Pennsylvania and Washington became the first two states to offer official guidance on how their existing tax regimes apply to nonfungible token (NFT) transactions. Their approaches offer two blueprints for other states to follow. Even though states are just starting to address taxation of NFTs, sellers may already be subject to the sales tax regimes of various states. NFT sellers should take time now to address their potential tax obligations and set procedures for collecting information and analyzing liability. NFT sellers may also want to seek opinion letters from informed counsel or binding letter rulings from a State to assist in determining their tax obligations. Waiting until a sales tax audit may be too late.
Pennsylvania and Washington offer differing blueprints on taxing NFT transactions. Pennsylvania’s simple guidance states that NFTs are subject to sales tax under the category of digital services and products. No further explanations were offered about how NFTs fit within the regime.
Washington, on the other hand, offered a thorough, but basic, examination of how NFTs interact with its tax system. Unlike Pennsylvania, Washington does not treat all NFTs as digital products. Washington considers the underlying components of the NFT to determine taxability. If the NFT merely grants access to a standalone digital product (digital artwork, photograph, video clip, etc.) then the NFT will be categorized as a digital product subject to the retail sales tax. On the other hand, if the NFT grants access to a standalone good or service (for example, access to a concert), the NFT will be subject to retail sales tax only if the good or service represents a retail sale. In addition to the taxability of NFTs, Washington’s guidance covers other topics such as sales price, record retention, and marketplace facilitators.
Recently, two other jurisdictions joined the fray. Minnesota offered guidance on the taxation of NFTs in line with Washington’s blueprint. Meanwhile, Puerto Rico followed Pennsylvania’s blueprint by adding NFTs to a list of taxable items. More states are expected to offer guidance on the taxation of NFTs.
An important note about these blueprints is that they offer interpretations of existing law, not changes in the law. This means that Pennsylvania, Washington, Minnesota, or Puerto Rico can apply their guidance both retroactively and prospectively. Moreover, it also means that states may not have to issue guidance before claiming taxing authority over NFT transactions. Approximately 30 states already impose a sales tax on digital product or electronically delivered software, so these states may claim retroactive taxing authority over NFT transactions.
Addressing State Tax Compliance
Collect Customer Data
To cope with potential state tax liabilities, NFT sellers should focus on collecting and retaining transaction records. These records will not only help the NFT sellers determine their tax obligations but will also serve as evidence in the event of a sales tax audit. Washington’s NFT guidance states that taxpayers are responsible for retaining the documentation necessary to determine the amount of any tax for which the taxpayer is liable. For NFT sellers, this means that they must retain documentation to substantiate the nature, character, time, and place of each sale, the consideration received, and the taxability of each transaction.
Collecting buyer information, especially location data, is an important aspect that NFT sellers should not overlook. However, this information may prove to be difficult to collect due to the anonymous or pseudo-anonymous nature of the blockchain. Many buyers embrace the anonymous aspects of the blockchain and may be unwilling to provide their personal information, especially because this information is generally not required to complete blockchain based transactions. Moreover, NFT marketplaces facilitating payments from anonymous buyers may be reluctant to collect buyers’ data, especially if their competitors do not collect the data. However, this information is vital for NFT sellers because many states tax digital property based on the location or address of the buyer. At the very least, an NFT seller should collect the buyer’s 5-digit ZIP code. As an NFT seller, be sure to work with marketplaces that collect location data or come up with procedures for collecting the necessary data.
Identify State Tax Obligations
As NFT sellers complete transactions, the sellers must evaluate their tax obligations for each state, including the duty to collect and remit sales taxes. An NFT seller may not have any tax obligations within a state unless they create sufficient connection (or “nexus”) with the state. Generally, a seller does not need to be physically present in a state to have sales tax nexus. In most states, nexus is created if a seller completes a certain number of transactions with buyers located in the state or if the seller derives a certain amount of revenue from sales in the state. Once nexus is established, NFT sellers will be subject to the state’s tax regime and may be required to collect and remit sales taxes on NFT transactions with buyers located in the state. NFT sellers must be aware of each state’s nexus thresholds and sales tax requirements because sellers usually will remain liable for sales taxes regardless of whether the taxes were collected from buyer.
Take a Position on Taxability
If an NFT seller creates sufficient nexus with a state and is subject to the state’s sales tax regime, it becomes important for the seller to determine how their NFTs will be taxed by the state. Does the state tax all NFTs as digital products like Pennsylvania, or do taxpayers have to determine the taxability of the underlying components of the NFT like in Washington? So far, the states are evenly split on this issue. For states that have not decided how they will tax NFTs, sellers can request a binding letter ruling from the state’s taxing authority. Obtaining a letter ruling is a protection for NFT sellers, especially when there are open issues with the state’s tax regime, because the state’s taxing authority is required to follow any letter ruling it issues.
All of this may sound overwhelming to the average NFT seller, but this does not have to be done alone. Sellers can seek the help of competent legal counsel who can navigate each state’s tax regime. Legal counsel will not only analyze any current tax obligations arising out of a seller’s operations but can track new guidance produced by the states. When there are open issues in a state’s tax regime, legal counsel can provide opinions as to what the seller should do or help the seller apply for a binding letter ruling.
Access the last installment of Today in Tax here: Digital Assets in Mergers & Acquisitions—Three Things Every Seller Should Know.
This article is provided for informational purposes only—it does not constitute legal advice and does not create an attorney-client relationship between the firm and the reader. Readers should consult legal counsel before taking action relating to the subject matter of this article.