Hot as a Recalled MacBook Battery

The non-fungible token market has become as hot as a recalled MacBook lithium battery (if that’s possible). You’ve probably seen the figures: digital artist Beeple sold an NFT for a remarkable $69 million; a LeBron James non-fungible dunk clip lasting ten seconds went for $200,000; Jack Dorsey’s first tweet was auctioned for $2.9 million (though shortly after the sale, the tweet’s value plummeted 99% at a subsequent auction).

Various funds and exchanges now tally NFT transactions in the hundreds of millions of dollars.

The lucky beneficiaries of the market have surely taken into consideration federal taxes. But if they are nonresidents of California, they may not be thinking of how California might treat NFTs for tax purposes. Specifically, depending on the location of the buyer and the status of the seller, the income from NFT sales might be sourced to California, making it subject to California income tax. Oddly, in that case, due to favorable federal capital gains treatment of NFTs, it’s even possible that the California income tax might be higher than the federal tax. To add further complexity, NFTs are almost exclusively sold in exchange for cryptocurrency, adding cryptocurrency tax issues on top of the transaction.

What is an NFT?

People are used to non-fungible assets in the analog world: Action Comics #1 (the first Superman comic book), a stretch of beachfront real estate, the Mona Lisa. You might be able to copy these assets one way or another, but only the original has value. A snapshot of the Mona Lisa or a video of a beach house isn’t worth much. Hence, the non-fungible designation.

In contrast, media on the internet has always been susceptible to unlimited reproduction (whether in violation of copyright or not) without much loss in value. A copy of a YouTube video of Milli Vanilli has pretty much the same value, or lack thereof, as the original. Then came blockchain. The same public-ledger technology that authenticates bitcoin transactions can be used to validate the original digital file of a work of online art, or the NBA’s official slam-dunk competition clips, or Jack’s first, fateful tweet. Blockchain transformed digital media that could be infinitely reproduced with no significant diminishment of value, into a class of assets, like comic books or baseball cards, that could never be copied without a total loss of value. You can still copy an online version of an NFT as a screenshot or other facsimile. But the result is equivalent to a photo of the Mona Lisa.To summarize. The “token” part of NFTs refers to the fact that they are digital files with a key attribute: they are one of a kind. The “non-fungible” part refers to the fact that, like cryptocurrency, they are authenticated by a blockchain public ledger, and can’t be replicated. And like crypto, that means NFTs are intangible personal property, analogous to marketable securities, business goodwill, and patents.

NFTs and California-Source Income

In common with cryptocurrency, NFTs are taxed as intangible assets. See this article on how California sources bitcoin. The tax treatment is relatively easy to determine for federal purposes. For residents of California, it’s also unequivocal. The rule is California imposes an income tax on all the taxable income of residents, regardless of the source of that income. If a California resident sells an NFT for a profit, the income is subject to California taxes. It’s no different from a resident selling appreciated stock (though determining the basis might be trickier in some cases).

But there’s a corollary to that rule, which isn’t so easily parsed. California does not impose income taxes on the income of nonresidents, unless the income is sourced to California. This begs the question of whether an NFT sale can be sourced to California.

The short answer is yes. But it depends on whether the seller is investing in NFTs on his own account or is in the business of trading digital assets, and whether the buyer is a resident or has a business situs in California.

Let’s review each of these situations in order.

NFT Sales by Investors Not Engaged in Trade or Business

As with cryptocurrency, some owners of NFTs may occasionally invest on their own account and others may be engaged in the trade or business of buying and selling NFTs.

For nonresidents who are not in the business of NFTs, sourcing the proceeds of the sale for California income tax purpose falls under two rules. Let’s call them the old rule and the new rule.

Under the old rule, the proceeds of the sale of an intangible asset are not subject to California income taxes, regardless of who the buyer is, if the seller is a nonresident. The concept is, intangible assets don’t have a situs in California (unlike real estate or inventory kept in state). Rather, intangible assets fall under the legal principle of mobile sequuntur personam – that is, “movables follow the person.” NFTs, being intangible, have the same situs as the person who owns them. Accordingly, a nonresident’s NFTs have no situs in California.

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The reasonable conclusion is, under the new rule, NFT sales will produce California-source income to the extent the NFT is “used” in California

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Now, it’s possible for intangibles to gain a situs in California under rare circumstances. It involves pledging the intangible for a loan, and using the proceeds for an investment in California. In over twenty years of practice focused exclusively on California residency tax planning, I have never seen a case where an intangible acquired a California situs.

The consequence of the old rule is that residents who developed successful business in California could change residency (usually to a zero-income-tax state for obvious reasons), sell their business interest for a large profit (entity interests are intangible), and own no income taxes to California. It a tried-and-true tax strategy that’s been used for almost a century.

