Crypto assets represent a fast-moving asset class, and nonfungible tokens (NFT) are an especially fast-growing subset of that class, which have attracted outsized attention in the press and markets. With such growth comes a plethora of questions about such assets—how to report them, how to value them, and how they are to be taxed. This article is a starting point for further discussion between CPAs and those individuals and institutions involved in the NFT space. Although the answers to many questions may still be uncertain, there is a great need for advice and guidance.
Though Bitcoin once grabbed all the crypto headlines, recent years have seen a surge in alternative cryptocurrencies like Dogecoin and digital assets like nonfungible tokens (NFT). Led by the $69.3 million fetched by the NFT Everydays: The First 5000 Days by Beeple, NFTs became the “hot” digital asset of 2021 (https://yhoo.it/3pP2OWP). This rapid ascent also brought many questions about their risks as the crypto market chilled in the winter of 2022, which also extended to NFT prices. That said, and expanded upon below, the potential for NFT extends far beyond simple price speculation.
Crypto assets generally—and NFTs specifically—present a variety of considerations for the accounting profession. The absence of widely applicable crypto-specific authoritative accounting standards, sporadic and increasingly antagonistic engagement by regulators, and widespread confusion about these assets mean that CPAs and investors alike have many questions.
In this article, the authors provide a primer on NFTs for CPAs, covering what NFTs are and what the future holds for them; the current views of financial reporting treatment for NFTs; tax considerations for NFT holders; and other considerations that warrant proactive discussions with clients.
What Are NFTs?
To understand the implications of NFTs for CPAs, it is first important to get a feel for what they are. NFTs represent a particular class of digital assets stored on a blockchain. In some ways, they can be viewed as a unique incarnation of cryptocurrencies, with aspects that can both simplify and complicate the accounting conversation. Typical cryptocurrencies are designed to be plentiful and interchangeable; NFTs are, in contrast, designed to be unique (or at least limited in number). Intuitively, crypto-currencies can be viewed as analogous to currencies (or stocks) in that they are publicly available, divisible, and exchangeable. NFTs, on the other hand, share characteristics of art, trading cards, or other unique collectibles whose value is both subjective and inherently tied to their scarcity.
In many respects, NFTs emerged as a way to generate scarcity and mimic the ownership of assets that are otherwise ubiquitous, like digital artwork. Unlike traditional art, a piece of digital art can be costlessly and indistinguishably replicated; an NFT that is uniquely tied to the piece of original art cannot. This can explain why art emerged as a particularly valuable early domain for NFTs. Digitizing ownership—even if symbolically—of assets of any kind is a key role that NFTs stand positioned to play (see “NFTs, explained,” https://bit.ly/46TcFLF).
A caveat to this digitization, however, is the reality that the specifics of ownership are often misunderstood. The distinction between ownership of the NFT (the token) itself, and the ownership rights to the underlying asset is a primary issue: simply because an investor owns an NFT and a token has been minted, it does not necessarily convey any ownership or control over the underlying asset.
Ownership questions also naturally bring concerns of theft, a problem that is magnified for digital assets. Along with problems come new solutions. One such solution goes by the name of Trusted Execution Environment (TEE), which is an environment that allows NFT creators to execute code in a secure environment as well as providing a location to store NFT-specific information in either a cloud or cold storage solution. NFT markets (e.g., Casper Networks) have already started to implement these kinds of solutions, with others currently under development. Stated another way, solutions such as TEEs provide a viable, albeit emerging, solution to the very real problem of NFT fraud and theft.
As NFTs have ballooned in popularity, their potential uses too have expanded, from ways of holding brand value to social networking and club memberships (see “The Top 5 Brand NFTs You Need to Know About Right Now,” Parker Herren, https://bit.ly/3pXvKvB). Leveraging the key traits of uniqueness and differentiated status is enabling NFTs to move beyond early use cases to a wider array of uses.
