Non-Fungible Tokens (NFTs) have taken the markets by storm with their ease of transferability and proof of digital ownership. The differences between fungible and non-fungible assets are significant and help explain NFTs’ meteoric rise. Fungible assets such as cryptocurrency or commodities are easily exchanged for another asset of the same class. Conversely, non-fungible assets such as a work of art, song, speech, or tweet are not mutually interchangeable because of the distinctive features that make them each unique.
Ownership of a digital asset is authenticated via blockchain technology. The exclusivity and digital signature of an NFT stored on the blockchain has created a billion-dollar industry. Twitter founder Jack Dorsey sold his first tweet for $2.9 million, and a piece of digital art called “Beeple” sold for $69.3 million.
However, disruptive technologies are not without risk and require business vigilance in the form of cybersecurity protocols, procedures, and audits. Unfortunately, there are countless examples of fraud and cybercrime in the crypto space. One estimate of investor fraud using PlusToken was as high as $4 billion from more than two million investors.
Exploring the Benefits of Digital Assets
Businesses and artists are exploring digital assets and their potential uses. From a taxation standpoint, NFTs have consequences for both creators and investors. From a creator perspective, ordinary income tax (including self-employment tax) will apply on a sale; however, Internal Revenue Code (IRC) Section 162 allows for ordinary and business expenses to be claimed to offset such income. With proper guidance, creators can retain copyrights or structure the sale to continue to monetize and mine the asset creating an additional layer of potential future tax. With implementation and planning, there are avenues to utilize to minimize one’s tax burden.
NFT investors must approach the sale from both the buy and sale sides. The buy-side can have unintended tax consequences since the investment is purchased via cryptocurrency.
The sale of the NFT creates taxation that can be viewed as a capital asset or collectible. Whether considered as a collectible taxable under IRC Section 408(m)(2) taxed at 28 % or as a capital asset (preferential long-term rates), the surtax (Net Investment Income Tax) of 3.8 % should also be considered from a taxation perspective.
Soulbound (SBT) Emerges as New Cybersecurity Protection
“Soulbound” is derived from the popular game World of Warcraft (WOW). Experts predict its namesake technology could create an even more lucrative market than NFTs. “Soulbound” is a gaming terminology that cannot be transferred or sold to anyone once acquired. Essentially, soulbound is a direct contradiction to NFTs. In WOW, the purpose of soulbound is to keep the game challenging and prevent it from being traded or sold to another person. In the crypto space, soulbound tokens (SBTs) have a clear value and resolve and could be adapted to enhance current cybersecurity measures taken by firms to protect themselves.
The co-founder of Ethereum, Vitalik Buterin, believes that proposals to store sensitive information such as driver’s licenses, proof of age, or medical information, on an SBT (as opposed to an NFT) can provide greater confidence that the data is authentic and belonging to the proper individual. NFTs are routinely bought and sold and can be more vulnerable. The concept of SBTs is akin to the “proof of attendance protocol” (“POAP”) that is used to prove a person’s participation in some event.
If your business is considering using digital assets or disruptive technologies to strengthen your bottom line or improve your cybersecurity, Daszkal Bolton can help you evaluate the risk and tax consequences before you tokenize assets on a blockchain. Even if not on the blockchain, our cybersecurity team, DB Digital Advisors, understands the financial risks, measures, and strategizes to ensure your network is secure and, more importantly, that your business progresses without interruption.
Adam Korenfield is a Tax Managing Director at Daszkal Bolton with 20+years of experience in federal, international, and state income tax compliance. Roberto Valdez is a Director of Digital Advisory at Daszkal Bolton and certified in cybersecurity and information security.