Non-fungible tokens: a fiduciary, tax and legal snapshot

Article 01 June 2022 Experience: Art

This article was originally published in Trust & Estates, April 2022 Art, Auction & Antique Special Report.

Given that the desire for non-fungible tokens (NFTs) is only getting stronger, and the prices only higher, it’s incumbent on fiduciaries to apprise themselves of the legal considerations that affect the ownership and disposition of NFTs. To the perplexed fiduciary or practitioner, we’ll provide an overview of: (1) the general nature of an NFT, (2) how fiduciary obligations are affected by the nature of and market for NFTs, (3) tax implications that arise on the sale or transfer of an NFT, and (4) security, fraud and other illicit activity concerns that arise in the NFT marketplace.

Introduction to NFTS

At its essence, an NFT is a digital token traded on a blockchain. NFTs are distinct from cryptocurrency because they’re “non-fungible” versus “fungible”— meaning NFTs aren’t exchangeable with each other for equal value. In terms of content, NFTs vary in type, ranging from tokens that relate to art, music and even sneakers. And by the day, innovators are coming up with even more creative ideas for what may constitute an NFT and how NFTs may be used. NFTs are traded on specialized NFT marketplaces, such as OpenSea and Nifty Gateway, which are platforms on which people link crypto wallets and exchange NFTs for the types of cryptocurrencies supported in the respective marketplace.1 In this sense, an NFT marketplace resembles an online marketplace like eBay or Amazon, where third parties offer goods that purchasers may buy and even resell using the payment types accepted in the specific marketplace.

Fiduciary Concern

Duty of care. As more and more Americans begin to collect and invest in NFTs, fiduciaries have begun to take a serious look at this new digital asset class. Fiduciaries owe a duty of care regarding the investment of trust assets. For example, for trustees, the specific standard of the duty of care differs based on the jurisdiction where the trust is created and on the terms of the trust instrument. However, as a general matter, trustees are typically restricted from making highly volatile investments, as doing so would create a great risk of depleting a trust’s assets. As the NFT market has experienced great volatility since its inception, a question arises as to whether a trustee would violate its duty of care by retaining or purchasing an NFT in a trust’s asset portfolio. Historically, when evaluating whether an asset’s degree of risk exceeds the type of risk permitted under an applicable standard of care, fiduciaries have reviewed critical financial variables such as volatility, security and fraud risks. We would expect the same approach to apply to a fiduciary’s assessment of digital assets like NFTs. However, a fiduciary should also consider how the availability of insurance, or lack thereof, affects NFTs’ holdings. NFTs are new and evolving, and insurers have been hesitant to provide insurance coverage for NFTs. On the cryptocurrency front, some insurers have even taken measures to specifically exclude coverage from a variety of policies. Given the novel market circumstances surrounding NFTs, a fiduciary might reasonably determine that retaining or purchasing an NFT, for which no insurance coverage may be obtained, would be in contravention of the fiduciary’s duty of care.

Administration. Even if fiduciaries determine that purchasing an NFT doesn’t meet the fiduciary’s duty of care, what do fiduciaries do when NFTs are already a part of the fiduciary’s portfolio? How do fiduciaries administer them? The legal profession has created a sophisticated apparatus to facilitate and ease the transfer of conventional assets during life and at death. Take, for example, the assignment of bank accounts between a decedent and the decedent’s trustees following death. Yet once digital assets like NFTs enter the picture, the once routine process of assigning assets to a trust or transferring title in a probate proceeding must suddenly contend with an opaque digital marketplace that, given its novelty, hasn’t yet adapted to the complexities of administration.

For example, once an owner of an NFT dies, it isn’t always clear how to transfer title to an NFT to the person who stands to inherit the NFT. NFT owners who wish to assign an NFT to a trust or make a gift of an NFT during their life may also twist themselves in digital circles trying to figure out proper documentation in such a way that tax authorities would recognize the transfer in an audit. Alas, cryptocurrencies and NFTs don’t have deeds or certificates in a conventional sense, and crypto wallets don’t have names that may be changed. Fortunately, the 2015 Revised Uniform Fiduciary Access to Digital Assets Act, which most states have enacted,2 enables a holder of a digital account to direct a provider of the digital account to hand over control of the account to a fiduciary or other designee.3 Fiduciaries may rely on this statute where available, so it’s conceivable that the statute could be used for NFT transfers. But to be sure, owners who wish to transfer ownership of an NFT should be careful to share the password to the crypto wallet that holds the NFT. In the case of a transfer at death, the owner may provide the crypto wallet password to a trusted fiduciary in advance or keep the password in a safe or lockbox. In the case of a lifetime transfer, the owner should share the password to the crypto wallet at the time of transfer and be sure that the transferee changes the password so that the owner isn’t deemed to retain dominion and control over the NFT.4

Tax Consequences

Though the Internal Revenue Service hasn’t yet put forth any regulations or guidance outlining the tax treatment of transactions involving NFTs, various practitioners have begun to consider how NFT transactions fit within existing federal and state tax frameworks.5 As a preliminary step, it’s important to note that the IRS has issued guidance deeming the exchange of cryptocurrencies as a recognition event, for which a U.S. taxpayer must pay a capital gains tax to the extent of any gain over the taxpayer’s cost basis in the cryptocurrency when purchased.6 Thus, if a purchaser of an NFT acquires the NFT using a token of cryptocurrency that’s increased in value since the purchaser initially acquired such token, the purchase of the NFT would make the purchaser liable for capital gains tax on the gain realized in the underlying cryptocurrency token. The seller of an NFT would then owe taxes on the sale. Precisely which taxes apply isn’t certain in the absence of express guidance from the IRS; however, like cryptocurrency, NFTs are likely to be deemed capital assets under Section 1221 of the Internal Revenue Code of 1986 (as amended), for which the gains of any sale would be subject to capital gains tax.