The Future of NFTs
Virtual artwork and digital collectibles may have seized the bulk of initial dialogue and commentary in this NFT realm, but they represent only one small part of the broader conversation. There are several other emerging use cases for NFTs, all of which raise accounting questions.
Virtual real estate.
Highlighted by several high-profile purchases by institutional investors and organizations, virtual real estate continues to move from abstract idea to market reality. Underscored by Decentraland, blockchain secured virtual real estate is a fast-growing sector with concerts, holiday gatherings, corporate meetings, and even mortgages being held virtually (“Metaverse mortgages are being issued to buy virtual land — and one of the first ever was just signed for a property in Decentraland,” Phil Rosen, Feb. 1, 2022, https://bit.ly/44rWof7). Cryptoasset manager Grayscale estimates that this kind of virtual real estate may ultimately represent an asset class worth in excess of $1 trillion.
With the enormous potential value held in virtual environments, the natural question is: how will this virtual real estate be purchased and verified? At their core, NFTs are a blockchain-secured record of tokenized control associated with assets, which can either be physical or digital in nature. These assets can include artwork, collectibles or digital real estate; the implications are the same.
Streaming content and gaming.
The January 2022 purchase of Activision for nearly $70 billion by Microsoft (a purchase that appears to be moving forward as of July 2023 after hitting anti-trust obstacles initially), which itself has exceeded a market capitalization of $2 trillion at various points since 2021, should be a wake-up call for the financial magnitude of gaming. Video games, streaming games, e-sports, and other forms of online content creation might strike some as an unimportant. But the global online gaming marketplace is forecasted to be worth nearly $100 billion by 2023; with approximately two-thirds of U.S. adults playing video games, the market seems poised for continued growth (https://bit.ly/44Yyub1).
What brings together NFTs and online gaming? It seems straightforward that digital currencies—including stablecoins that are centralized, have safeguards to protect users and investors, and increasingly the primary way regulators and enterprises utilize crypto for transactions—make sense as the medium through which items are purchased in a virtual gaming environment (https://bit.ly/46WdeVm, https://bit.ly/3pQKYTl). Building on this, an important component of many online gaming experiences is the purchase or upgrading of a digital avatar or other assets. NFTs can, reinforced by both the initial price and marketplace within the gaming ecosystem, be valued in a more simplified manner. With video game makers actively investing in these opportunities, gaming NFTs represent a potentially lucrative new market (“Why Video Game Makers See Huge Potential In Blockchain—And Why Problems Loom For Their New NFTs,” Justin Birnbaum, Forbes, https://bit.ly/3K3YFoL). Gamers are increasingly seeking to monetize gaming activities, but have traditionally not recognized the fact that their virtual tokens, trophies, and assets still belong to the gaming organizations. With the global gaming industry, particularly the streaming segment, representing a multi-billion dollar industry, market participants are looking for a solution to help cement control. Although the concepts of virtual assets, digital assets, or gamification are not new in and of themselves, two points distinguish the integration of NFTs into gaming from other previous trends. First is the direct connection of NFTs and other NFT-related information to an underlying blockchain, enabling security that was not previously available. Second are the active efforts underway to crack down—and potentially eliminate—fraud and other unethical activities connected to gaming NFTs.
Rounding out the conversation around other virtual use cases for NFTs is the concept of the “metaverse.” Moving beyond online gaming or virtual real estate, the metaverse is increasingly seen as the future of how many interactions will take place. Such pronouncements might strike some professionals as fanciful, but with Prager Metis opening an office in Decentraland in 2022, the themes of virtual and digital asset ownership are converging rapidly in ways that many investors and businesses cannot escape (“Prager Metis Opens First-Ever CPA Firm in the Metaverse,” Glenn L. Friedman, Jerry Eitel, Brian Goldblatt, Jan. 7, 2022, https://bit.ly/3XUZDth). Even with the fallout from the collapse of FTX causing some legal issues for Prager Metis and other CPA firms closely connected to the crypto sector, the trend of offering and building out cryptoasset services continues largely unabated. One example of how accounting firms are continuing to play a role in this expansion is the partnership between EY and a branch of the Norwegian government to open an office to streamline the processing of certain government registers (“Norwegian gov’t agency opens metaverse office in collaboration with EY,” Savannah Fortis, October 26, 2022, https://tinyurl.com/3vujywxa.)
