Decoding the Sales Tax Treatment of NFTs

Cryptocurrency made its debut as Bitcoin in 2009 but took several years to gain mainstream attention. After growing somewhat used to the concept of cryptocurrency, new blockchain inventions have gained traction. Many of us are still wrapping our heads around non-fungible tokens (NFTs), first debuted in 2014, which serve as a certificate of ownership of a digital file. Many NFTs are a unique work of art or collectible. Non-fungible tokens such as those in the CryptoPunk series have sold for millions of dollars (for reference see https://nftnow.com/guides/cryptopunks-guide/). Many of us are grappling with the tax issues associated with NFTs, such as whether they are subject to sales tax. The creation and sale of NFTs is based in young technology, which presents a conundrum when applying sales tax laws originally promulgated for a manufacturing economy. At first glance, the easy answer is NFTs are digital products subject to sales tax in the over 30 jurisdictions that tax digital products. However, there is more to the analysis than first meets the eye.

Sales taxes have long been a common element of state tax regimes throughout the nation. Perhaps one reason for the levy’s longevity has been the states’ willingness to adapt it to technological advances. Over the past few decades, the imposition of sales tax has expanded from mostly applying to brick-and-mortar retail transactions to a variety of business conducted over the internet. For instance, the sales tax treatment of transactions involving the cloud or Software as a Service (SaaS), while inconsistent among states, is fairly settled. The issue of taxing jurisdiction has also been recently clarified in South Dakota v. Wayfair, whereby the 2018 U.S. Supreme Court found federal law did not prohibit the imposition of a sales tax collection obligation upon a remote seller. The next question is whether state sales taxes apply to NFTs.

What Are NFTs?

Non-fungible tokens can be anything digital and often include drawings, music, a designer belt in digital form, etc. Many popular NFTs are essentially digital art, such as The Smoking Apes NFT Collection popularized by celebrities, that are digitally stamped with a serial number. Non-fungible tokens are built primarily on the Ethereum blockchain. Ethereum is a cryptocurrency, like Bitcoin or Dogecoin, but its blockchain also supports NFTs, which store extra information that makes them work differently from, say, an Ethereum coin. (Other blockchains – including Solana for which transactions are faster and more affordable – can implement their own versions of NFTs as well.)

Sales and Use Tax Treatment

Technically what most people refer to as sales tax is actually comprised of two different levies that complement one another. The first is a sales tax, which is generally imposed on the retail sale of goods or enumerated services. The second is a use tax, which is imposed on the storage, use or consumption of a taxable item or enumerated service upon which no sales tax has been paid. For example, a Maryland resident who purchases a computer in Delaware for use in their home in Maryland would be subject to Maryland use tax on the purchase price of the computer.

Does sales or use tax apply to the purchase of NFTs? The answer may depend on the approach each state has adopted in taxing digital products.

Differing State Approaches

Certain states have updated their tax code to specifically address digital products. Such laws have extended the definition of taxable tangible personal property to include products that were previously sold in tangible format that are now distributed digitally, such as electronically delivered books, music and magazines. The states differ on whether the delivery method is meaningful. For example, in Colorado, the method of delivery does not impact taxability. Examples of methods used to deliver tangible personal property under current technology include compact disc, electronic download and internet streaming (Colo. Code Regs. 39-26-102(15)). A movie purchased on VHS tape, compact disc, downloaded from the internet or streamed is taxable as tangible personal property under all methods of purchase. Unless Colorado and other states that treat digital products similar to Colorado can demonstrate that an NFT has a physical counterpart, it may be difficult for those states to subject an NFT to sales or use tax as a digital product or as tangible personal property.

Other states, such as Texas, tax digital products as tangible property based on the conclusion that when the consumer downloads the item, they change the medium on which the property is stored. For example, Texas Policy Letter Ruling No. 200101966L stated that “downloaded music is tangible personal property because it causes a physical change to the medium on which it is stored and it can be measured.” Applying this analysis to NFTs may require one to consider whether NFTs have the characteristics of tangible personal property, and whether the NFT causes a change to the medium on which a tangible item is stored or captured on medium that can be seen, weighed, measured, felt, or touched (See Tex. Code Ann. Sec. 151.009). This leads to the question, what is the tax result if the purchaser only receives an NFT’s unique code but does not receive the underlying tangible personal property that the NFT represents or is based upon? Texas may consider viewing one’s own NFT within the state, even if the wallet that stores the unique code is located outside of Texas, to cause a minuscule change to the display within Texas and therefore subject the NFT to Texas sales or use tax.

Some states have exemptions unrelated to digital products that may relieve a seller of a sales tax collection responsibility even if the state taxes digital products. Arizona defines tangible personal property to include “personal property that may be seen, weighed, measured, felt or touched or that is in any other manner perceptible to the senses” (Ariz. Rev. Stat. Ann. Sec. 42-5001(21)). Given this broad definition, an NFT that has a visible representation may be taxable as measurable personal property or property that is perceptible to the senses. However, an Arizona city or town may exempt proceeds from sales of paintings or similar works of fine art if such works of fine art are sold by the original artist (Ariz. Rev. Stat. Ann. Sec. 42-5159(H)). Would Arizona be equally broad in the application of its exemption and consider a Logan Paul Pokémon card NFT a similar work of fine art and the NFT minter an original artist?

One would hope that uniformity might be found within the 24 member states of the Streamlined Sales and Use Tax Agreement (SSUTA). While the SSUTA states all define specified digital products to include digital audio works, digital audiovisual works, and digital books, the SSUTA does not make any reference to NFTs, and the taxability of specified digital products varies by state. Given that NFTs represent an array of digital goods, if the SSUTA were to take a position on NFTs it seems that NFTs like (or possibly as) specified digital products could be categorized differently and each category may or may not be taxable in a given state.

The Takeaway

Applying tax laws still struggling to catch up with a digital economy to NFTs first minted eight years ago is like Alice’s trip to Wonderland. Going down the rabbit hole of the sales and use tax treatment of NFTs unsurprisingly generates more questions than answers. The tenuous support for the sales or use taxability or nontaxability of NFTs in most states leaves purchasers on a quest to find the safest place to have tokenized digital art delivered. To eliminate all questions of sales or use tax collection and remittance responsibility, NFT purchasers find themselves in familiar territory for many collectors of old fashioned fine art: taking title and accepting delivery in a state that does not impose a sales tax and use like the First State of Delaware, or that does not extend the sales and use tax to digital items like California. Given all the potential sales and use tax pitfalls of moving NFTs from state to state, it might be wise to plan on parking an NFT in a cold storage wallet in a favorable state and forgetting about it for a while. Of course, one should be wary of other obligations in a state where NFTs may be stored. You may not want to leave an NFT stored in Delaware unattended too long or the solution to an NFT sales or use tax headache might turn into an unclaimed property migraine – which we will attempt to relieve in the next newsletter.