But buying and selling aren’t the only uses people have for NFTs. Some philanthropists have deemed that NFTs could be of use in charitable causes, and some museums and charities have begun to accept NFTs as gifts and used NFTs for fundraising purposes.7 Gifting an NFT to a charitable organization isn’t as straightforward as simply donating the proceeds of an NFT sale. For one, NFTs are difficult assets to appraise, meaning that the charitable deduction available for a gift of an NFT may not always be readily apparent. There’s typically no easily ascertainable comparable market for an NFT, despite the existence of multiple NFT marketplaces. NFTs also may fluctuate greatly in value, in part due to the volatile swings in the values of different cryptocurrencies. There’s also a lack of express guidance on the type of asset an NFT comprises for tax purposes, which could impact how an NFT is valued for purposes of calculating the applicable charitable deduction.

Security and Fraud Concerns

Hacking of cryptocurrency wallets for NFTs has made countless headlines and presents a significant problem for owners of high value NFTs. For instance, hackers recently stole an NFT collection last year with an estimated value of $2.2 million, which the collector reported to the world via tweet.8 And theft of NFTs by phishing attempts and by exploiting bugs in NFT marketplaces has become widespread.9 Relatedly, some NFT owners have also been locked out of their accounts entirely simply by forgetting the password to access their crypto wallet.10

Fraud is another major security concern on the NFT market. A great many NFT creators have masqueraded as prominent contemporary artists to sell NFTs for high prices.11 Though artists are unable to track every fraudulent NFT given the sheer volume of fakes and the lack of any central regulation, artists have been able to push back and take certain fakes off the marketplace. But artists have expressed frustration with a lack of responsiveness in taking down fraudulent NFTs that are flagged, and with the even larger issue that the onus is on the artist to pursue enforcement even though most artists don’t have the resources to monitor all NFT appropriations. One area in which fraudulent NFTs have received considerable pushback is in the use of corporate property. Certain companies have been aggressive in litigating alleged trademark infringement of logos and company products, apparent in recent litigation involving Nike12 and Hermes.13 The case filed by Nike concerned NFTs that were created by a company and depicted Nike shoes owned by the company. Nike alleges that the NFTs are likely to dilute the market for their shoes and cause confusion over the NFTs’ association with the Nike company. Similarly, Hermes’ case involves an NFT depicting multiple Birkin bags, an iconic type of handbag invented by the company decades ago.14 The defendant in the lawsuit created digital representations of the handbag in varying color schemes, minted the images as NFTs and sold them on the OpenSea platform for tens to hundreds of thousands of dollars.15 Hermes has alleged that the defendant’s unauthorized use and profiteering off of the NFTs constitutes trademark infringement, while the defendant has responded that the NFTs are art that comments on the designer bag.16 Though the outcomes of both lawsuits are yet to be determined, they serve as bellwethers of a litigious future for the wild west that is the NFT marketplace.

Lastly, we note that NFTs have the potential to be used for money laundering purposes. A 2021 report from the blockchain data company Chainanalysis estimated at least $8.6 billion had been laundered across all cryptocurrency exchanges.17 It further found that NFTs were being used to funnel at least $1.4 million worth of cryptocurrency to illicit parties in 2021.18

NFTs present a new landscape of digital property for practitioners and fiduciaries to plan for—they’ll certainly provide new challenges for administration and transfer that will keep all of us on our toes.

[1] See www.wired.com/story/how-to-choose-set-up-crypto-wallet/.
[2] Stacy E. Singer and Fredrick B. Weber, Keep Up-to-Date With Digital Responsibilities, WealthManagement.com (April 20, 2021), www.wealthmanagement.com/print/134870.
[3] See 2015 Revised Uniform Fiduciary Access to Digital Assets Act, Sections 1 and 4.
[4] See 26 CFR Section 25.2511-2.
[5] www.forbes.com/sites/matthewerskine/2022/01/19/the-income-taxationof-creators-investors-dealers-and-collectors-of-nfts/?sh=159468adf600.
[6] Internal Revenue Service, Notice 2014-21, www.irs.gov/pub/irs-drop/n-14-21.pdf.
[7] www.councilofnonprofits.org/thought-leadership/fundraisers-turn-theirsights-non-fungible-tokens.
[8] www.vice.com/en/article/5dg5xq/nft-collector-iloveponzi-loses-valuableape-nfts-to-hackers-is-upset.
[9] www.theverge.com/2022/2/20/22943228/opensea-phishing-hack-smartcontract-bug-stolen-nft.
[10] www.nytimes.com/2021/01/12/technology/bitcoin-passwords-walletsfortunes.html.
[11] www.theverge.com/22905295/counterfeit-nft-artist-ripoffs-openseadeviantart.
[12] www.wsj.com/articles/nike-accuses-stockx-of-trademark-infringement-insales-of-nfts-11644001287.
[13] https://news.artnet.com/art-world/hermes-metabirkins-2063954.
[14] See www.hermes.com/us/en/story/106191-birkin/.
[15] https://news.artnet.com/art-world/hermes-metabirkins-2063954.
[16] Ibid.
[17] “https://blog.chainalysis.com/reports/2022-crypto-crime-report-preview-cryptocurrency-money-laundering/”:“https://blog.chainalysis.com/reports/2022-crypto-crime-report-preview-cryptocurrency-money-laundering/.
[18]” https://blog.chainalysis.com/reports/2022-crypto-crime-report-previewnft-wash-trading-money-laundering/”:https://blog.chainalysis.com/reports/2022-crypto-crime-report-preview-nft-wash-trading-money-laundering/.