The entire concept of the metaverse, virtual reality, or augmented reality interactions are all dependent—at least to a partial extent—on an immutable, traceable, and publicly verifiable digital record of ownership. More than that, this record needs to have a transparent valuation that can be updated to reflect ongoing investments, additional purchases, and changes in the ecosystem at large. NFTs provide an instrument to track and provide that information on a continuous, transparent, and accessible basis.
Financial Reporting for NFTs
When individuals or businesses hold, create, or trade NFTs, the question naturally arises regarding how to treat NFT transactions for financial reporting purposes. Although NFTs are distinct from Bitcoin and other cryptocurrencies, they do share some common characteristics with other digital assets: NFTs bring potentially large financial value along with substantial volatility without being a tangible, consumable asset. Once again, it is important for all parties involved to understand the distinction between control over the NFT (the token), and any affiliated underlying asset itself. These characteristics together highlight the difficult accounting questions that arise when NFTs are held as assets.
Before highlighting the unique accounting questions presented by NFTs, consider the accounting questions presented by digital assets more broadly. Most notably, digital assets currently have no specific authoritative guidance for financial reporting purposes, though practice has largely converged on a consensus, with codified standards expected by the end of 2023. In the first crypto boom in 2017, some asset holders treated them as they would investment assets and marked them to market accordingly. In the case of the Silicon Valley Community Foundation, this treatment yielded billions of unrealized gains in the wake of the boom (“Cryptocurrency may explain Silicon Valley Community Foundation’s mysterious asset surge,” Kathleen Pender, San Francisco Chronicle, Aug. 1, 2018, https://bit.ly/3NRccBa). Since the subsequent crash in values in 2018, a consensus emerged on a more conservative reporting approach, treating cryptoassets not as financial assets or currencies but instead intangible assets (“Bitcoin Holdings: Why Tax and Accounting Matter,” Wall Street Journal, March 18, 2021, https://bit.ly/3Q8TiZr). The logic is that because cryptoassets are not typically legal tender financial markets, they cannot be treated as currencies; because they are not cash or a right to receive cash or another financial instrument (with some exceptions), they cannot be viewed as financial assets. Following this process of elimination leaves intangible assets as the logical conclusion.
The treatment of indefinitely lived intangible assets generally necessitates initially recording cryptoassets at cost if purchased or fair value if received in an exchange transaction. Then, in subsequent periods, the asset is not generally marked to its market value but instead kept at its acquisition value (i.e., historical cost). The assets are thenceforth subject to evaluation for impairment and subsequent markdown in the event value is impaired. What triggers such impairment evaluations, how frequently to assess impairment, whether impairment is on an asset-by-asset basis or can be determined at a portfolio level, and how to determine such values in assessments are important questions whose answers vary depending upon circumstances (https://bit.ly/3Ov17Yd).
Given the scale and scope of digital assets and the open questions about their treatment, the topic has made its way onto FASB’s research agenda. This may indicate that the board recognizes the issues presented by recording, such as a volatile asset class at cost rather than mark-to-market. With estimates placing the proposed FASB rule, set to allow mark-to-market accounting for a handful of cryptoassets, the possibility of NFT-specific reporting cannot be entirely discounted.
Though authoritative guidance remains on the horizon, the AICPA Practice Aid, Accounting for and Auditing of Digital Assets, spells out many of the issues that arise in accounting for digital assets. NFTs represent a particular class of such assets, and their unique nature magnifies several of the accounting difficulties. Unlike cryptocurrencies, NFTs are not readily exchangeable for one another (by design), so valuation or impairment assessments become particularly difficult. And while most cryptocurrencies trade on exchanges akin to public stock exchanges, yielding regular valuation benchmarks, NFTs are perhaps best viewed as analogous to art, real estate, or other unique and differentiated assets—items whose value is not readily identified outside of a sale. As such, the valuation aspect, either the initial asset recognition of gifted NFTs or the determination of impairment of held NFTs, is especially challenging.
