Pennsylvania and Washington have become the first two states to offer official guidance on how their existing tax regimes apply to non-fungible token (NFT) transactions. Their approaches offer two models for other states to follow. Even though states are just beginning to address the issue of NFT taxation, sellers may already be subject to various state sales tax regimes. NFT sellers should now take the time to address their potential tax liabilities and put procedures in place to collect information and analyze liability. Sellers of NFTs may also wish to request informed attorney opinion letters or state binding letter rulings to help them determine their tax liability. Waiting for a sales tax audit may be too late.
Pennsylvania and Washington offer different plans on taxing NFT transactions. Pennsylvania’s simple guidelines state that NFTs are subject to sales tax under the category of digital services and products. No further explanation was provided on how NFTs fit into the scheme.
Washington, on the other hand, offered a thorough, but basic, look at how NFTs interact with its tax system. Unlike Pennsylvania, Washington does not treat all NFTs as digital commodities. Washington considers the underlying components of the NFT to determine taxation. If the NFT merely grants access to a stand-alone digital product (digital artwork, photograph, music video, etc.), then the NFT will be classified as a digital product subject to retail sales tax. On the other hand, if the NFT provides access to a stand-alone good or service (for example, access to a concert), the NFT will only be subject to retail sales tax if the good or service represents a retail. In addition to the taxation of NFTs, the Washington guidelines cover other topics such as sale price, record keeping and market facilitators.
Recently, two other jurisdictions have joined the fray. Minnesota offered guidance on taxing NFTs in accordance with Washington’s plan. Meanwhile, Puerto Rico followed Pennsylvania’s plan by adding NFTs to a list of taxable items. More states are expected to offer advice on taxing NFTs.
An important note about these plans is that they offer interpretations of existing law, not changes to the law. That means Pennsylvania, Washington, Minnesota, or Puerto Rico can apply their guidelines both retroactively and prospectively. Additionally, it also means that states may not have to issue guidance before claiming tax authority over NFT transactions. About 30 states already impose sales tax on digital goods or electronically delivered software, so these states can claim retroactive tax authority on NFT transactions.
Addressing State Tax Compliance
Collect customer data
To address potential state tax liabilities, NFT sellers must focus on collecting and maintaining transaction records. These records will not only help NFT sellers determine their tax obligations, but will also serve as evidence in the event of a sales tax audit. Washington’s NFT guidelines state that taxpayers are responsible for maintaining documentation necessary to determine the amount of any tax for which the taxpayer is liable. For NFT sellers, this means that they must maintain documentation to substantiate the nature, character, time and place of each sale, the consideration received and the taxation of each transaction.
Collecting buyer information, especially location data, is an important aspect that NFT sellers should not overlook. However, this information can be difficult to collect due to the anonymity or pseudo-anonymity of the blockchain. Many buyers accept the anonymous aspects of blockchain and may not want to provide their personal information, particularly because such information is generally not required to complete blockchain-based transactions. Additionally, NFT marketplaces facilitating payments from anonymous buyers may be reluctant to collect buyer 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 buyer’s location or address. 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 offer procedures to collect the necessary data.
Identify state tax obligations
As NFT sellers transact, sellers must assess their tax obligations for each state, including the obligation to collect and remit sales taxes. An NFT seller may not have tax obligations within a state unless it creates a sufficient nexus (or “connection”) with the state. Generally, a seller does not need to be physically present in a state to have a sales tax nexus. In most states, a nexus is created if a seller conducts 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 linked, NFT sellers will be subject to state tax and may be required to collect and remit sales taxes on NFT transactions with buyers located in the state. NFT sellers should be aware of each state’s connection thresholds and sales tax requirements, as sellers will generally remain liable for sales tax whether or not the tax has been collected from the buyer.
Take a position on taxation
If a seller of NFTs creates a sufficient connection to 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 goods like Pennsylvania, or should taxpayers determine the taxation of the underlying components of NFT like in Washington? So far, 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 taxing authority. Obtaining a ruling by letter is a protection for NFT sellers, especially when there are open issues with the state tax system, as the state taxing authority is required to follow up on any letter decision it issues.
All of this may seem overwhelming to the average NFT seller, but it shouldn’t be done alone. Sellers can seek the assistance of knowledgeable legal counsel who can navigate each state’s tax system. Legal counsel will not only analyze all current tax liabilities arising from a seller’s operations, but may follow new guidelines produced by the states. Where there are open issues in a state’s tax system, legal counsel can provide advice on what the seller should do or assist the seller in requesting a ruling by binding letter.
Access the latest episode of Today in Tax here: Digital Assets in M&As: Three Things Every Seller Should Know.