Through the Looking Glass: Will a Look-Through Rule for Taxing NFTs Clarify or Further Distort?

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In a recent article, we observed that the Treasury and the Internal Revenue Service (“IRS”) could address the complex tax issues presented by emerging digital assets either by developing a cohesive framework for taxing these unique assets or by attempting to shoehorn them into existing legal constructs. The recent IRS announcement that it intends to classify some nonfungible tokens (“NFTs”) as “collectibles” for tax purposes indicates its continued inclination toward the latter approach. See Notice 2023-27 (the “Notice”). 

NFTs are digital identifiers typically used to certify ownership of distinct rights or assets (either physical or digital) where such ownership is recorded on a distributed ledger. Like units of a cryptocurrency, an NFT represents a distinct and transferable digital asset. However, unlike units of traditional cryptocurrency (whose value is fungible and typically untethered to any other asset), an NFT is nonfungible and its value is tied to the value of the underlying right or asset with which an NFT is associated. The close relationship of an NFT with its underlying right and/or asset raises the question of precisely how the NFT should be differentiated, if at all, from its underlying right or asset for tax purposes.

The Notice announces the IRS’s and Treasury’s intention to issue guidance that treats certain NFTs as “collectibles” under Section 408(m) of the Internal Revenue Code. Collectibles (e.g., works of art, antiques, gems, etc.) are subject to specific federal income tax rules, namely, increased long-term capital gains rates of 28% as well as restrictions on acquisitions of collectibles by individual retirement accounts (i.e., treating the transaction as a deemed distribution of money to the taxpayer equal to the cost of the collectible and possibly subject to a 10% early withdrawal penalty). 

While the Notice asks for comments regarding the shape and scope of its intended guidance, in the interim the Notice states that the IRS will utilize a look-through approach to determine if an NFT constitutes a collectible. Thus, if the underlying right and/or asset would constitute a collectible, then the NFT itself will constitute a collectible. While it may seem intuitive that merely tokenizing a collectible using an NFT should not allow a taxpayer to escape collectible treatment for the underlying asset, it is unclear whether applying a traditional look-through rule to NFTs is the best approach. In particular, the Notice offers no indication of whether a look-through approach would be applied more broadly or be limited to the collectibles context. A broadly applied look-through approach could have wide-ranging implications for the nature and source of income generated by an NFT as well as for tax rules that key off the status of the owner of an underlying asset. For example, if a broad look-through approach is applied to an NFT with securities as underlying assets, an NFT holder that is otherwise a dealer in securities could be subject to the mark-to-market rules on its NFT.

Applying look-through concepts could be particularly difficult where the NFT certifies ownership of multiple rights and/or assets or conveys only limited or proportionate rights in assets, such as where an NFT has been created with dual purposes. For example, a single NFT might facilitate a customer reward program by both tracking participation in the program as well as digital or physical rewards elected to be received under the program. In this regard, Starbucks is currently testing this type of unique NFT usage with its Odyssey Rewards Program, which allows users to both collect points that can be redeemed for “immersive coffee experiences” as well as purchase “coffee themed artwork,” which artwork can be bought or sold through a marketplace to other users. Arguably the coffee themed artwork could constitute a collectible for tax purposes, although the remaining rights associated with the coffee rewards would not appear to be collectibles. Whether merely applying existing tax law concepts (like a look-through rule) will be flexible enough to fit these unique NFT uses remains to be seen. 

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