As NFTs continue to migrate from a niche cryptoasset application to a mainstream asset class utilized by musicians, athletes and corporations alike, determining the correct valuation methodology will be increasingly important. One additional factor is that while athletes, artists, and musicians might be among the first individuals to dabble with NFTs, they are just the beginning of the adoption curve. As NFTs that represent or are connected to physical assets become more commonplace, the potential for leveraging them to track inventory or other physical goods will become more mainstream and create a new set of accounting-related questions.
The first factor to be considered is that there are existing accounting guidelines and standards that can be leveraged in assessing fair value or impairment–specifically, ASC Topic 820. Level 1, 2, and 3 valuation guidelines are already utilized for assets that are more or less liquid or actively traded. To that end, it would make sense to apply a similar methodology when attempting to value the NFT marketplace, which consists of thousands of newly created assets. An additional factor that should be taken into account is the process by which the valuations of different NFTs are going to be determined. While there are some exchanges and platforms that host NFTs that are liquid or widely traded, and whose fair market value is readily determinable, that is not the case for every single NFT in the marketplace. Though the assets themselves might be new, that does not mean that the process to evaluate variation across exchanges or marketplaces needs to be reinvented. An additional consideration when attempting to accurately and consistently value NFTs is the matter of establishing ownership and control over the NFT in a comparable manner. For example, an individual or institution can create a new crypto wallet in a matter of seconds, which can then be used as a cut-out or other mechanism to obfuscate the record of ownership.
Another financial consideration for NFTs that is not present with cryptocurrencies is the potential for resale royalties. Many NFTs are built with “smart contracts” that permit creators to receive royalties every time an NFT is subsequently sold. These smart contracts give creators an opportunity to receive benefits every time an NFT changes hands and not just with its initial sale (https://bit.ly/44IfGwG). Such creator royalties make the valuation of NFTs even more difficult when they are held by the creator. It is no longer a matter of estimating just an initial sale price, but an estimate of future sales frequency and values to determine; not just the exit value of the NFT, but also the future royalties it will secure.
A related question in the accounting for NFTs as intangible assets is what would warrant recognition of impairment. This has already generated vastly different approaches in the context of cryptocurrencies in that some organizations are testing for impairment only quarterly (or whatever their reporting frequency), whereas others opt for continuous impairment tests, essentially reporting the asset value as its historical low (https://bit.ly/3Ov17Yd). For holders of NFTs, this question leads to more uncertainty. Because the value of an NFT is not tied to an underlying asset with discernable value or revenue stream, it is best viewed as an asset whose financial value comes from the cash it can generate upon sale. Absent a liquid market for the asset, it is unclear what triggers impairment beyond a downturn in the asset class generally. As a result, the decline in an NFT’s value might not materialize until the asset is sold, which runs counter to the intent behind intangible asset treatment.
Additional Reporting Considerations
Impairment assessment raises a more fundamental question about the nature of NFT assets, namely intent: For what purpose will an individual or entity hold an NFT in its pool of assets? Is the intent financial gain, or something else? If the intent is financial gain, the above discussion highlights the difficulties in determining value at any point in time. These difficulties mirror those of other illiquid assets, though the less tangible underlying value and necessity of impairment tests mean they are particularly volatile to hold on a balance sheet.
This also leads to the following issue: What additional information should be reported within the financial statements of an organization which buys, sells, or holds NFTs? Balance sheet treatment gets the most attention, but additional disclosures can represent challenges and opportunities for practitioners. CPAs will not always have definitive answers to these questions, simply because there is so little authoritative guidance, but they need to be aware of them, which include the following:
- ▪ Does the integration of NFTs and related cryptoassets onto the balance sheet increase the operational risk profile of the organization, including insurance, risk concentration, and liquidity?
