By Julian Schubach – Head of Entertainment Division | VP, ODI Financial and Jacob T. Martin – Managing Attorney, JTM Tech Law
Shortly after joining the social media app Clubhouse I learned a few things but nothing stuck out to me quite as much as this: People are happy to put NFTs into the world and they love the idea of doing it with another complimentary creative, but there is an incredibly loose approach to doing so that pervades the space. Not only is collaboration a big part of creating and selling an NFT, it also leads to multiple major issues in the long term viability of the revenues generated off of the product.
Prior to getting into the details of thow the IRS views NFTs and collaborations, I feel the need to say this “NFTs are awesome. Working with your friends and other creatives… is awesome. But the idea of tying yourself, to another individual and an NFT, that has a single wallet address in PERPETUITY has never been done before. There are many major issues across the NFT marketplace platforms right now with royalties that fall off if the NFT is moved from one place to another, the simple inability to set up a “split royalty” between two wallets, and the lack of guidance from most marketplaces on how they intend to handle issuing 1099’s. That last part is also due to the lack of clarity on what platforms are centralized vs. decentralized or contain elements of both centralization and decentralization. This blog post also won’t cover important issues such as Know Your Customer (KYC) or Anti-Money Laundering (AML), but look out for more on those topics in the not so distant future.
Now after working with and talking to hundreds of artists, I’ve brought in Julian Schubach from ODI financial in New York to help write a piece on the details associated with taxation of cryptocurrencies as well as a simple walkthrough of how collaboration deals should be set up. His insight is one of an incredible financial advisor out of New York and he works primarily with entertainers. This topic is near and dear to both of our clients, and we hope you learn something useful along the way!
As of March 2021, The IRS states that for federal tax purposes, virtual currency is treated as property “if you exchange virtual currency held as a capital asset for other property, including for goods or for another virtual currency, you will recognize a capital gain or loss.”
Here is a practical example: in 2019, you purchased $50 worth of Bitcoin and held it as it appreciated to $500. If you then used the bitcoin to buy a pair of $500 sneakers, you would owe capital gains taxes on the $450 in profit you realized—even though it seems as if you spent the Bitcoin, rather than sold it. For the IRS, it is the same thing. Long term capital gains taxes range from 0%-20% based on your income.
The IRS is not playing games when it comes to taxes on crypto assets, adding a line item at the top of the 1040 Schedule 1 tax form which looks like this:
In 2019, the IRS sent letters to more than 10,000 taxpayers who failed to report crypto transactions and that number will continue to rise each year moving forward. The IRS also created ‘Publication 544’ which breaks down the rules surrounding the usage of property, detailing gain/loss calculations, gains category and treatment of gains.
NFTs
Sales of NFTs, or nonfungible tokens, have exploded in recent weeks, topping $500 million in 2021, according to nonfungible.com as of March 2021. As a practical example of taxation surrounding NFTs – John purchases $200 of Ethereum in 2018 and it has appreciated to $2,000 in 2021, which John then uses to purchase a $2,000 NFT. John would have to pay tax on the gain of $1,800 as part of the NFT purchase, since the act of exchanging the Ethereum for another asset counts as a sale or “disposition.” John would owe the IRS — assuming a top capital gains rate of 20% — a tax of $360. John may also owe state taxes, depending on his state’s tax laws regarding capital gains.
This scenario changes if John did not have any gains on his Ethereum. If he instead bought $2,000 of Ethereum and then immediately purchased the $2,000 NFT, he would not face any capital gains taxes on the purchase since the Ethereum did not go up in value before being disposed.
Two months after purchasing the NFT for $2,000, John flips the item on the secondary market for $4,000. He will be on the hook for a 28% capital gains tax on the $2,000 he made from the flip. The sale of NFTs for gain are taxed in the same manner as collectibles, which carry a higher capital gains tax rate.
Collaborations
One huge tax issue artists have overlooked is managing tax implications of collabs. Let’s say Jacob and I want to drop a collaborate NFT digital art collection - we design the items together, mint a collection on a curated marketplace and drop on April 1st, 2021. Who owns the wallet? Who is the creator of the minted NFT art? Who reports the sales and revenue to the IRS?
HERE IS WHAT MOST COLLABORATORS ARE DOING RIGHT NOW AND WHAT YOU SHOULD AVOID
Jacob and I have a handshake deal to split revenue 50/50 on the initial drop and secondary market transactions. Jacob links a wallet to the marketplace, we sell $1m at our primary drop. $1m in Ethereum is transferred to Jacob’s wallet and the following week, he transfers $500k to my wallet.
THERE ARE A FEW SERIOUS ISSUES HERE….
First, Jacob and I do not have a written, executed contract. Because the funds were transferred directly to Jacob, he can bail and ghost me. I end up with nothing. Good luck filing a lawsuit to recover the money!
Second, the primary sale funds went to Jacob’s personal wallet. We learned he will now have to report the $1mm proceeds as income to the IRS.
Third, the transfer of the asset may have greatly appreciated or depreciated in the week
since the proceeds were received by Jacob. How much does Jacob now have to pay Julian?
Fourth, how will Julian track secondary market sales and cash flow to Jacobs personal wallet?
NOW, HERE IS THE RIGHT WAY TO DROP A COLLAB COLLECTION.
Julian and Jacob draft a written contract, laying out terms of revenue sharing for primary and secondary sales. The contract is executed and notarized. Jacob and Julian then establish a business entity with their attorney and they each own 50% of the new company. That company has a Tax ID number and establishes a corporate Ethereum wallet. The cash flow into the corporate wallet is then re-directed to Julian and Jacob as per terms of the contract. Even though gas fees have to be accounted for in each distribution, this is a much better approach than simply receiving funds into a singular wallet and passing along without structure. Each year, the corporation files a tax return, which Julian and Jacob share in as 50/50 owners and each owner files a personal tax return which shows the outflow of funds to each of them. This allows for simple cash flow management in the present and the future.
If you are considering dropping a collab, be sure to work with an attorney and CPA who can help you establish a proper contract and entity, as well as provide tax management and oversight.
Corporate Wallets
US based corporations looking to invest in cryptocurrency/crypto assets must consider the potential tax implications. The act of purchasing cryptocurrencies with USD or another fiat currency is not a taxable event. Conversely, a taxable event does occur when cryptocurrency is sold for USD or another fiat currency. Additionally the transition of one cryptocurrency to another cryptocurrency is ALSO considered a taxable event. You might feel as though transitioning Bitcoin into Ethereum is just a simple transition, but the IRS views it as though whatever increase in Bitcoin you experienced you are now “selling” your gains and then “buying” another asset. Remember that the IRS treats cryptocurrency as property and the same taxes that apply to the sale of property applies to crypto.
The amount of tax a company is on the hook for regarding cryptocurrency transactions depends on the amount of gain or loss. A gain happens when a cryptocurrency is sold for more than it was purchased for (gain = sale price - cost basis). The cost basis is the amount you originally paid to acquire the cryptocurrency. If the cost basis is higher than the sale price, a loss is recognized.
As a brief note, Jacob Martin may be The NFT Attorney, but by way of reading this blog he is not your lawyer and Julian Schubach, although a wonderful advisor, is not your financial advisor. This is not legal or financial advice. But if you would like to learn more about the legal or financial implications mentioned herein do feel free to contact either one of us or both of us and we would be happy to learn more about your situation and provide services in our respective fields!
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