if the NFT’s associated right or asset is a section 408(m) collectible. For example, a gem is a section 408(m) collectible under section 408(m)(2)(C), and therefore an NFT that certifies ownership of a gem constitutes a section 408(m) collectible. Similarly, an NFT does not constitute a section 408(m) collectible if the NFT’s associated right or asset is not a section 408(m) collectible. For example, a right to use or develop a “plot of land” in a virtual environment generally is not a section 408(m) collectible, and therefore, an NFT that provides a right to use or develop the “plot of land” in the virtual environment generally does not constitute a section 408(m) collectible.” See IRS Notice 2023-27.
It is not clear whether the “look-through” approach would be limited to an underlying physical asset tied to the NFT or whether it might include potential money-generating components of an NFT. More than likely, however, the relevant IRS section could not be broadly interpreted to include future gains unrelated to specific associated assets. Moreover, earning rewards by way of an NFT should not be taxable given rewards are generally treated as a rebate or discount on purchases – that should be treated no differently than frequent flyer miles.
The lesson learned for businesses seeking to grow NFT adoption is that market validation and future growth opportunities are now inevitable given the tax hounds have gotten the scent. To the extent there were any previous regulatory barriers to growth opportunities, those will be lifted so long as the government gets it take.