- ▪ If stablecoins are utilized to mitigate volatility in the purchase or disposition of NFTs, is there appropriate disclosure around the functionality of the stablecoins themselves, including reserve and redemption processes?
- ▪ Depending upon the blockchain that houses the NFTs, are there climate or other sustainability factors that should be reported? This is an especially pertinent consideration for public companies.
- ▪ Should fair market valuation also be disclosed in the footnotes when NFTs, or other cryptoassets are reported at cost less impairment losses?
- ▪ Should the criteria by which impairment losses are determined also be disclosed in the footnotes? Especially because NFTs are unique and distinct assets, the impairment process and amount need to be reported transparently for readers to track how valuations might have changed.
Although CPAs must be aware of the financial ramifications of NFTs when viewed as investment vehicles, the past year has also seen the emergence of NFTs being held for other reasons, namely artistic. With their genesis in the art world, NFTs have close ties to creative endeavors, many of which are conducted by organizations whose focus is on furthering public appreciation of art. In many ways, the index case is the gift of “CryptoPunk 5293” to the Institute of Contemporary Art in Miami (Associated Press, “Charitable Organizations Have Begun to Dabble in NFTs,” Dec. 29, 2021, https://on.mktw.net/3O2HpBg). Besides necessitating an assessment of value to initiate recognition of the contribution revenue and associated asset, a wider question comes from this development—if an NFT is held for public artistic benefit, is it accounted for as part of an organization’s collection? The question is a nontrivial one, because collection accounting rules permit non-recognition as an asset (see ASU 2019-03, Not-for-profit (Topic 958): Updating the Definition of Collections, 2019).
Although the similarities between NFTs and art (digital art in particular) suggest that an NFT held for artistic purposes by a museum can permit collection treatment and thereby bypass questions of valuation and impairment, the reality is more complicated and likely necessitates additional guidance. After all, collection accounting rules can only apply when the asset is “held for public exhibition, education, or research in furtherance of public service” (ASU 2019-03). The nature of an NFT is that it is distinct from the displayed art itself and is better viewed as a certificate of authenticity tied to the art. Traditional art is such that the item for display and that which makes it authentic are physically intertwined. For digital art, in contrast, the item on display and the NFT are typically distinct, so viewing an NFT as part of the exhibition (rather than the art itself) is difficult to justify. Which is to say—even art museums may face questions about the valuation and impairment of the NFTs tied to art they hold.
Tax Considerations for NFTs
Financial reporting is just one of many accounting considerations for NFT holders. Those who dabble in NFTs, whether they are individuals, part of a partnership, or acting in a corporate capacity, must also consider the tax implications. This is another arena in which the intent in holding the assets is critical. There are several implications directly related to taxes. The first step is identifying the relevant tax rates. Who engages in an NFT transaction, and why they do so, matters. NFT investors and traders must consider both ordinary income and capital gains rates; NFT creators and holders must also consider the collectible tax rate.
The collectible tax rate can be an unpleasant surprise for NFT creators and holders as well as an opportunity to proactively assess and plan. The IRS further highlighted the possibility of NFTs being taxed at 28% in a March 2023 notice, which indicated that certain NFTs are to be treated and taxed as collectibles (“The IRS Plans to Tax Some NFTs as Collectibles—and the Rich Would Pay up to 28% on Profits,” Greg Iacurci, March 22, 2023, https://tinyurl.com/x9d9vdbd). The classification of NFTs as collectibles ultimately depends upon the interpretation of IRC section 408(m)(2). Under this section, collectibles are defined as 1) any work of art, 2) any rug or antique, 3) any metal or gem, 4) any stamp or coin, 5) any alcoholic beverage, or 6) any other tangible personal property labeled as a collectible by the IRS. Though NFTs may conceptually be viewed as a type of collectible, the lack of specific identification by the IRS as such means their classification remains open to interpretation. Because NFTs seem to have found an initial stronghold in the art and digital collectible worlds, tax advisors should be prepared to take such a position and inform clients accordingly. On top of this, there might be additional investment taxes and state taxes levied on the proceeds from NFT transactions.