That’s the old rule. The new rule is not as forgiving. In 2017, the Franchise Tax Board, California’s tax enforcement agency, got fed up with mobile sequuntur personam. Accordingly, it adopted a regulation (CCR § 25136-2), which imposes income taxes on the net profit from the sale of intangible personal property based on various formulas. The formulas allocate a portion of the profit to California using various factors. For intangible property other than business interests (that is, stock, LLC memberships, partnerships, etc.), the formula involves “use” of the intangible property in California. The FTB had in mind intellectual property like patents, copyrights, trademarks, broadcast rights. But the regulation doesn’t limit itself to the listed intangibles, and specifically includes “other similar intangible assets.” Arguably, NFTs fall into this category.

The reasonable conclusion is, under the new rule, NFT sales will produce California-source income to the extent the NFT is “used” in California. That might mean, that if the buyer is a California resident and is collecting the NFTs for personal use (as a collectible or for future sale), the entire use is situated in California, and all the income is allocated to the state. It might mean that if the NFT is used for marketing or other broader business purposes, only a portion of the proceeds would be allocated to California. And of course, there are circumstances where there is no California allocation. But in whatever manner the allocation is actually carried out, what is apparent is that the FTB could use the regulation to impose an income tax on a nonresident selling an NFT in situations where it will be used in California.

It should be noted the validity of CCR § 25136-2 as a whole is disputable. Regulations are not statutory law, but merely the rules of the implementing agency, in this case, the FTB. The regulation appears to contradict the old law on its face, which is ingrained in case law, statutory law and other regulations. In our practice (which focuses exclusively on California residency and sourcing issues), I am unaware of the FTB enforcing the regulation at all or even citing it in an audit. It has never been referred to in appellate decision or FTB Chief Counsel Ruling. There are no current cases reviewing it. Accordingly, it is quite possible the regulation violates California law, if not the Commerce Clause. That said, it is an adopted regulation, entitled to deference by a court, and is enforceable if the FTB chooses to apply it.

NFT Sales in a Trade or Business

The potential of NFTs hasn’t been lost on entrepreneurs, and there are now funds that invest in the asset. Presumably, there are also nonresidents in the trade or business of intangible assets who have added NFTs to their inventory. In those cases, other sourcing rules apply.

If the seller is in the trade or business of buying and selling intangible assets, including NFTs, and they make a sale to a buyer who is a resident of California or is a business with a California situs, the seller is arguably doing business in California. Sellers who do business in California are subject to California income taxes to the extent that revenues are sourced to the state. A different set of regulations determine what constitutes doing business in California, and the distinctions can get byzantine. But on its face, a sale of this type would appear to constitute a California sale, subject to California income taxes.

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Given the explosion of the NFT market (assuming it doesn’t collapse like the tulip mania or Armie Hammer’s acting career), expect the FTB to adopt new regulations

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The NFT Capital Gains Conundrum

Typically, federal income taxes are substantially higher than California income taxes. But NFTs, like other intangible assets, can turn the graph on its head. For federal purposes, NFT sales will clearly fall under capital gains treatment, with the holding period determining whether the gains or long- or short-term. But California doesn’t have a capital gains category for income. It treats all income as ordinary. This can lead to odd results. For example, if a married couple with income at or under $80,000 sold an NFT, there would be zero long-term capital gains imposed by the IRS. But California would impose its ordinary income tax rate, which could be 6% in this case. The actual taxes in the lower brackets aren’t substantial. However, it is sobering to keep in mind that California’s 13.3% rate is imposed on income over $1 million. For long-term capital gains on NFT sales of that magnitude, it results in a total tax of 33.3% on the sale, once you include the top federal rate. For non-traders in the top bracket, they may also be subject to the “collectibles penalty” of IRC § 408(m)(2), which imposes an additional 8% at the federal level, for a total state and federal tax of 41.3%.

Finally, note that if the investor purchased the NFT with cryptocurrency, which is almost always the case, there may have been an additional tax in the chain of this transaction. If the cryptocurrency had appreciated from the time the purchaser-investor obtained it, the IRS would have imposed a tax on the appreciated value of the crypto. It’s unlikely California would have done so, because crytocurrency is rarely sourced, but it’s possible. This adds an additional layer of required tax analysis for those in the business of buying and selling NFTs.

Our Thought Bubble

While the old rule still applies, it’s unclear whether the new rule is being enforced or even whether it is enforceable. Given the explosion of the NFT market (assuming it doesn’t collapse like the tulip mania or Armie Hammer’s acting career), expect the FTB to adopt new regulations or revise the old ones, to directly address NFTs. It will probably involve a maximalist approach.

 

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Manes Law is the premier law firm focusing exclusively on comprehensive, start-to-finish California residency tax planning. With over 25 years of experience, we assist a clientele of successful innovators and investors, including founders exiting startups through IPOs or M&As, professional athletes and actors, businesses moving out of state, crypto-asset traders and investors, and global citizens who are able to live, work, and retire wherever they want. Learn more about our services at our website: www.calresidencytaxattorney.com.

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