NFTs—or “nonfungible tokens”—are everywhere. What was once seen as a collectors’ item for crypto geeks and LeBron James TopShop fanatics is now gaining popularity with a much wider audience. Take the recent example of the elite wine maker Robert Mondavi and French porcelain house Bernardaud’s NFT, which would give wine aficionados one of 1,966 Limoges porcelain Magnum bottles. The very premise of the NFT appeals to a customer base largely made up of high-net-worth, potentially older-generation investors. Or consider the even more exclusive appeal of Quentin Tarantino’s seven NFTs, never-released scenes from his handwritten screenplay. Marketed as a new “asset class” and once-in-a-lifetime investment opportunity, the NFTs are expected to be sold for millions. Dare we say, NFTs are becoming mainstream.
As NFTs continue to gain popularity, one rising narrative is that NFTs will allow creatives to gain financial independence and bypass third-party producers and promoters. Indeed, it is with this in mind that artists like Snoop Dogg and John Legend recently announced the launch of proprietary NFT platforms, which will allow new and upcoming musicians to raise money from their fans by selling NFTs on their platforms and releasing blockchain-based songs on their “NFT” record labels.
Before launching headfirst into releasing an NFT, creatives should consider the risks involved in their participation. We outline a few of those considerations and risks below:
Tax
As with other digital assets like cryptocurrencies, NFTs are posing novel tax questions. The potential taxes that are due vary depending on whether the taxpayer is a creator, a buyer or a seller. When the NFT is initially minted, or created, and sold by the creator, the creator will pay income taxes on the revenue received from the sale. Because NFTs allow creators to potentially continue to earn revenue through secondary sales, any revenue that those sales generate will also be subject to income taxes. Buyers may also be subject to taxes when they purchase an NFT using cryptocurrency depending on any gains or losses on the cryptocurrency used to make the purchase from the date the buyer initially purchased or received the cryptocurrency.
Additionally, because NFTs are considered to be a form of property for tax purposes, sellers of NFTs incur capital gains or losses when the NFT is transferred or sold depending on the changes in value of the NFT from the date of purchase to the date of its disposal. The capital gains rate will depend on a few factors, including whether or not the NFT is considered to be a collectible, which are subject to a higher capital gains tax rate, and the length of time that the NFT is held, for example short-term versus long-term capital gains tax rates.
Classifying NFTs as a collectible versus a non-collectible is another area that is continuing to evolve as the different use cases for NFTs continues to grow. The IRS definition of a collectible includes works of art, antiques, metals, gems, stamps, alcoholic beverages and other personal property that the IRS determines to be a collectible under Section 408(m) of the Internal Revenue Code. NFTs that represent digital artwork or a Lebron James NBA Top Shot NFT will likely be classified as a collectable by the IRS. NFTs that represent ownership and tokenization of real-world assets, such as real estate or business ownership or goods for sale subject to a smart bill of lading, will likely fall under the standard capital gains tax rules for property. One example of tokenization of a real-world asset was the $18 million digital real estate token sale of Aspen Coins by Elevated Returns that tokenized ownership in the iconic St. Regis Aspen Resort in Colorado. By purchasing an Aspen Coin, investors were able to participate in indirect equity ownership of the hotel. As tokenization of real world assets grows, the potential lines between collectibles and other property may continue to blur.
Copyright/Trademark
The creation and sale of NFTs is also leading to novel issues regarding intellectual property.
Most NFTs are associated with works of authorship protected by copyright, such as digital artwork, music and other collectibles. It is important to note, however, that just like purchasing a tangible object, such as a painting or a vinyl record, purchasing an NFT does not automatically convey copyright in the underlying work to the purchaser. Unless the creator of the NFT conveys title to the underlying intellectual property rights in the NFT (which is the novel approach taken by the Bored Ape Yacht Club) or, at a minimum, conveyed certain license rights to the purchaser, the purchaser may not be able to further reproduce, publicly display, or create derivative works of the NFT. Significantly, this could even affect the right to re-sell the NFT.
Under the first sale doctrine, owners of tangible works can resell physical copies of copyrighted works even if they do not own the underlying copyright. Currently, however, copyright law contemplates no first sale doctrine for digital works. Accordingly, purchasers prepared to drop many thousands or millions of dollars on an NFT should be aware of what intellectual property rights they are actually acquiring—including the right to resell the NFT. On the other hand, NFT creators may gain a competitive advantage by conveying title to the underlying IP to purchasers. As a recent article discussing Bored Ape Yacht Club’s approach notes, “one [model] gives its owners the right to make use of the underlying material and one just lets them have something to look at.”
NFTs are also posing intellectual property headaches for rights-holders, such as artists and brand owners. NFT creators can easily copy physical or other digital artworks, giving them new life as an NFT. Of course, copying a work of art constitutes prima facie copyright infringement, but NFT creators appear to be banking on the likelihood that certain artists, such as Banksy, won’t enforce against the infringement. Due to the prospect of uncontrolled copyright infringement, some NFT platforms and auction sites are already introducing processes under the Digital Millennium Copyright Act to target and take down infringing and unauthorized NFTs. Brands, too, are hitting back at perceived infringement of their trademark rights. Recently, the storied brand Hermès filed a lawsuit against a digital artist for selling unauthorized Birkin Bag NFTs for as much as six-figure sums. Hermès claims these “MetaBirkins” infringe the brand’s famous Birkin trademark. It remains to be seen whether Hermès can prove the core element of a trademark infringement case—that the digital versions of the famous Birkin bag are causing consumer confusion. Other brands are sure to be watching this case closely, as well as considering whether they need to begin engaging in brand monitoring on NFT platforms and auction sites.
Money Laundering
Creatives should also make sure that the NFT that is being issued is perceived to have authentic value. The U.S. Treasury Department recently released a study on NFTs being a conduit to money laundering and criminal finance. NFT promoters should work with counsel to mitigate their risks of being perceived as facilitating money laundering. Contrary to popular belief, recording ownership on the blockchain can help deter criminal enterprise because transactions will be recorded and traceable.
Securities
We have written previously about the risk that certain NFT products would constitute “securities.” The SEC continues to make public comments about the risk of NFTs. The question then becomes what sort of potential liability could an issuer—e.g. the creative—take on for the NFT, even if they use a third party to run the promotion. The answer is quite a bit. If any individual receives the benefit or gross proceeds of an illegal, unregistered securities offering, they can be responsible for disgorgement as a “relief defendant.” To be clear, relief defendants are not necessarily alleged to have engaged in wrongdoing but instead to have benefited from illegal proceeds. Creatives considering releasing an NFT should engage securities counsel to ensure their NFT is not designed to appeal or market an investment value—and instead are advertised as a form of access or charitable support of an artist.
This document is intended to provide you with general information regarding the litigation risk of NFTs. The contents of this document are not intended to provide specific legal advice. If you have any questions about the contents of this document or if you need legal advice as to an issue, please contact the attorneys listed or your regular Brownstein Hyatt Farber Schreck, LLP attorney. This communication may be considered advertising in some jurisdictions. The information in this article is accurate as of the publication date. Because the law in this area is changing rapidly, and insights are not automatically updated, continued accuracy cannot be guaranteed.