One other area that continues to produce questions is how the NFT is purchased. If one is able to purchase the NFT using U.S. dollars, the tax reporting and payment implications only take effect with regards to the NFT itself. If, however, the taxpayer has to pay for the NFT using ether (ETH, the cryptocurrency most often used in NFT sales) there may be a gain recognition linked to the purchase of the NFT if the fair market value of ETH increased since it was initially acquired by the taxpayer.
Regardless of the specifics of the NFT being assessed, and how one is involved, clients will be seeking advice from their CPAs as these cryptoassets continue to expand and develop.
There are several questions all CPAs should ask of clients who have, or intend to engage with, NFTs:
- ▪ How did the individual or institution obtain the NFT?
- ▪ Are there other conditions, such as royalty agreements, that need to be assessed and documented to correctly file and report tax items?
- ▪ Is there a definitive record of ownership and custody (i.e., is there a potential for multiple parties to claim ownership of the same NFT)?
- ▪ Does the taxpayer have accurate information connected to adjusted gross income (AGI), deductions, and itemizations that could influence the applicable tax rate?
- ▪ Are there appropriate reserves set aside to pay taxes due as a result of NFT acquisition, monetization, or trading activities?
Under its own current interpretations and guidance, although not yet formalized into the tax code (law), the IRS has deemed that every transaction involving crypto generates a tax reporting and potential tax liability event. Such an outlook has been confirmed in media commentary and press releases, and should be considered a best practice for tax preparers. This treatment pertains to decentralized cryptoassets, stablecoins, and other cryptoassets, but that is relatively old news, as is the 1040 reporting obligation for taxpayers involved in crypto transactions.
NFTs create unique and additional complications through rewards, royalties, and income streams. Specifically, the current consensus is that all staking rewards, block rewards, and other crypto-related earnings should be taxed as ordinary income, but this misses a rather obvious point. If the IRS classifies and treats all cryptoassets—including NFTs—as property, then why should any crypto-denominated royalties tied to them be taxed when earned? A parallel might be as follows: if a farmer owns an apple orchard and grows apples, those apples are only taxed when sold, not when picked. It could be argued that the exact same treatment should apply to all crypto-denominated income, including those NFTs that contain royalty components.
Even if clients are transparent about crypto-related activities, there are several additional questions that CPAs need to ask. Simply knowing that cryptoassets were used or owned by the client is not enough. A CPA must understand the specific nuances of each cryptoasset—including each NFT—that is owned or has been owned by an individual or institution during the preceding tax year. As crypto and NFTs become more complicated, the tax reporting and compliance conversations surely will evolve as well.
Planning Questions for NFTs
Beyond the core issues of taxation and reporting, there are a slew of other questions that CPAs should discuss with clients engaging in the space. The sidebar, Planning Questions for NFTs, can be used as a starting point for further analysis and discussion.
With such high levels of uncertainty and ambiguity still remaining with regards to NFT tax treatment and reporting there is a distinct opportunity for CPAs to provide clients with advice. Namely, in addition to conducting due diligence for practice management purposes, CPAs should be proactive in both helping clients understand potential tax obligations as well as what factors might be on the horizon.
Although CPAs may be tempted to dismiss NFTs because they are not yet a material item for most publicly traded corporations, this subset of the sector creates a unique set of accounting questions that will only become increasingly important as crypto expands. This article provides a springboard for further discussion and examination as CPAs engage with clients involved in the crypto space. Stated another way, NFTs are a fast-growing subset of a fast-moving asset class, with multiple implications for users, investors, and accounting professionals, and CPAs have an obligation and opportunity to provide trusted guidance in this evolving realm.