Cryptocurrency and taxation update

In 2021, approximately $44 billion was spent in the rapidly growing non-fungible token (NFT) market. Despite the fact that the U.S. Generally Accepted Accounting Principles (GAAP) does not currently contain specific guidance for NFTs, it is still crucial for tax and accounting professionals to ensure legal compliance and financial efficiency for their clients.

What is an NFT?

An NFT is a digital, cryptographic asset. Each NFT is stored on the blockchain—a public, immutable ledger—paired with a unique identification code and metadata. This allows for permanent, visible recognition of ownership, and makes each NFT distinct from another “non-fungible,” unlike other physical or digital currencies.

Though NFTs were largely popularized by way of hype­-driven speculation, the technology itself allows organizations to issue general units of value, usually representing usage or access rights. A key benefit is the sense of tangible consumer ownership and collectability created by the blockchain. For example, artists of varying mediums can mint their work as NFTs, combating the inefficiencies and devaluation driven by digitized, copied, and shared content. Tickets, memorabilia, and other unique perks can be distributed without the interference of third-party companies or scammers. Others have used NFTs as incentives in video gaming and social media platforms.

It is this very flexibility that makes accounting for NFTs legally and financially problematic. While NFTs are most similar to indefinite-lived tangible assets such as trademark or perpetual franchise, they do not fall neatly into categories such as cash and cash equivalents, securities, or financial instruments. NFTs can contain any number or category of assets, which necessitates accounting treatment on a case-by-case basis.

Categorization and valuation

In terms of reporting, the value of an NFT is its carrying value: acquisition cost minus impairment cost. To determine fair market value, two methods can be used:

1. Discounted cash flow (DCF): Consider future revenue or cash flow, such as licensing and royalty payments.
2. Market approach: Consider past transactions and prior sales of similar NFTs.

The key to accounting for NFTs is to understand each one as an individual asset, which is itself a vehicle for other assets. In any given case, consider how this asset would be categorized if it were not an NFT. Generally, they will fall under the securities category, unless they are designed with an expectation of profit to the buyer. In these cases—such as a fractional NFT—they would be categorized as a commodity. Making this distinction is crucial because it completely changes the relevant set of laws and regulations.

NFTs are taxed as property in a similar manner to cryptocurrency. However, care must be taken depending on if the taxpayer is an NFT creator, buyer, or seller. For example, while creators assume tax liability on sale, buyers and sellers are taxed with long-term capital gains and ordinary income rates.

Other legal concerns

The unprecedented clarity that blockchain technology creates through public availability has resulted in legal complications. For example, the EU’s General Data Protection Regulation framework guarantees citizens the ability to remove data held by public and private companies, a privilege rendered impractical or even impossible by the blockchain.

Tax and accounting professionals must also consider intellectual property rights. Some sales transfer intellectual property to the buyer, while others do not. In addition, the minting of an NFT may contradict prior copyrights, resulting in copyright infringement. You should advise your clients to fully understand the terms and conditions before a transaction is made.

Finally, though NFTs have not received specific regulation from the U.S. Office of Foreign Assets Controls, those that function similar to currency will attract increased attention from U.S. regulators in the near future. For example, those who want to bypass U.S. law may favor the anonymity and decentralization created by the blockchain. Recent events, such as Russia’s invasion of Ukraine, further complicate this, as the number of government-sanctioned individuals has increased dramatically. Tax professionals should pay close attention to differing legal standards between states, in addition to U.S. sanctions and money laundering laws.

Editor’s note: Be sure to download Sonia Dumas’ Cryptocurrency Guide for more content on cryptocurrency.